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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, 1997

[   ] 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: (650)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. $11,094,930

The aggregate  market value of Common Stock,  $.01 par value per share,  held by
non-affiliates of the registrant was $18,018,715 on March 23, 1998 (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).  Shares of Common Stock held
by each  officer  and  director  and by each  person  who owns 5% or more of the
outstanding  common stock have been  excluded in that such persons may be deemed
to be affiliates.  This  determination  of  affiliate  status is not necessarily
a conclusive determination for other purposes.

On March 23, 1998, there were 24,082,714  shares of Common Stock, $.01 par value
per share, of the registrant outstanding.

                       Documents Incorporated by Reference
      Proxy Statement for the 1998 Annual Meeting of Stockholders Part III

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                                       2


                                    PART I

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

Item 1.  Description of Business

      Teknowledge  Corporation  (the "Company") is in the distributed  knowledge
management  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
government  and commercial  applications.  The Company's key business lines are:
Distributed Systems Engineering, Situation Assessment and Data Fusion, Education
& Training  Technologies,  C4I & Information  Security  Systems,  and Electronic
Commerce  ("E-Commerce")  Systems.  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.

      Teknowledge  is the surviving  corporation of the merger (the "Merger") of
American  Cimflex  Corporation  and  Teknowledge,  Inc., that was consummated in
1989.  Since the Merger,  the Company has  discontinued  or divested some of its
business  units,  and grown new lines of  business.  Ongoing  operations  of the
Company consist of a Corporate headquarters located in Palo Alto, California and
four distributed  engineering  offices located in San Diego,  California (1996),
Arlington,  Virginia  (1996),  Fairfax,  Virginia (1997),  and Orlando,  Florida
(1997).

      Teknowledge  is increasing its focus on commercial  software  products and
services,  particularly in the E-Commerce market; however, this transition takes
time. The current customer base for the Company's products and services consists
primarily of government related projects.  For the year ended December 31, 1997,
the Company's  direct revenue mix from continuing  operations was  approximately
99% government and 1% commercial  products and services.  The Company's business
is concentrated in the United States.

Overview

      The  information   economy  places  a  huge  competitive   premium  on  an
organization's ability to manage its knowledge effectively. Knowledge has become
the key  competitive  weapon in the marketplace  and the  battlespace.  However,
knowledge  acquired  by  people  often  does not get  reused  because  it is not
organized or distributed effectively.  Knowledge management systems are software
programs that enable  combinations  of people and computers to capture,  refine,
distribute,   and  apply  knowledge  to  solve  business  application  problems.
Teknowledge  develops  software   architectures  and  programs  which  integrate
conventional   software  and  knowledge   management   systems  in  distributed,
heterogeneous network applications. These architectures are embodied in products
and services that support integration, processing, and systematic utilization of
an organization's knowledge assets.

     Teknowledge   has  five  business   units.   Specifically,   Teknowledge's
Distributed Systems Engineering program provides the foundation for distributing
webs of  objects  that  contain  information  about an  application's  technical
content  and its  relationships  to  other  applications.  The Data  Fusion  and
Situation   Assessment   program  develops   software   algorithms  that  refine
information  from multiple sources into a coherent body of knowledge that can be
acted  upon.  The  Education  and  Training  Technologies  program  encapsulates
knowledge  into  reusable  media,   develops  intelligent  tutoring  systems  to
communicate that knowledge,  and distributes the tutoring systems over the World
Wide  Web.  The  C4I  and  Information   Security  Systems  program  focuses  on
architectures  and  software  that  protect the  information  stored in computer
networks, and utilize the knowledge to make timely decisions,  and execute plans
effectively. Finally,  Teknowledge's E-Commerce  Systems  business unit provides
commercial software  products and services that enable  corporations  to  manage
their sales knowledge,   and  sell  products   effectively   over  the Internet.
Each  of Teknowledge's  business  units  provides  essential  components  of  an
integrated knowledge management solution.

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      Computer software  applications provide maximum value when integrated into
networked  operations,  both within and among 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 network  protocols  across many different types
of computers.  The Company's  products and services are designed to maximize the
value of integrating, distributing and activating application knowledge.

      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 software to make it possible to delegate  knowledge-intensive tasks to
network-enabled computer software associate systems. These associate systems may
accomplish routine tasks as well as accelerate knowledge gathering,  refinement,
dissemination,  and utilization over computer networks.  Teknowledge's strategic
plans include  commercializing  associate  systems software that amplifies human
productivity  and the ability to manage knowledge  effectively.  Teknowledge has
built six associate systems and commercialized  one. These systems include:  the
Briefing Associate, the Parent's Associate, the Student's Associate, the Project
Center Associate, the Desktop Associate, and the commercial Sales Associate(TM).

Operations

      Teknowledge has distributed  operations,  with its headquarters located in
Palo Alto, California and offices in San Diego, California, Orlando,Florida, and
Arlington and Fairfax,  Virginia.  The Company continues to expand its technical
staff in accord with the mix of skills  needed in each  office.  The Company has
five business areas that represent interrelated, but distinct lines of business,
as discussed below.

      Distributed Systems Engineering

      Operations that are widely distributed  require extensive  object-oriented
systems  infrastructure.  Currently,  the World Wide Web provides little of this
systems  infrastructure,  but instead relies on the  distribution  of multimedia
documents.  In the future, complex webs of objects and knowledge will have to be
distributed systematically and dynamically updated. This requires the ability to
provide  reliable quality of service,  security of operations,  maintainability,
and distribution by intelligent "push" and "pull" techniques.  In addition,  the
types and  quantity of  knowledge  distributed  will require new designs and new
software,  specialized for specific  knowledge  processing tasks.  Teknowledge's
Distributed  Systems  Engineering  program  focuses on providing next generation
systems infrastructure.

      Situation Assessment and Data Fusion

      Complex  problem  solving  in  emergencies  and  international   conflicts
requires  the ability to quickly and  effectively  access and combine  data from
multiple  sources  in order 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 includes the Defense  Advanced  Research
Projects Agency ("DARPA")  sponsored  HIBURST project that focuses on the design
and  implementation  of  high  performance  information  bases  using  real-time
scaleable technology in time critical applications. This program is developing a
situation  server,  which  combines  data from  multiple  sources,  and  detects
patterns or conditions of interest to a customer.  These  conditions may in turn
trigger alerts or actions to respond to a situation quickly and effectively.

      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

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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 1997 it created a program  devoted
entirely to this growing opportunity.  Teknowledge 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 Computer  Assisted  Education and
Training Initiative sponsored  Teknowledge's work on Parents Associate 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 now  leading  the  Business  and  Marketing  Group  of  the  new
Government  sponsored Advanced Distance Learning  Initiative,  which is actively
developing  distance  learning  technology to provide cost effective  industrial
strength courseware over the Internet.

      C4I and  Information Security Systems

      Teknowledge's Command, Control, Communications, Computer, and Intelligence
("C4I")  program  has  focused on the 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. C4I
systems uses all of the available information provided by web servers, situation
servers,   and  other  specialized   servers.  The  resulting  digital  planning
application 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.

      The new focus of this program is in  information  security  systems  which
protect information stored in computers or distributed over networks.  This is a
critical,  high priority  application area that requires the technical resources
Teknowledge  possesses.  The need for information security solutions has created
tremendous  demand  in  both  government  and  industry,   including  E-Commerce
applications.

      E-Commerce Systems

      Electronic  Commerce is the conduct of business  operations  over computer
networks. It is an obvious commercial target for knowledge management technology
and  product  development.   Teknowledge  began  focusing  a  business  unit  on
commercial sales knowledge  management in 1997. The E-Commerce  Systems business
unit  provides  assessments  of corporate  E-Commerce  strategy and  technology,
services  to  support  leading   E-Commerce   products,   and  installations  of
Teknowledge's own Sales Associate(TM) software.

      The Sales  Associate(TM)  is a commercial  software product which provides
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(TM) creates a unique profile of every
customer and specializes the sales presentation to each prospect.  It learns and
remembers a  customer's  profile  and  preferences,  and  applies all  available
information towards the next sale. The system can cater its visual form to match
the user's profile,  selecting among web text, audio, or 3D graphics.  The Sales
Associate(TM)  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
third-party  electronic credit or digital cash.  Customer  fulfillment comes via
third-party express mail service or local delivery.

      The Sales Associate(TM) is a new product in a relatively new market. There
are uncertainties and risks associated with the introduction of any new software

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product;  (see Part II Item 6.  Management's  Discussion  & Analysis  or Plan of
Operation - Certain Factors That May Affect Future Results of Operations  and/or
Stock Price) however,  Teknowledge  has continued to evolve Sales  Associate(TM)
capabilities,  and is committed to making the product a commercial success.

      Teknowledge has also developed  custom  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  developed by  Teknowledge  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.

Sales and Marketing

      Teknowledge's   services  and  software  are  marketed  primarily  by  the
Company's employees,  including the Chief Executive Officer, the President,  and
five experienced business unit managers supported by senior technical engineers.
Each  business unit offers  consulting  services to help  prospective  customers
define their  problems  and  projects.  Government  proposal  work  conducted in
response to a Broad Area  Announcement  or Request for Proposal is typically not
funded. However, consulting assignments are funded to evaluate current corporate
E-Commerce  capabilities,  and to recommend  next steps,  including  application
work.

      The Company has increased its  commercial  sales and marketing  efforts to
lay the foundation for increased commercial  business.  In 1998, the Company has
begun implementation of a new strategy to win potential customers. This strategy
includes  earning  Value Added  Reseller  (VAR) and premier  certified  solution
provider  status from market  leaders such as IBM,  Microsoft,  and Oracle.  The
Company  is  targeting  value-added  services  squarely  in  the  center  of the
commercial  marketplace  to broaden the appeal and reduce the risk to  potential
customers.  Teknowledge  is  positioning  its products to integrate with and add
value to the large number of services and products third-parties develop for the
Internet market.

      Teknowledge  has  launched a public  relations  program to ensure  greater
awareness  of the Company in a broader  base of  customers,  industry  analysts,
market makers, stock brokers, and the general public.

Backlog

      At December 31, 1997,  the expected  order backlog was  approximately  $25
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, 1997 backlog is from government customers. Approximately 84% 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 Part II 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
48%.

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

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Research and Development

      Almost all of the Company's  operations except for the E-Commerce business
unit were related to advanced government  development projects. As a result, the
Company's  R&D  activities   were  mostly  funded   externally  by  the  Federal
Government.  Generally,  the Company  retains the exclusive  right to market the
government  sponsored R&D commercially.  From time to time the Company funds its
own R&D, mostly in the form of  commercializing  the technology  developed under
its  government  contracts.  As the  Company  continues  to grow the  commercial
products and services  business,  more  internally-funded  R&D is expected.  The
Company  expensed  $206,603  and $0 of its own funds on R&D for the years  ended
December 31, 1997 and 1996, respectively.

      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 $10,712 and $59,485 for the periods ended December 31, 1997 and 1996,
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,  Selectica,   Brightware,  Baan,  SAP,  Oracle  and  others.
Knowledge  management  systems are provided by Carnegie Group,  Inference Corp.,
Neuron Data Corp.,  Intellicorp,  Inc.,  and Trinzic Corp.  Distributed  systems
engineering,  data fusion, and C4I & Information  Security services are provided
by GTE, Trusted Information  Systems,  Lockheed-Martin,  Boeing,  Perceptronics,
ISX, and SAIC,  among  others.  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

      Teknowledge   maintains  an  active  intellectual  property  program,  and
currently holds eight U.S. software patents.  The application software developed
by Teknowledge includes the Sales Associate(TM) for configuring  automated sales
on the Internet,  knowledge-based  expert  systems,  pattern  detection and data
fusion tools,  and systems to manage and protect webs of networked  information.
Sales  Associate(TM) is a trademark of the Company. The COPERNICUS(TM) trademark
is 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.

      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.

      There can be no assurance that the Company's  protective  measures will be
adequate to protect  its  proprietary  rights,  that others have not or will not
independently develop or acquire equivalent or superior technology,  or that the
Company  will not be  required to obtain  royalty-bearing  licenses to use other
intellectual  property  in order  to  utilize  the  inventions  embodied  in its
patents. There also can be no assurance that any patents will be issued pursuant
to the Company's  current or future patent  applications  or that patents issued
pursuant to such applications or any patents the Company currently owns will not
be invalidated,  circumvented or challenged.  From time to time, the Company may
be notified that it may be  infringing  patents or  proprietary  rights owned by
third parties. There can be no assurance that the Company would be able to enter
into an acceptable  license under such third party patent or proprietary  rights
or redesign or modify its products and processes to avoid  infringement  of such
patent  or  proprietary  rights,  or that  the  Company  could  otherwise  avoid
infringement of such patent or proprietary  rights.  In the event the Company is
unable to take such action,  its  business,  financial  condition and results of
operations could be materially and adversely affected. Additionally,  litigation
may be necessary to protect the Company's proprietary rights.

Government Contracts

      In 1997,  approximately 99% of the Company's  revenues were from cost-type
government  contracts,  and  100% of its  December  31,  1997  backlog  was from
government contracts.  The Company's business has been 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. The portion of the Company's  revenues  attributed to government
business  has risen from 98% in 1996 to 99% in 1997.  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
relatively  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  beyond what is permitted in the  government  regulations.  In addition,
Federal  Acquisition  Regulations  exclude from reimbursement some "unallowable"
expenses   which  the  Company   considers  a  regular  part  of  the  business.
Furthermore,  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.
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                                       8



      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  contracts during the year.
Excluded from these rates, and not subject to  reimbursement,  are certain costs
(approximately 3% of total costs in 1997) which are proscribed 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  reduces  the  amount  of
compensation and 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  a  potential   increase  in  the   expenses   not  eligible  for
reimbursement,  combine to  restrict  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 a candidate
for software product  commercialization.  This helps the government amortize the
considerable  cost  of  maintenance,   and  it  provides  Teknowledge  with  the
opportunity to compete in a growing commercial marketplace.

Employees

      Including contract  engineers and temporaries,  the Company had a total of
71 full time  employees at December 31, 1997. 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  any  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,  under a lease for a period of three years commencing April 5,
1996, with an option to extend the lease for an additional  three years when the
lease expires.  The Company has also signed renewable leases for office space in
Arlington and Fairfax,  Virginia,  San Diego,  California and Orlando,  Florida.
Although  there is  sufficient  space to  accommodate  new employees in the near
term,  the Company will  contemplate  acquiring  additional  office space in the
future as it approaches full capacity.

      In January 1994, the Company entered into a settlement  agreement with the
landlord for its 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,  1997,  a total of $77,328 in payments  have been
made and the remaining  liability was included in "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 $18,305 by the Company
per annum  until 1998.  There has been no such rent  assessment  to date.  As of

<PAGE>
                                       9



December  31,  1997,  a future  possible  assessment  of $18,305 was included in
"Current liabilities - Other" (see Part II Item 7. Financial Statements).

Item 3.  Legal Proceedings

      On  May  15,  1997,  the  Company  and  Trilogy  Development  Group,  Inc.
("Trilogy") agreed to a settlement of all outstanding lawsuits and debts between
the companies.  Pursuant  to the  Settlement Agreement,  License Agreement, and
Mutual Release, the  Company  immediately  granted  to Trilogy a  non-exclusive,
royalty-free license to the Company's United States Patent 4,591,983 in exchange
for 2,338,969 shares of Company stock owned by Trilogy, which the Company valued
at  $1,006,000,  and  $400,000 in cash.  The  Agreement  also  provided  for the
transfer  of  certain  proxy  rights to the  Company  and  other  consideration,
including  the orderly  disposal  of  Trilogy's  remaining  stock  ownership  of
approximately 900,000 shares in open market transactions through May 14, 1998.

      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, interest,  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.  Management
believes  the ultimate  resolution  of the above matter 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 1997.



<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 23, 1998 the listed closing "bid" price of the stock was
$.84 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.

                 1997                             High            Low

   First quarter, ended March 31, 1997           $ .59          $ .38
   Second quarter, ended June 30, 1997             .68            .38
   Third quarter, ended September 30, 1997         .51            .43
   Fourth quarter, ended December 31, 1997         .65            .43


                 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

      As of December 31,1997 there were 1,900 holders of record of Common Stock
of the Company.




<PAGE>
                                       11





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

Overview of Significant Matters

      Forward  looking  statements  made in this section relate to recruiting of
additional  employees,  expected growth and revenues,  realizability of backlog,
competition for expected new government contracts,  development and announcement
of commercial products,  and deferred tax assets. 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, 1997
                            Quarterly Results Summary
                    (in thousands except for per share data)

                               First     Second     Third     Fourth     Total
Revenues                      $1,805     $2,482    $3,367     $3,441   $11,095
Costs and Expenses             1,690      2,457     3,045      3,249    10,441
Other and Tax Benefit/Provision   10      1,130        50        916     2,106
Net Income                       125      1,155       372      1,108     2,760
Net Income per share             .00        .04       .01        .04       .10

      Teknowledge's  revenues for the year ended  December 31, 1997 increased to
$11,094,930, a 55% improvement over 1996. 99% and 98% of the revenue in 1997 and
1996, respectively, were from agencies of the Federal government. Revenue growth
was fueled by new contract awards totaling $17.5M, which increased total backlog
from $18.5M at December 31, 1996, to approximately $25M at December 31, 1997. To
meet the demands of the new contracts,  the Company grew its total  workforce by
45% to over 70 employees,  despite  competition  for technical  personnel in the
Silicon Valley labor market. The growth of the workforce in 1998 is likely to be
modest compared to 1997 as the Company  approaches  targeted  staffing levels on
existing projects. This situation could change, however, if the Company wins new
contracts  currently  under  consideration  by the  government.  There can be no
assurance  that the Company will be able to attract and retain the key technical
personnel needed to perform the contracts.

      During  the second  quarter  of 1997,  the  Company  reached  an  amicable
settlement with Trilogy in Federal court. As a result,  approximately $1,146,000
of income was  recorded  during  the second  quarter of 1997 (see Part 1 Item 3.
Legal Proceedings). This additional income contributed $.04 diluted earnings per
share in 1997.

      The  Company  recorded  a  deferred  tax asset of  $900,000  in the fourth
quarter of 1997, after evaluating the Company's profitable results over the last
three years and the prospects for improvements in the future. Recognition of the
deferred  tax asset  contributed  $.03 diluted  earnings per share in 1997.  The
Company's  net  operating   loss   carryforwards,   subject  to  certain  annual
expirations,  can be utilized until the year 2009.  The amount  recorded in 1997
represents only a fraction of the potential tax savings which may be realized in
subsequent years (see Note 6. Tax Loss Carryforwards). Additional amounts may be
recorded  for  estimated  reductions  in tax  liabilities  pertaining  to future
periods if the Company  continues  to maintain  its  profitability  and positive
outlook.  Likewise, an unfavorable future event may require an adjustment in the
amount of the tax asset, with a negative effect on income.

      Net  income  for  the  year  improved  310%  over  the  previous  year  to
$2,759,654,  or $.10 diluted  earnings per share.  Net income before the Trilogy
settlement  and  recognition  of the  deferred tax asset was  $713,825,  or $.02
diluted earnings per share. 88% of this income is from government  sources.  The
government has approved an increase in the allowable  compensation limit used in
the computation of government overhead rates in 1998. This change is expected to
have a positive effect on income in 1998.


<PAGE>
                                       12



      Generally, product sales were below expectations in 1997. Breaking through
Internet fire walls proved harder than  expected and  potential  customers  were
reluctant  to invest in a new  product  offered  by an  emerging  company.  As a
result,  the Company has fortified and  restructured  its product sales team and
adopted  a new  marketing  strategy  as  discussed  in Part I Item 1.  Sales and
Marketing.

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.  To mitigate this
risk, five senior program  managers have been hired in recent years. The Company
relies  on  its  executives  and  program   managers  for  the  acquisition  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 the Company,  and that it is in an  excellent  position to
convert  software  developed under  government R&D contracts into new commercial
products.  The market for Internet  software,  however,  is at an early stage of
development,  rapidly  evolving,  and  characterized by an increasing  number of
market  entrants  who  have  introduced  or are  developing  competing  software
products and services.  As is typical for a new and rapidly  evolving  industry,
demand and market acceptance for recently  introduced  products and services are
subject  to a high  level  of  uncertainty.  Further,  aspects  of the  Internet
(including security, reliability, cost, ease of use and quality of services) are
undergoing  rapid evolution that may affect growth of the use of the Internet in
general and of Internet software in particular. The demand for Internet software
will  require  broad  acceptance  of new  methods  of  conducting  business  and
exchanging information over the Internet. It is not known how soon, if ever, the
demand for Internet  software will become  sufficient to sustain a viable market
for the products developed by the Company. Even if a market develops,  there can
be no  assurance  that the  Company  will be able to develop and bring to market
products which will gain market  acceptance or generate  significant  revenue or
profits.  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. If the Internet E-Commerce develops more
slowly than expected,  becomes saturated with  competitors,  or if the Company's
products for the Internet market do not achieve market acceptance, the Company's
business,  financial  condition,  and results of operation may be materially and
adversely affected.

      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 government intervention.

Year 2000

      The Company is aware of the issues associated with the programming code in
existing  computer systems as the millennium ("year 2000")  approaches.  The key
issue  is  whether  computer  systems  will  properly  recognize  date-sensitive
information  when the year  changes to 2000.  All of the  hardware  and software
currently in use at the Company are relatively new and year 2000  compliant.  No
significant  reprogramming  efforts and year 2000 compliance expenses inside the
Company are expected to be necessary.


<PAGE>
                                       13


Results of Operations

      1997 compared to 1996

      Revenues rose $3,936,167,  or 55%, to $11,094,930 in 1997, from $7,158,763
in 1996.  During  1997,  the Company was  successful  in winning a number of new
contracts from the  government.  In order to meet the new project  requirements,
the Company  accelerated  its recruiting  efforts and grew its workforce by 45%.
There  was  also  a  corresponding  increase  in  subcontractor  and  consultant
engagements,  as the Company often teamed with subcontractors on larger and more
complex  projects.  For the year ended  December  31,  1997,  subcontractor  and
consultant costs were $2,417,308,  as compared to $747,399 in 1996. The increase
in labor and  subcontractor  costs incurred by the Company in the performance of
the contracts are  reimbursed by the government and the results are reflected in
revenues.

      Cost of revenues  increased  67% from  $4,541,823 in 1996 to $7,575,634 in
1997. The increase was mostly attributable to the aforementioned growth in labor
and use of  subcontractors  and  consultants,  the costs of which  accounted for
nearly 70% of total cost of revenues in 1997. As a percentage of revenues,  cost
of revenues  rose from 63% in 1996 to 68% in 1997.  As the company  continued to
grow its technical staff on a relatively stable general and administrative base,
cost of revenues accounted for an increasingly  larger portion of total revenues
from its cost-plus-fixed fee contracts.

      General and  administrative  costs were  $2,122,499 and $2,054,698 in 1997
and 1996, respectively. Although the Company incurred increased expenses related
to  recruiting  and  bonuses as it grew,  there was an  offsetting  decrease  in
executive  stock  compensation  costs  and  legal  expenses  as a result  of the
settlement of the Trilogy litigation.  Overall, general and administrative costs
were  relatively  stable between years,  reflecting the Company's  conscientious
effort to control  administrative  costs as it grew.  General and administrative
costs decreased from 29% in 1996 to 19% in 1997 as a percentage of revenues.

      Sales and marketing costs increased almost five times from $95,961 in 1996
to $535,746  in 1997,  as the Company  built a team and  dedicated  increasingly
substantial  resources  to market  and sell  commercial  Internet  products  and
services.  The  Company's  sales  and  marketing  efforts  include  applications
engineering  and  technical  support,  as well as trade  shows,  demonstrations,
advertising  and other  traditional  marketing  activities.  The Company has not
recognized  any marked  revenues  from these efforts to date and there can be no
assurance these revenues will develop.

      The  Company  expended  $206,603 of its  internally  funded  research  and
development ("R&D") costs in 1997 and did not report measurable amounts in 1996.
Most  of the  Company  sponsored  R&D was  concentrated  in the  development  of
commercial products for the Internet. The development of commercial products for
the Internet has not achieved  significant revenues to date. The majority of the
Company's R&D efforts were funded externally  through  government  projects (and
recorded  as cost of  revenues),  which are  expected  to provide  the basis for
future commercial development opportunities.

      Interest  income was $83,229 in 1997 versus  $57,612 in 1996. The increase
was  primarily  due to increased  cash  balances  during the year.  Other income
increased  from  $173,131  to  $1,145,108  in 1997,  largely  as a result of the
settlement of a lawsuit with Trilogy  earlier in the year.  Income from the sale
of a product  line was  completed in 1996 and there was no income from this sale
in 1997.

      Net income in 1997 was  $2,759,654  versus  $672,374  in 1996.  Income per
share on a diluted basis was $.10 for 1997 and $.02 in 1996.



<PAGE>
                                       14




Inflation

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

Liquidity and Capital Resources

      As of December 31, 1997,  unused  sources of liquidity of the Company were
$2,172,235  in cash and cash  equivalents,  an  increase  of  $374,343  over the
previous  year.  The  Company  generated  cash  reserves  of  $863,887  from its
operating  activities  and  used  $500,426  for  computer  equipment  and  other
improvements.

      The Company  believes that the present level of cash and cash  equivalents
is adequate to service the liquidity  needs of the Company in 1998.  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  $1,500,000.  The  Company may borrow up to the lower of 60% of
the receivable base or $1,500,000 at a rate of one percent over Prime.  The line
is subject to certain  covenants and  maintenance  requirements  which have been
fulfilled.  The line  expires in June 1998 and is expected  to be  renewed.  The
Company did not utilize the credit line in 1997.

Item 7.  Financial Statements

     The response to this item is incorporated by reference in a separate
section of this report.  See Exhibits,  Financial  Statement  Schedules 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
Arrangements"  included in the definitive proxy statement for the Company's 1998
Annual Meeting of Stockholders (the "1998 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 and Other Matters" and "Proposal
1: Election of Directors - Directors  Compensation"  included in the 1998 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 1998 Annual Meeting
Proxy Statement.




<PAGE>
                                       15





Item 12. Certain Relationships and Related Transactions

        The information  required by Item 12 is incorporated herein by reference
to the section entitled "Certain  Relationships and Other Transactions" included
in the 1998 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

        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 (5)

   3.2       Amended and Restated Bylaws of Teknowledge Corporation (9)

   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)

  10.1       Teknowledge Corporation 1989 Stock Option Plan (7)

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

  10.3       Amended Employment Agreement, dated as of January 21, 1992, between
             Cimflex Teknowledge Corporation and Daniel R. Robusto (2)

  10.4       Settlement Agreement, General Release, and Waiver of Claims, dated
             November 21, 1992, between Daniel R. Robusto and Cimflex
             Teknowledge Corporation (3)

  10.5       Settlement Agreement, dated May 21, 1993, between Cimflex
             Teknowledge Corporation and Third Copley-Franklin Trust (4)

  10.6       Settlement Agreement, dated September 1, 1993, between Cimflex
             Teknowledge Corporation and Pittsburgh Great Southern Company (4)

  10.7       Change of Control Agreement, dated November 21, 1994, between
             Teknowledge Corporation and Frederick Hayes-Roth and Neil
             Jacobstein (6)

  23.1       Consent of Arthur Andersen LLP, independent public accountants

    27       Financial Data Schedule


<PAGE>
                                       16


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, 1991.

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

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

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

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

   (7) Filed as an Exhibit to the Company's  Annual  Report on Form 10-KSB,  for
       the fiscal year ended December  31, 1995.

   (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.

   (9) Filed as an Exhibit to the Company's  Quarterly Report on Form 10-QSB for
       the quarter ended March 31, 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.



<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 30, 1998                     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 30, 1998
---------------------------        of Directors and
Frederick Hayes-Roth               Chief Executive Officer
                                   (Principal Executive
                                   Officer)

/s/ Neil A. Jacobstein             President, Chief Operating    March 30, 1998
---------------------------        Officer and Director
Neil A. Jacobstein

/s/ Dennis A. Bugbee               Director of Finance,          March 30, 1998
---------------------------        Treasurer and Secretary
Dennis A. Bugbee                   (Principal Financial and
                                   Accounting Officer)

/s/ Lawrence Druffel               Director                      March 30, 1998
---------------------------
Lawrence Druffel

/s/ General Robert T. Marsh        Director                      March 30, 1998
---------------------------
General Robert T. Marsh

/s/ William G. Roth                Director                      March 30, 1998
---------------------------
William G. Roth

/s/ James C. Workman               Director                      March 30, 1998
---------------------------
James C. Workman




<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, 1997 AND FOR THE TWO YEARS ENDED DECEMBER 31, 1997

                             TEKNOWLEDGE CORPORATION

                              PALO ALTO, CALIFORNIA



<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, 1997                                21

Consolidated Statements of Operations - Years ended
December 31, 1997 and 1996                                                    22

Consolidated  Statements of Stockholders' Equity - Years ended
December 31, 1997 and 1996                                                    23

Consolidated Statements of Cash Flows - Years ended
December 31, 1997 and 1996                                                    24

Notes to Consolidated Financial Statements                               25 - 34






<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, 1997, and
the related consolidated statements of operations, stockholders' equity and cash
flows for the years ended December 31, 1997 and 1996. These financial statements
are the  responsibility of the Company's  management.  Our  responsibility is to
express an opinion on these financial statements based on our audits.

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

In our opinion,  the financial  statements  referred to above present fairly, in
all material  respects,  the financial  position of Teknowledge  Corporation and
subsidiary  as of December 31,  1997,  and the results of their  operations  and
their cash flows for the years ended  December  31, 1997 and 1996 in  conformity
with generally accepted accounting principles.



/s/ Arthur Andersen LLP



San Jose, California
February 11, 1998

<PAGE>
                                       21





                         TEKNOWLEDGE CORPORATION
                        CONSOLIDATED BALANCE SHEET
                         As of December 31, 1997

                                  ASSETS

Current assets:

    Cash and cash equivalents                                 $  2,172,235
                                                                -----------
    Receivables:
       Customer - billed, net of allowance of $10,000            1,949,476
       Customer - unbilled                                         339,277
                                                                -----------

           Total receivables                                     2,288,753
                                                                -----------

    Deferred tax asset, short-term                                 400,000
    Deposits and prepaid expenses                                   97,905
                                                                -----------

       Total current assets                                      4,958,893
                                                                -----------

Capitalized software development costs, net of accumulated
    amortization of $623,215                                        27,398
                                                                -----------

Fixed assets, at cost:
    Computer and other equipment                                 2,758,384
    Furniture and fixtures                                         103,909
    Leasehold improvements                                         829,904
                                                                -----------

                                                                 3,692,197
    Less accumulated depreciation and amortization              (3,093,603)
                                                                -----------

       Net fixed assets                                            598,594
                                                                -----------

Deferred tax asset, long-term                                      500,000
                                                                -----------

Total assets                                                  $  6,084,885
                                                                ===========

                   LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
    Accounts payable                                          $    702,898
    Payroll and related liabilities                                744,934
    Other accrued liabilities                                      477,012
                                                                -----------

       Total current liabilities                                 1,924,844
                                                                -----------

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 and outstanding 23,982,714 shares            239,823
    Additional paid-in capital                                   1,217,055
    Retained earnings since January 1, 1993
       (following quasi-reorganization)                          2,703,163
                                                                -----------

       Total stockholders' equity                                4,160,041
                                                                -----------

Total liabilities and stockholders' equity                    $  6,084,885
                                                                ===========

The  accompanying  notes are an integral  part of these  consolidated  financial
statements.
<PAGE>
                                       22


                           TEKNOWLEDGE CORPORATION
                    CONSOLIDATED STATEMENTS OF OPERATIONS


                                                      Years Ended December 31,
                                                      ------------------------
                                                         1997            1996
                                                         ----            ----

Revenues                                       $   11,094,930  $    7,158,763
                                                 -------------   -------------

Costs and expenses:
  Cost of revenues                                  7,575,634       4,541,823
  General and administrative                        2,122,499       2,054,698
  Sales and marketing                                 535,746          95,961
  Research and development                            206,603               -
                                                 -------------   -------------

   Total costs and expenses                        10,440,482       6,692,482
                                                 -------------   -------------

   Operating income                                   654,448         466,281

Interest income                                        83,229          57,612
Other income and expense, net (Note 10)             1,145,108         173,131
                                                 -------------   -------------

Income before tax                                   1,882,785         697,024
Provision (Benefit) for income tax                   (876,869)         24,650
                                                 -------------   -------------

Net income                                     $    2,759,654  $      672,374
                                                 =============   =============

Net income per share:

                     - Basic                   $         0.11  $         0.03
                                                 =============   =============

                     - Diluted                 $         0.10  $         0.02
                                                 =============   =============

Shares used in computing net income per share:

                     - Basic                       24,714,501      26,010,743
                                                 =============   =============

                     - Diluted                     28,878,933      30,275,473
                                                 =============   =============





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

<PAGE>
                                       23


<TABLE>

                             TEKNOWLEDGE CORPORATION
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<CAPTION>

                                       Common Stock                                        Retained
                                   ----------------------   Additional                     Earnings
                                    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, 1996          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

Exercise of stock options             248,913       2,490        16,078              -              -              -        18,568

Net income                                  -           -             -              -      2,759,654              -     2,759,654

Reversal of portions of
   provisions made prior to
   quasi-reorganization for
   restructuring reserve                    -           -       193,306              -              -              -       193,306

Company stock from
   Trilogy settlement                       -           -             -              -              -     (1,005,757)   (1,005,757)

Retirement of treasury stock       (2,362,969)    (23,630)     (985,127)             -              -      1,008,757             -
                                 -------------  ----------  ------------  -------------  -------------   ------------  ------------

Balance, December 31, 1997         23,982,714 $   239,823 $   1,217,055 $            - $    2,703,163  $           - $   4,160,041
                                 =============  ==========  ============  =============  =============   ============  ============



The  accompanying  notes are an integral  part of these consolidated financial statements.
</TABLE>
<PAGE>
                                       24



                           TEKNOWLEDGE CORPORATION
                    CONSOLIDATED STATEMENTS OF CASH FLOWS


                                                      Years Ended December 31,
                                                      ------------------------
                                                            1997          1996
                                                            ----          ----
Cash flows from operating activities:
  Net income                                        $  2,759,654   $   672,374
  Adjustments to reconcile net income to net cash
  provided by operating activities:
   Depreciation and amortization                         326,805       296,590
   Noncash portion of other income from Trilogy
    settlement                                        (1,005,757)            -
   Stock compensation expense                                  -       120,173
   (Gain) Loss on sales of equipment                         729          (100)
   Changes in assets and liabilities:
    Receivables                                         (999,350)       65,975
    Deposits and prepaid expenses                        (36,453)       (4,748)
    Deferred tax asset                                  (900,000)            -
    Accounts payable                                     493,136        28,255
    Accrued liabilities                                  225,123       (29,543)
                                                    -------------  ------------

   Net cash provided by operating activities             863,887     1,148,976
                                                    -------------  ------------

Cash flows from investing activities:
  Capitalization of software development costs           (10,712)      (59,485)
  Purchase of fixed assets                              (500,426)     (258,328)
  Proceeds from sale of equipment                          3,026           100
                                                    -------------  ------------

   Net cash used for investing activities               (508,112)     (317,713)
                                                    -------------  ------------

Cash flows from financing activities:
  Proceeds from issuance of common stock                  18,568         7,504
  Payments of capital lease obligations                        -        (3,599)
                                                    -------------  ------------

   Net cash provided by financing activities              18,568         3,905
                                                    -------------  ------------

Net increase in cash and cash equivalents                374,343       835,168

Cash and cash equivalents at beginning of year         1,797,892       962,724
                                                    -------------  ------------

Cash and cash equivalents at end of year            $  2,172,235   $ 1,797,892
                                                    =============  ============



The  accompanying  notes are an integral  part of these  consolidated  financial
statements.
<PAGE>
                                       25



                           TEKNOWLEDGE CORPORATION

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                              DECEMBER 31, 1997




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,  1997,  there  remained  approximately  $73,000  of  accrued
      liabilities for  discontinued  operations and  restructuring  obligations,
      which are scheduled to be paid in 1998.

            The Company is in the  distributed  knowledge  management  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 primarily
      government and commercial  applications.  The Company's key business lines
      are:  Distributed  Systems  Engineering,  Situation  Assessment  and  Data
      Fusion,  Education & Training  Technologies,  C4I and Information Security
      Systems,  and  E-Commerce.  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  to  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, and
      capital and financing needs.

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.
<PAGE>
                                       26


2.    Summary of Significant Accounting Policies (cont'd)

            For certain income statement amounts,  prior year balances have been
      reclassified to conform to the current year presentation.

      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, 1997,  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 Development Costs

          Teknowledge  capitalizes  software development costs starting from the
      point technological  feasibility is determined  and  continuing  until the
      general availability  of the  product.  During  1997  and  1996,  software
      development  costs of $10,712 and $59,485 were  capitalized, respectively.
      Amortization costs were $83,408 in 1997 and $114,458 in 1996.

          The Company's policy is to amortize  capitalized  software development
      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.

<PAGE>
                                       27



2.    Summary of Significant Accounting Policies (cont'd)

      Fixed Assets

            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  under which 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.

          In 1997,  approximately 99% of the Company's  revenues were recorded
      in  connection  with  U.S.  Government   contracts,   principally  of  the
      cost-plus-fixed-fee  type. These contracts are predominantly funded by the
      Defense  Advanced  Research  Projects  Agency and  administered by various
      government agencies.  In 1996 cost-type  government contracts  represented
      approximately 98% of the revenues.

          For the year ended December 31, 1997,  the Naval Command,  Control and
     Ocean  Surveillance  Center ("NCCOSC") was the sponsor of the Company's two
     largest  government  contracts,  accounting for  approximately 23% of total
     revenues.  This  percentage  represents a reduction from 1996,  when NCCOSC
     sponsored the Company's three largest government contracts, which accounted
     for approximately 85% of the Company's revenues in that year. For 1997, the
     third  largest  government  contract,  which  contributed  9%  of  total
     revenues, was sponsored by Rome Laboratories.

     (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.



<PAGE>
                                       28



2.    Summary of Significant Accounting Policies (cont'd)

      Net Income Per Share

            Net income per share is calculated in accordance with the provisions
      of Statement of Financial  Accounting  Standards  (SFAS) No. 128 "Earnings
      per Share", adopted by the Company in the fourth quarter of 1997. SFAS No.
      128 requires  companies to compute  earnings per share under two different
      methods  (basic and  diluted).  Basic  earnings per share is calculated by
      dividing net income (loss) by the weighted  average shares of common stock
      outstanding during the period. Diluted earnings per share is calculated by
      dividing net income (loss) by the weighted  average  shares of outstanding
      common stock and common stock equivalents during the period.  Common stock
      equivalents included in the diluted calculation consist of dilutive shares
      issuable  upon the  exercise of  outstanding  common stock  options.  As a
      result,  the 1996 earnings per share amount has been restated.  The effect
      of this accounting  change on previously  reported earnings per share data
      was as follows:
                                                              1996
                                                              ----
            Earnings per share as previously reported        $0.02
            Effect of SFAS No. 128                            0.01
                                                             -----
            Basic earnings per share                         $0.03
                                                             =====

            A summary of the earnings per share  calculation for each of the two
      years ended December 31, 1997 and 1996 is as follows (in thousands, except
      per share amounts):

                                                            1997      1996
                                                            ----      ----
            Basic earnings per share:
               Net income                                 $2,760    $  672
               Weighted average common shares             24,715    26,011
                                                          ------    ------
            Basic earnings per share                      $ 0.11    $ 0.03
                                                          ======    ======

            Diluted earnings per share:
               Net income                                 $2,760     $ 672
                                                          ------    ------
               Weighted  average common  shares           24,715    26,011
               Weighted average common shares equivalent:
                  Options                                  4,164     4,264
                                                          ------    ------
               Diluted weighted average common shares     28,879    30,275
                                                          ------    ------
            Diluted earnings per share                    $ 0.10    $ 0.02
                                                          ======    ======

      SFAS 123 Accounting for Stock-Based Compensation

            Effective  January 1,  1997,  the  Company  adopted  the  disclosure
      provisions of SFAS No. 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. 25 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
      1997 and 1996 based on the fair value of the  options at the grant date as
      prescribed by SFAS 123.



<PAGE>
                                       29



2.    Summary of Significant Accounting Policies (cont'd)

      New Accounting Standards

            During 1997,  the  Financial  Accounting  Standards  Board  ("FASB")
      issued  SFAS No. 130  "Reporting  Comprehensive  Income"  and SFAS No. 131
      "Disclosures About Segments of an Enterprise and Related Information." The
      Company's adoption of these standards in the fourth quarter of 1997 has no
      effect on the Company's consolidated financial statements.

3.    Other Accrued Liabilities

            Other  Accrued  liabilities  as of December  31, 1997 consist of the
      following:

                   Legal reserve                            $ 184,134
                   Provision for contract charges             150,000
                   Restructuring reserve                       54,534
                   Provision for discontinued operations       18,305
                   Miscellaneous                               70,039
                                                            ---------
                                                            $ 477,012
                                                            =========

4.    Commitments

            Teknowledge  leases  its  facilities  and  certain  equipment  under
      operating  leases.  As of December 31, 1997, the Company had active leases
      in Palo Alto and San Diego, California,  Fairfax and Arlington,  Virginia,
      and Orlando,  Florida. The remaining obligations under these leases are as
      follows:
                                 Year Ending
                                 December 31,
                                 ------------
                   1998            $382,000
                   1999             212,000
                   2000             160,000
                   2001             126,000
                   2002              45,000
                                   --------
                                   $925,000
                                   ========

            Rent  expense for the years ended  December  31, 1997 and 1996
      totaled $421,655 and $326,720, respectively.

5.    Line of Credit

          The Company has a $1,500,000 unsecured line of credit agreement with a
     bank.  The line  expires on June 10, 1998 and can be extended  from year to
     year. The Company can borrow up to 60% of the eligible  receivables base or
     $1,500,000, whichever is lower. The maximum rate that may be charged is one
     percent  over  the  bank's  prime  rate.  The  agreement  includes  certain
     financial  reporting and disclosure  requirements  that were met during the
     year. The line was not utilized in 1997.


<PAGE>
                                       30



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:
                                                          1997     1996
                                                          ----     ----
      Provision at U.S. statutory rate                    34.0%    34.0%
      State income taxes, net of Federal benefit           6.1      6.1
      Permanent differences                                0.0      7.0
      Change in valuation allowance                      (86.7)   (43.6)
                                                         ------    -----
      Provision (benefit) for income taxes               (46.6)%   3.5%
                                                         ======    =====


            The  components of the net deferred  income tax asset as of December
      31, 1997 was as follows:

      Net operating loss carryforwards                         $27,701,153
      Cumulative temporary differences                             516,593
      Tax credit carryforwards                                   1,756,613
                                                               -----------
                                                                29,974,359
      Valuation allowance                                      (29,074,359)
                                                               -----------
      Net deferred income tax asset                            $   900,000
                                                               ===========

            The valuation allowance consists 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.

          At December 31, 1997, the Company had net operating loss carryforwards
     of  approximately  $81 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.

          Realization  of the net  deferred tax asset of $900,000 as of December
     31, 1997 is dependent on  generating  sufficient  taxable  income to offset
     future deduction of the related items. Although realization is not assured,
     management  believes it is more likely than not that the net  deferred  tax
     asset will be realized.  The amount of the  deferred  tax asset  considered
     realizable,  however,  could be  reduced in the near term if  estimates  of
     future taxable income are reduced.


<PAGE>
                                       31



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, 1998, the Board of Directors amended the Plan, and increased the
     Company  matching  provision  of eligible  wages from 3% to 4%. The Company
     matching  contribution vests at 20% a year over a five-year period.  During
     1997, the Company contributed $115,599 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,  that were determined and assessed by the Board of
      Directors  to a maximum of 100% of base  salary.  As of December 31, 1997,
      $249,137 in incentive  compensation  was accrued for these  executives and
      was included in Accrued Payroll & Related Liabilities.

9.    Stock-Based Compensation Plans

            The Company has two stock  option  plans.  The stock option plan for
      employees  is called the  Teknowledge  Corporation  1989 Stock Option Plan
      (the "1989  Plan") and the stock  option  plan for Directors is called the
      Teknowledge  Plan for  Non-Employee  Directors.  The Company  accounts for
      these plans 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:
                                                     1997          1996
                                                     ----          ----

      Net Income         As Reported            $2,759,654       $672,374
                         Pro Forma              $2,642,156       $575,043

      Diluted EPS        As Reported                  $.10          $.02
                         Pro Forma                    $.09          $.02

            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 for employees.The Company has granted options for 800,000 shares
      ($.38 - $.65 per share) and 459,022 shares ($.25 - $.86 per share) in 1997
      and 1996, respectively, and has reserved for issuance a total of 6,545,288
      shares  through  December  31, 1997.  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

<PAGE>
                                       32


9.    Stock-Based Compensation Plans (cont'd)

      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 starting the second  year  of  a  three-year
      term and expire  ten years  after the grant date.  The 1989  Stock  Option
      Plan is  scheduled  to expire at the end of 1998.

            The Company also 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.  60,000 shares were available for
      future  grant as of  December  31,  1997.  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 from the grant date.  Options to
      purchase a total of 165,000  shares were  outstanding  as of December  31,
      1997 at $.15 to $.86 per share and a  weighted  average of $.56 per share.
      Options  for  105,000  shares  at $.15 to $.86 per  share  and a  weighted
      average of $.55 per share were vested at December  31,  1997.  Options for
      25,000  shares were  exercised at a weighted  average price of $.21 during
      the year.

            A summary of the status of  the  Company's  stock  option  plans  as
      of December  31, 1997 and 1996, and  changes  during the years then ending
      is presented below:

                                         1997                   1996
                                  ------------------   -----------------------
                                             Wtd Avg                   Wtd Avg
                                     Shares Ex Price      Shares      Ex Price
                                  ------------------   -----------------------
       Outstanding at beg.of year 6,046,828    $.32      5,880,902        $.30
       Granted                      990,000     .48        459,022         .55
       Exercised                   (248,913)    .07       (173,096)        .04
       Forfeited                   (445,334)    .50       (120,000)        .17
                                  ------------------   -----------------------
       Outstanding at end of year 6,342,581     .35      6,046,828         .32
                                  ------------------   -----------------------
       Exercisable at end of year 5,586,705     .33      5,520,453         .31
       Weighted average fair value
       of options granted             $0.27                $0.39

            The following table summarizes information about stock options
      outstanding at December 31, 1997:
<PAGE>
                                       33


9.    Stock-Based Compensation Plans (cont'd)

                           Options Outstanding            Options Exercisable
                    -------------------------------     ------------------------
                                   Wtd Avg
         Range of        Number  Remaining                   Number
        Ex Prices   Outstanding  Plan Life  Wtd Avg        Exercisable   Wtd Avg
            ($'s)      12/31/97    (Years) Ex Price         12/31/97    Ex Price
      -----------   -------------------------------     ------------------------
        .01 - .03     4,051,164     6.5       $ .03       4,044,914      $ .03
        .04 - .99     1,498,938     7.9         .44         749,312        .37
       1.00 -3.53       792,479      .8        1.80         792,479       1.80
                    -------------                       -------------
        .01 -3.53     6,342,581     6.1         .35       5,586,705        .33
                    -------------                       -------------

            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  1997  and  1996,
      respectively;  risk-free  interest rates of 6.3 and 6.1 percent;  expected
      lives of 5.3 and 3.4  years;  expected  volatility  of 50% and  100%;  and
      expected dividend yield of 0%.

            As of December 31, 1997,  the  following  number of shares of Common
      Stock have been reserved for future issuance under both Plans:

      Teknowledge Corporation 1989 Stock Option Plan        6,545,288
      Stock Option Plan for Non-Employee Directors            225,000
                                                            ---------
                                                            6,770,288
                                                            =========

10.   Other Income and expense

            The composition of other income and expense is as follows:

                                                  1997      1996
                                                  ----      ----
      Income from sale of product line      $        -  $148,998
      Settlement of patent litigation, net   1,145,108         -
      Other                                          -    24,133
                                            ----------  --------
         Total                              $1,145,108  $173,131
                                            ==========  ========

          On May 15,  1997,  the  Company and Trilogy  Development  Group,  Inc.
     ("Trilogy")  agreed to a settlement of all  outstanding  lawsuits and debts
     between the companies.  The Settlement  Agreement,  License Agreement,  and
     Mutual Release  specifies that the Company  immediately  grant to Trilogy a
     non-exclusive,  royalty-free  license to the Company's United States Patent
     4,591,983  in  exchange  for  2,338,969  shares of Company  stock  owned by
     Trilogy,   with   a  fair  value  of  $1,006,000,   based  on  the  average
     trading stock price over six months preceding the settlement, and  $400,000
     in cash.  After the  provision  for  legal  fees of $260,000,  net proceeds
     of $1,145,000  were  reported as Other Income.

<PAGE>
                                       34
11.   Contingencies

      Litigation

            The  Company is  subject to legal  proceedings  and  claims,  either
      asserted or  unasserted,  which arise in the  ordinary  course of business
      from time to time.  While the outcome of these claims  cannot be predicted
      with certainty, management does not believe that the outcome of any of the
      pending 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 and (v) a lump sum severance
      payment equal to two times their most recent respective annual salaries.

      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.