**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**




**For
      the fiscal year ended December 31, 2006**




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




**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
                of Incorporation)*
            
            *(I.R.S.
                Employer Identification No.)*




**1800
      Embarcadero Road, Palo Alto, California 94303**


*(Address
      of principal executive offices, including zip code)*


Issuer’s
      telephone number, including area code: **(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, $0.01 Par Value**


**Series
      A Preferred Stock Purchase Rights**




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 the 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**




Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15(d) of the Exchange Act. ** ̈**




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act. Yes ** ̈** No **x**




State
      issuer’s revenues for its most recent fiscal year: $2,930,261




The
      aggregate market value of Common Stock, $0.01 par value per share, held by
      non-affiliates of the registrant was $1,054,233 on April 10, 2007 (based on
      the
      average bid and ask price per share of Common Stock on that date as reported
      by
      the Pink Sheets Electronic Quotations Service). 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
      December 31, 2006, there were 5,735,754 shares of Common Stock, $0.01 par value
      per share, of the registrant outstanding.




Documents
      Incorporated by Reference:


None.







1




**INDEX****PART
                I****Item
                1.**
            Description
                of Business
            3**Item
                2.**
            Description
                of Property
            8**Item
                3.**
            Legal
                Proceedings
            8**Item
                4.**
            Submission
                of Matters to a Vote of Security
                Holders
            9**PART
                II****Item
                5.**
            Market
                for Common Equity, Related Stockholder Matters and Small
                Business Purchases of Equity Securities
            9**Item
                6.**
            Management’s
                Discussion and Analysis of Financial Condition and
                Results of Operations
            10**Item
                7.**
            Financial
                Statements
            23**Item
                8.**
            Changes
                in and Disagreements with Accountants on Accounting and
                Financial Disclosure
            23**Item
                8A.**
            Controls
                and Procedures
            23**Item
                8B.**
            Other
                Information
            24**PART
                III****Item
                9.**
            Directors,
                Executive Officers, and Corporate Governance;
                Compliance with Section 16(a) of the Exchange Act
            24**Item
                10.**
            Executive
                Compensation
            26**Item
                11.**
            Security
                Ownership of Certain Beneficial Owners and Management
                and Related Stockholder Matters
            27**Item
                12.**
            Certain
                Relationships and Related Transactions, and Director
                Independence
            28**Item
                13.**
            Exhibits
            28**Item
                14.**
            Principal
                Accountant Fees and Services
            30**PART
                IV****Item
                15.**
            Financial
                Statement Schedules
            32-50**EXHIBITS**
            
            51-56**CERTIFICATIONS**
            57-60




2
 *Index*





PART
      I




**Item
      1.** **Description
      of Business**




**Forward
      Looking Statements**




*This
      Annual Report on Form 10-KSB, the exhibits hereto and the information
      incorporated by reference herein contain “forward looking statements” within the
      meaning of Section 27A of the Securities Act of 1933, as amended (the
“Securities Act”) and Section 21E of the Securities Exchange Act of 1934,
      as amended (the “Exchange Act”), and such forward looking statements involve
      risks and uncertainties. When used in this Annual Report, the words “expects,”
“anticipates,” “believes,” “plans,” “intends” and “estimates” and similar
      expressions are intended to identify forward looking statements. These forward
      looking statements include predictions regarding our future revenues and
      profits, income from settlement and patent licensing, customer concentration,
      customer buying patterns, research and development expenses, sales and marketing
      expenses, general and administrative expenses, litigation and legal fees, income
      tax provision and effective tax rate, realization of deferred tax assets,
      liquidity and sufficiency of existing cash, cash equivalents, and investments
      for near-term requirements, sufficiency of leased facilities, purchase
      commitments, product development and transitions, expansion and licensing of
      our
      patent portfolio, competition and competing technologies, and financial
      condition and results of operations as a result of recent accounting
      pronouncements. Such statements are subject to risks and uncertainties that
      could cause actual results to differ materially from those projected. These
      risks and uncertainties include those discussed below and those discussed in
      Item 6 under “Risk Factors” as well as others incorporated by reference herein.
      Teknowledge Corporation (the “Company,” “we,” or “Teknowledge”) undertakes no
      obligation to publicly release any revisions to these forward looking statements
      to reflect events or circumstances after the date this Annual Report is filed
      with the Securities and Exchange Commission or to reflect the occurrence of
      unanticipated events.*




Teknowledge
      Corporation (“the Company,” “we,” or “Teknowledge”) provides advanced software
      and services to transform data into customer value. The Company was founded
      more
      than 25 years ago as a software technology company with the vision of codifying
      and distributing knowledge via computers. The Company’s revenue is derived
      primarily from government-sponsored contract research and development,
      commercial Financial Solutions customers, and intellectual property licenses.
      Teknowledge was incorporated on July 8, 1981, under the laws of the State of
      Delaware. Teknowledge has technical operations offices located in Palo Alto,
      California and Marina Del Rey, California. Teknowledge’s business is currently
      concentrated in the United States.




The
      Company’s website address is www.teknowledge.com. The Company’s filings with the
      Securities and Exchange Commission (“SEC”), including its Annual Reports on Form
      10-KSB, its Quarterly Reports on Form 10-QSB and its Current Reports on Form
      8-K, including amendments thereto, are made available as soon as is reasonably
      practical after such material is electronically filed with the SEC. These
      filings can be accessed free of charge at the SEC’s website at
      http://www.sec.gov, or by following the “SEC Reports” link provided in the
“Investor Relations” section of the Company’s website.




Teknowledge®
      is a trademark of Teknowledge Corporation. All other brand names, product names,
      trademarks and registered trademarks are the property of their respective
      holders.




The
      Company operates three reporting segments, Financial Solutions, Government
      Contract R&D, and Patents and Technology Licensing. Teknowledge’s direct
      revenue mix from operations for the year ended December 31, 2006, was
      approximately 34% Patents and Technology Licensing, 34% Financial Solutions
      and
      32% Government Contract R&D compared to 11% Patents and Technology
      Licensing, 50% Financial Solutions and 39% Government Contract R&D in 2005.
      Year-to-year revenues from Financial Solutions operations declined 51% from
      2005. There was a 40% decline in Government Contract R&D revenue due to
      contracts ending during the year that were not replaced by new contracts. Sales
      of Financial Solutions products provided 34% of commercial revenues in 2006
      and
      81% in 2005. In 2006, the remaining 34% of commercial revenue came from
      $1,000,000 of patent licenses.




In
      terms
      of our financial position at the end of 2006, Teknowledge has experienced a
      decrease in net income and cash, as well as a downturn in revenue compared
      to
      2005. The decreases can be largely attributed to the Company’s sale in 2005 of
      its TekPortal software assets to Intuit Inc., which created a cash infusion
      of
      $5,950,000 in that year. These funds were used to pay off the majority of the
      Company’s debts and improve its cash reserves. In 2006, the Company reported a
      net loss of $1,196,897, and a stockholders’ deficiency of $1,001,206. In 2005,
      the Company reported net income of $1,855,289 and stockholder’s equity of
      $187,475. Teknowledge ended 2006 with less cash in the bank, $771,112, a
      decrease of $1,397,396 from December 31, 2005. These numbers necessarily do
      not
      include the $1,050,000 which was escrowed for 18 months as part of the $7M
      sale
      of TekPortal to Intuit, Inc, and which was received in February of 2007. In
      addition, during 2006, Teknowledge invested $1,407,000 in internally sponsored
      R&D, including its new ActionWebTM product line. These numbers are discussed
      in more detail in Part II, Item 6: Results of Operations.





3
 *Index*




**Operating
      Segments**




**Financial
      Solutions.** Financial Solutions revenues for 2006 were down from the previous year (see
      Part
      II, Item 6: Results of Operations). Teknowledge transferred most of its
      TekPortal maintenance contracts during 2006, and in conjunction with Intuit
      personnel, is continuing to provide support services for some TekPortal banking
      customers. Teknowledge
      is now developing innovative knowledge-based software called ActionWebTM, and a
      team to provide hardware and software storage integration services to financial
      and other institutions. This may
      also provide opportunities for selling innovative software developed in
      Teknowledge’s Government Contract R&D segment.




**Government
      Contract R&D.** Teknowledge’s
      Government Contract R&D segment conducts contract research and development
      in complementary technical application areas. Teknowledge has been working
      for
      over two decades in software technology areas related to national security.
      Many
      of Teknowledge’s current R&D contracts are directly relevant to
      counterterrorism. The Company’s relationships with the relevant government
      agencies are well established. The Company is continuing to respond to new
      requests for defense and intelligence capabilities by various government
      agencies. Management believes that this work will contribute to solving key
      problems as well as help grow our revenues. In addition, it may provide
      significant new computer security and knowledge-based software that can be
      utilized commercially. For example, in 2004 Teknowledge won Phase I of a Defense
      Advanced Research Projects Agency (DARPA) sponsored Small Business Innovation
      Research (“SBIR”) contract to develop Deductive Spreadsheets that can add-in
      symbolic knowledge processing capabilities to commercial spreadsheets like
      Microsoft Excel®. Teknowledge received a $700,000 Phase II follow-on contract
      for Deductive Spreadsheets in the second quarter of 2006.




Technical
      personnel in the Government Contract R&D segment focus primarily on funded
      government research, although many have also done some development for the
      Company’s commercial operations. Teknowledge supports its research and
      development capabilities by writing proposals and winning contracts sponsored
      by
      DARPA Broad Area Announcements, Small Business Innovative Research programs,
      and
      a variety of government agencies. The contracts awarded provide Teknowledge
      with
      a deep source of technology for its own focused product development, patents,
      and licensing. In the last two years, the government has funded over $2.5
      million of contract R&D programs at Teknowledge. Technical personnel in the
      Government Contract R&D segment are organized into groups that support
      specific contracts and projects. The teams are interdependent in terms of
      infrastructure, talent, technology, and management incentives. Teknowledge’s
      Government Contract R&D segment may provide so called “dual-use” software to
      utilize software from the commercial segment, depending on the specific
      application needs of its customers. Whenever possible, the Company tries to
      develop dual-use software such as TekPortal and ActionWeb that have significant
      application in both the commercial and security and defense arenas. Teknowledge
      has also developed prototype software technology, such as Safe Software
      wrappers. This is working software that is more robust than a prototype, but
      less mature than a product. Rather than attempt to sell directly all of the
      software that it develops, Teknowledge has a program to license some of its
      software to larger companies that have additional marketing and sales resources.
      In 2006, Government Contract R&D revenue was concentrated with the
      Department of Defense (DOD). Teknowledge’s Government Contract R&D segment
      tends to propose projects in the four application areas described below.




Security
      Systems .
      The
      need for information security on computer networks and desktops has created
      demand for solutions in both government and industry. Keeping Internet sites,
      desktops, laptops, and transactions secure from hackers and identity thieves
      is
      critical to effective military and financial institution operations. Security
      systems go beyond simply protecting information. It is relatively easy to
      protect information if it is fully isolated and does not need to be readily
      accessible via networks. However, both military and financial information needs
      to be accessible by people globally, seven days a week, 24 hours a day. A key
      emerging area is information fusion for security, or aggregating text, photos,
      and other media from distributed web sites, organizing it into a coherent whole,
      and being able to make knowledge-based inferences from it. This application
      area
      shifts the focus from information protection to collecting, organizing, and
      providing security-related knowledge access to the appropriate customers. In
      addition, the techniques for accomplishing traditional computer security, such
      as authentication, encryption, and firewall protection are constantly evolving.
      Teknowledge has acted as the subcontractor or prime contractor on a number
      of
      DARPA and other government sponsored projects focused on advanced techniques
      for
      Internet or cyber security.




Training
      Systems . **** Most
      corporate and government training today occurs either in traditional classrooms,
      or over the Internet using an electronic version of books and classroom
      materials. However, the Internet and the World Wide Web have created an
      opportunity to distribute formerly isolated and more sophisticated
      computer-aided instruction that ran on desktop systems. Not only have the
      techniques of computer-aided instruction improved dramatically in recent years,
      but also the means to distribute them have undergone a veritable revolution.
      Now
      it is possible to provide individualized distance learning that models what
      the
      learner knows through an application delivered inside a standard web browser.
      There are major opportunities to deliver in-house corporate and defense training
      over intranets, K-12 instruction 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. Teknowledge served as the Cluster Leader for the U.S.’s
      largest multi-institution project on Intelligent Tutors and Associates between
      1995 and 1998. The DARPA Computer Assisted Education and Training Initiative
      sponsored Teknowledge’s prototype work on associate systems. Teknowledge has
      played an important role in the government-sponsored initiatives to provide
      cost
      effective and industrial strength courseware over the Internet. Teknowledge
      developed prototype Courseware FactoryTM components for converting podium-based
      traditional courses for delivery over the World Wide Web. This work was
      sponsored by the National Institute of Standards and Technology (“NIST”). From
      2000 to 2007, Teknowledge won several SBIR grants to provide advanced
      computer-based tutoring or user modeling systems. The key to unlocking the
      large
      potential education and training market is the persistent development of
      increasing capabilities and cost effective solutions until the ease of use,
      outcome statistics, and the return on investment are so compelling that they
      drive widespread adoption. This requires additional research and development,
      but the application potential is significant and the barriers are being overcome
      systematically. Teknowledge intends to continue to collaborate with the
      web-based training community, and to seek opportunities to embed its tutoring
      and application user modeling software in integrated solutions for commercial
      and government customers.





4
 *Index*




Distributed
      Systems .
      Operations that are widely distributed require extensive object-oriented systems
      infrastructure and the ability to extract reliable performance from distributed
      resources. Currently, the World Wide Web provides little of this systems
      infrastructure, but instead relies on the distribution of linked web pages
      or
      multimedia documents. In the future, complex webs of software objects,
      multimedia content, and knowledge will have to be distributed systematically,
      updated dynamically, and monitored for rogue behavior (e.g. viruses or worms).
      This requires the ability to provide reliable monitoring of software behavior,
      and the security of operations. Distribution of knowledge by intelligent “push”
and “pull” techniques has already become a critical technology for providing
      personalized briefings and reports to individuals. This business area focuses
      on
      providing new systems infrastructure to address these needs. Teknowledge was
      a
      prime contractor on the now completed DARPA-sponsored QUITE project, where
      the
      objective was to integrate innovative solutions to the problem of optimizing
      the
      quality of service of distributed resources on a network. Teknowledge’s projects
      often involve software wrappers and models for uniform access to heterogeneous
      software, associate systems to provide distributed and personalized briefings,
      and a system for implementing and controlling software components. The
      technology resulting from these projects has promising applications in
      commercial security, search engines, extensions to popular desktop software,
      and
      personalized financial briefings. One recent outcome of this research is an
      operational prototype security system called “LockdownTM”, which wraps all
      components and processes on Windows® computers, such as email and browsers, and
      monitors the system for any rogue behavior. This system has been tested
      extensively by outside “red teams”, and it has been effective in protecting
      Windows® machines from virus and worm attacks, particularly on computer systems
      with standard configurations. Another system Teknowledge has developed is called
      ActionWeb, which combines distributed processing and the knowledge-based systems
      described below.




Knowledge
      Systems .
      Decision-makers have noticed that using satellite and World Wide Web information
      systems is like “drinking from an information fire hose.” It is hard to take a
      sip without getting more information than is useful or necessary. Teknowledge’s
      work in this area focuses on providing knowledge-based tools, applications,
      and
      ontologies (knowledge structures) that allow computers to aid humans in
      interpreting the torrent of data coming at them. Teknowledge is advancing
      techniques for creating large knowledge systems that can apply problem solving
      knowledge harvested from humans about how to utilize the information in a
      database or an incoming stream of information. These knowledge systems are
      much
      more useful now than they have ever been. The problem solving power gained
      from
      applying these knowledge-based technologies is substantial. Teknowledge was
      the
      prime contractor on an Army sponsored effort to create a Standard Upper
      Ontology. This method of defining concepts formally and systematically is an
      important step in developing computer software that understands the meaning
      or
      semantics of the tasks it performs, rather than just processing numbers or
      words
      blindly. Specialized techniques for creating and applying knowledge have
      matured. There is now high potential payoff from combining several elements
      from
      this research into useful application systems. For example, complex problem
      solving requires the ability to access and synthesize data from multiple
      information sources quickly and effectively. Several of Teknowledge’s Knowledge
      Systems projects have an objective to develop a dynamic assessment of an
      evolving opportunity, problem, or competitive position. This infrastructure
      could serve as a basis for pragmatic, web-based problem solving, and
      sophisticated analysis of financial, operational, or defense information.




Teknowledge
      has a related long-term project, pursued over several government contracts
      as
      well as internally funded R&D to develop software that can be used to
      delegate knowledge-intensive tasks to computer software “associate systems.”
These associate systems may integrate several special-purpose software agents
      to
      accomplish routine tasks in a simple way. They may also accelerate knowledge
      gathering, refinement, dissemination, and utilization in the form of
      individualized briefings or tutorials. Teknowledge’s strategic plans include
      domain-specific associate systems that amplify human productivity with the
      ability to apply knowledge systematically and effectively. Teknowledge has
      built
      six prototype associate systems. The seventh associate system, called ActionWeb,
      is currently under development. Teknowledge sees this as a significant
      opportunity that will evolve as new Semantic Web capabilities emerge from
      R&D into many practical applications. However, there are uncertainties and
      risks associated with the introduction of any complex software module (see
      Part
      I, Item 1A).




**Patents
      and Technology Licensing.** Teknowledge
      maintains an active intellectual property program that has produced nine key
      U.S. software patents (6 active, 3 expired). The application software developed
      by Teknowledge includes TekPortal for financial information consolidation,
      associate systems for conducting automated transactions on the Internet,
      knowledge-based expert systems, pattern detection and alert tools, and systems
      to manage and protect webs of networked information. One software patent on
      Automatic Retrieval of Changed Files by a Network Software Agent, or Hotbox®,
      has two key components, network caching and alerts. Network caching refers
      to
      the strategic storage of information, such as web pages, to allow accelerated
      access to that information. Alerts refer to the ability to register interest
      in
      a particular data item on a specific web page and get notification when that
      item changes. As there are many high-value applications of the capabilities
      covered by this patent, Teknowledge is actively protecting its intellectual
      property rights related to the patent’s claim. Teknowledge has licensed its
      patents successfully to several large companies.





5
 *Index*




It
      is
      Teknowledge’s intention to increase its technology and intellectual property
      licensing investments and operations. The Company is aware of third parties
      it
      believes infringe on its intellectual property rights. Teknowledge has initiated
      actions to protect those rights. The Company is currently attempting to
      negotiate licensing arrangements with some of these entities. However, if the
      Company is unable to negotiate appropriate licensing arrangements, it will
      continue to pursue legal action.




**Intellectual
      Property Protection**




Teknowledge
      has relied on a combination of patent, copyright, trade secret and trademark
      laws, as well as contractual provisions, to protect its proprietary technology.
      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 relevant foreign jurisdictions. The Company requires
      all
      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 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.




Teknowledge
      provides its software products to commercial end users under non-exclusive,
      non-transferable licenses that typically have a perpetual term unless terminated
      for breach. Government contracts can be terminated at the government’s
      discretion. The Company protects the source code of its software products as
      trade secrets and unpublished copyrighted works. Additionally, Teknowledge
      holds
      patents for the knowledge processing and systems engineering technologies that
      form the basis of many of the products and configuration services that the
      Company markets.




There
      can
      be no assurance that Teknowledge’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. There can be no assurance that the Company would
      be
      able to enter into an acceptable license under such third party patents, or
      that
      it could redesign or modify its products and processes to avoid infringement
      of
      such patents 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. In some cases, litigation
      may be necessary to protect the Company’s proprietary rights.




**Sales
      and Marketing**




Teknowledge’s
      employees, the CEO, the CTO, group managers, and project leaders market and
      sell
      Teknowledge’s services and software. The Financial Solutions and Contract
      R&D operating segments offer consulting services to help prospective
      customers define their problems and projects. Prospective customers may fund
      consulting assignments to evaluate current corporate capabilities and recommend
      next steps, including application work. However, government proposal writing
      conducted in response to a Broad Area Announcement or Request for Proposal
      is
      typically not funded by the customer.




**Research
      and Development**




The
      Company’s investment in internally sponsored R&D for the year ended December
      31, 2006 was $1,406,839, up significantly from $505,452 in 2005. Much of this
      investment was in the development of the forthcoming ActionWeb product
      line.




Most
      of
      Teknowledge’s R&D (except in Financial Solutions) has traditionally been
      funded by R&D contracts sponsored by the government. In our fiscal year
      2006, the Financial Solutions operating segment spent $280,791 developing new
      software for sale, which was not included in the portion of the R&D costs
      reimbursed by the government. In 2006, the Company recorded $945,629 of revenue
      from the government for R&D contracts. Much of this development work is
      focused on fundamental software systems functionality, equally useful for
      military or commercial applications. Generally, the Company retains the
      exclusive commercial development rights to its government sponsored software
      development. The requirement for innovation is fundamental. Teknowledge also
      sponsors its own software development, as it has in the case of ActionWeb,
      which
      is related to the alerts functionality described in its ‘175 patent. We
      anticipate that ActionWeb, and the underlying TekPortal information aggregation
      engine will be reutilized in a variety of government applications that are
      not
      in the financial arena.





6
 *Index*




**Government
      Contract Administration**




In
      2006,
      approximately 87% of Teknowledge’s government revenues were from cost plus
      fee-type government-sponsored contract research and development. Since these
      R&D contracts are typically made on a multi-year basis, 72% of Teknowledge’s
      December 31, 2006 backlog was for contract R&D sponsored by the government.
      Teknowledge infrequently enters into cooperative “matching” agreements with
      government agencies in which some R&D costs are reimbursed. The Company’s
      success in winning contract R&D business depends on effective competitive
      bidding for contracts. The Company applies for contract R&D in the form of a
      proposal by responding to Requests for Proposals and Broad Agency Announcements
      issued by the United States Federal Government, by prime contractors under
      contract to the U.S. Government, or in some cases by commercial companies.
      Proposals include discussion of the technical approach to be taken to satisfy
      the sponsor’s or the prime contractor’s requirements and a detailed presentation
      of costs expected to be incurred. Teknowledge often collaborates with other
      contractors such as Massachusetts Institute of Technology and Northrop Grumman.
      In these cases, Teknowledge frequently serves as the subcontractor, and
      sometimes serves as the prime contractor. The proposal is reviewed and evaluated
      by technical and administrative personnel employed by the government or the
      prime contractor. Typically, these contracts are bid competitively, and 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 “negotiated
      award,” the government or the prime contractor enters into negotiations to
      determine a price for the contract; upon successful conclusion of negotiations,
      a contract is awarded. Government contracts are subject to agency funding
      limitations, congressional appropriation, and the war time priorities of the
      administration in Washington, D.C.




Most
      cost
      plus fee-type government contracts performed by the Company have a regulated
      fixed-fee limit, which limits the Company from improving profit margins on
      this
      type of contract beyond what is permitted in the government regulations. In
      addition, Federal Acquisition Regulations exclude from reimbursement some
“unallowable” expenses that the Company considers a regular part of the
      business. Almost all of the Company’s government contracts contain termination
      clauses that permit contract termination upon the Company’s default or at the
      contracting party’s discretion, and this has occurred on three occasions over
      the past ten years, for a variety of reasons. Such cancellations may occur
      again
      in the future; however, Teknowledge conducts contract R&D in several
      technically relevant areas, and this diversity helps protect against some of
      the
      effects of changes in sponsor priorities, personnel, or the mix of requirements.
      The Company intends to build its multi-year backlog further with additional
      proposals for new contract R&D projects, since this work provides a strong
      pipeline of software and technical innovation that can potentially be applied
      commercially.




The
      indirect costs and expenses accumulated in the performance of government
      contracts are allocated to the government in the form of overhead (indirect)
      rates. These rates, which are periodically reviewed by government auditors,
      fluctuate based on the relationship between 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 small amounts of unallowable
      costs, such as entertainment and advertising. In addition, the government has
      established compensation reimbursement limits for executives, which 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. Teknowledge
      typically receives a fee of about 7%-8% on new government contracts. New
      contracts that have been transferred to Teknowledge from other contractors,
      such
      as those that were transferred from University of Southern California (“USC”) in
      2000, may provide for technology rights, but no fees. The overall limitation
      on
      potential government contract fees, coupled with a potential increase in the
      expenses not eligible for reimbursement, restrict the Company’s ability to
      improve profit margins on government contracts in the future. The Company’s
      government-sponsored R&D is an effective development laboratory and test
      bed. The best software from this work becomes a candidate for software product
      commercialization. The government encourages commercialization of software
      developed under unclassified government R&D contracts so that it can buy so
      called “dual-use”, commercial off the shelf software that meets its needs,
      rather than be the sole customer for specialized military products. It also
      sharpens Teknowledge’s ability to provide competitive software.




**Competition**




A
      number
      of companies provide consulting services and software that compete with aspects
      of Teknowledge’s business. Many of these companies are substantially larger and
      have greater financial resources than Teknowledge. However, Teknowledge has
      several key competitive advantages, including: its experienced management team,
      specialized consulting and engineering teams, deeply technical R&D talent
      base, expertise in key application areas, patent portfolio and other
      software-based intellectual property, and strong and externally funded
      government R&D program.





7
 *Index*




Knowledge
      processing systems are provided by iLog, CycCorp, BBN, SRI, and others.
      Distributed systems and security services are provided by Trusted Information
      Systems, SRI, Secure Computing, Lockheed-Martin, Boeing, Level 3 Communications,
      ISX, and SAIC, among others. Internet-based distance education and training
      technologies include MacroMedia, IBM, KnowledgeNet, and Saba. Potential
      competitors could also be collaborators on some contracts.




**Employees**




Teknowledge
      utilizes a combination of full-time employees, subcontractors, and trusted
      consultants to accomplish its work. The Company had a total of 15 full-time
      employees at December 31, 2006. The majority of full-time employees are
      technical. All of the full-time employees were employed in the continental
      United States. Some subcontractors are employed outside the U.S. A large
      percentage of Teknowledge employees, subcontractors, and consultants have deep
      expertise in computer science, and many have specialized backgrounds in
      artificial intelligence, security, systems integration, or financial software.
      The future success of the Company will depend, in part, on the Company’s ability
      to retain, attract, and motivate highly qualified technical, sales, and
      management personnel that are central to its operations. The Company has never
      had a work stoppage, and it is not a party to any collective bargaining
      agreement with any of its employees.




**Executive
      Officers**




Mr.
      Jacobstein, 52, has served as Chairman of the Board, Chief Executive Officer
      and
      President of Teknowledge since November 1999. He served as President, Chief
      Operating Officer, and a Director of Teknowledge from January 1993 to November
      1999. After joining Teknowledge in 1984, Mr. Jacobstein was promoted over a
      nine-year period to: Senior Knowledge Engineer, Manager of the Research and
      Advanced Development Group, Vice President and General Manager of Research
      and
      Advanced Systems Development, and Vice President and General Manager of the
      Knowledge Systems Division. Mr. Jacobstein initiated Teknowledge’s eCommerce
      business unit in 1996. Prior to joining Teknowledge, Mr. Jacobstein was a
      Graduate Research Intern and consultant at Xerox PARC, and a Research Associate
      at CBNS. He has served on the Technology Advisory Board of the U.S. Army’s
      Simulation, Training, and Instrumentation Command. Mr. Jacobstein was the
      Chairman of the American Association for Artificial Intelligence’s 17th
      Innovative Applications of AI conference in July 2005. Since 1992, he has served
      as the Chairman of the Board of Directors of the Institute for Molecular
      Manufacturing, a private nonprofit organization. In 1999, Mr. Jacobstein was
      elected a Henry Crown Fellow in the Aspen Institute’s executive leadership
      program.




Benedict
      O’Mahoney, 46, is Vice President, Administration and Legal Affairs. Mr.
      O’Mahoney was elected a Director of Teknowledge in December 1999. Mr. O’Mahoney
      joined Teknowledge in 1996 as Corporate Counsel. Prior to joining Teknowledge,
      Mr. O’Mahoney practiced intellectual property law and served as General Counsel
      for Slatt Mortgage Company from 1988 to 1995. He served with the Federal Reserve
      Bank of San Francisco from 1985 to 1988.




Michael
      D. Kaplan, 45, has served as Vice President of Finance, Chief Financial Officer,
      and Secretary of the Company since his hire in September 2006. Mr. Kaplan
      previously held the positions of Director of Finance at OnVantage, Inc. and
      at
      Think3, Inc., both located in Santa Clara, CA. Mr. Kaplan succeeds Dennis A.
      Bugbee, who left the Company in 2006 due to a serious illness.




**Item
      2.** **Description
      of Property**




The
      Company’s executive offices are located at 1800 Embarcadero Road, Palo Alto,
      California, under a lease expiring in October 2007. The Company rents 9,300
      square feet of space in Palo Alto. The Company also has an office lease in
      Marina Del Rey, California (3081 sq. ft.). These properties are in good
      condition and are generally described as research and development facilities.
      All properties amounting to at least 10% of the Company’s total assets are
      adequately covered by insurance.




**Item
      3.** **Legal
      Proceedings**




On
      April
      1, 2006, Teknowledge filed a lawsuit against the United States Government in
      the
      United States Court of Federal Claims. Teknowledge is requesting that the court
      rule as improper a contracting officer’s decision dated January 19, 2006 that
      Teknowledge must account for all Software Amortization costs as direct costs
      of
      the Financial Services overhead pool, and that Teknowledge may, pursuant to
      the
      Federal Acquisition Regulation (FAR), account for 31% of the Software
      Amortization costs as indirect costs of the government overhead pool and recover
      those costs. No trial date has been set. A Pretrial Scheduling Order was filed
      on October 10, 2006 mandating that the parties submit a Joint Status Report
      by
      October 15, 2007.




On
      October 6, 2006, Teknowledge was served with a lawsuit from Large Systems
      Specialists, Inc., a contractor of Teknowledge. The lawsuit was filed in the
      Superior Court of California, Santa Clara County, and claims breach of contract
      and requests damages in the amount of $343,583. The lawsuit is a result of
      Teknowledge contesting an invoice submitted on June 29, 2006 in the amount
      of
      $252,265. The invoice was submitted under a consulting services agreement and
      related software maintenance services agreement, and was submitted for alleged
      under-billing by Large Systems Specialists, Inc for the period February 4,
      2003
      to June 16, 2006. On October 31, 2006, Teknowledge invoked the arbitration
      clause of the subject agreements and stipulated to a Stay of Action Pending
      Arbitration. It is anticipated that an arbitration on the matter will be
      scheduled during the second quarter of 2007.





8
 *Index*




The
      Company may be subject to legal proceedings and claims, either asserted or
      unasserted, which arise in the ordinary course of business. While the outcome
      of
      these claims cannot be predicted with certainty, management does not believe
      that the outcome of any of these legal matters will have a material adverse
      effect on the Company’s consolidated results of operations or consolidated
      financial position.




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




The
      2006
      Annual Meeting of Stockholders was held on December 7, 2006.





The
      proposal for one Class III Director to serve for a three-year term was approved
      by stockholders. The proposal received the following votes:





For
            
            WithheldIrwin
                Roth
            
            4,589,518
            
            702,115


The
      following directors continue:





Larry
      Druffel


Neil
      Jacobstein


Benedict
      O’Mahoney




Proposal
      No. 2 to ratify the selection of Burr, Pilger & Mayer LLP as the independent
      registered public accounting firm for the fiscal year ending December 31, 2006
      was approved by the stockholders. This proposal received the following votes:




For
            
            Against
            
            Abstain4,648,526
            
            636,233
            
            6,874






PART
      II




**Item
      5.** **Market
      for Common Equity, Related Stockholder Matters and small Business
      Purchases of Equity Securities**




The
      Common Stock of Teknowledge was traded on the Nasdaq SmallCap Market until
      October 20, 2005, after which date quotations for the Common Stock have been
      available through the Pink Sheets Electronic Quotations Service.




The
      following table sets forth the range of high and low closing price information
      for the Common Stock on the Nasdaq SmallCap Market and Pink Sheets Electronic
      Quotations Service for the quarterly periods indicated.





**2006**
            
            **High**
            
            **Low**First
                quarter, ended March 31, 2006*
            
            $
            0.28
            
            $
            0.17Second
                quarter, ended June 30, 2006*
            
            
            0.26
            
            
            0.18Third
                quarter, ended September 30, 2006*
            
            
            0.25
            
            
            0.17Fourth
                quarter, ended December 31, 2006*
            
            
            0.27
            
            
            0.17





**2005**
            
            **High**
            
            **Low**First
                quarter, ended March 31, 2005
            
            $
            1.89
            
            $
            1.03Second
                quarter, ended June 30, 2005
            
            
            1.00
            
            
            0.35Third
                quarter, ended September 30, 2005
            
            
            0.84
            
            
            0.36Fourth
                quarter, ended December 31, 2005*
            
            
            0.46
            
            
            0.17





As
      of
      December 31, 2006, there were 723 holders
      of record of Common Stock .





9
 *Index*




The
      Company has never declared a dividend and is not likely to do so in the near
      future.




*Since
      Oct 20, 2005, the Pink Sheets Electronic Quotations Service provides quotations
      that reflect inter-dealer prices, without retail mark-up, mark-down or
      commission, and may not represent actual transactions.






EQUITY
      COMPENSATION PLAN INFORMATION




The
      Company currently maintains two compensation plans that provide for the issuance
      of Common Stock of the Company to officers and other employees, directors,
      and
      consultants. These consist of the 1998 Stock Option Plan (the “1998 Plan”) and
      the 2002 Stock Option Plan for Non-Employee Directors (the “Director Plan”). The
      maximum term of options is 10 years. The following table sets forth information
      regarding outstanding options and shares reserved for future issuance under
      the
      foregoing plans as of December 31, 2006.




Plan
                category
            
            Number
                of securities to be issued upon exercise of outstanding options,
                warrants
                and rights
              (a)
            
            
            
            Weighted-average
                exercise price of outstanding options, warrants and rights
              (b)
            
            Number
                of securities remaining available for future issuance under equity
                compensation plans (excluding securities reflected in column
                (a))Equity
                compensation plans approved by security holders
            
            
            1,261,943
            
            
            (1)
            
            $
            1.35
            
            
            1,333,158
            
            
            (2)Equity
                compensation plans not approved by security holders
            
            
            -
            
            
            
            
            
            -
            
            
            -Total
            
            
            1,261,943
            
            
            
            
            $
            1.35
            
            
            1,333,158




(1) Consists
      of 1,163,919 shares subject to options that are outstanding and shares available
      for future issuance under the 1998 Plan and 98,024 shares subject to options
      that are outstanding and shares available for future issuance under the Director
      Plan.





(2) Consists
      of 1,181,182 shares that are reserved for issuance under the 1998 Plan and
      151,976 shares reserved for issuance under the Director Plan. Stockholder
      approval is required to increase the number of options available under either
      plan.




In
      connection with the credit facilities granted to the Company in prior financing
      agreements with Bridge Bank dated March 28, 2003 and 2004, the amended
      facilities of September 1, 2004, March 28, 2005 and June 21, 2005, the Company
      granted five warrants with five-year terms totaling 86,750 shares at a
      weighted-average exercise price of $2.59 per share. The warrants are exercisable
      in whole or in part one year after the first anniversary of the grant date
      and
      until the end of the five-year term. Each warrant was issued in a private
      transaction to Bridge Bank without general solicitation or advertisement
      pursuant to an exemption from registration under Section 4(2) of the Securities
      Act of 1933.




**Item
      6.** **Management’s
      Discussion and Analysis of Financial Condition and Results
      of Operations**




**Forward
      Looking Statements**




*The
      following contains forward-looking statements within the meaning of Section
      27A
      of the Securities Act of 1933, as amended, and Section 21E of the Securities
      Exchange Act of 1934, as amended. Words such as “anticipates,” “expects,”
“intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions
      identify such forward-looking statements. These forward-looking statements
      are
      subject to risks and uncertainties that could cause actual results to differ
      materially from those indicated in the forward-looking statements.
      Forward-looking statements made in this report relate to cash reserves required
      to support ongoing operations, commercial revenue increases and backlog, new
      business opportunities, demand for software and services, generation of revenue
      from intellectual property and the value of the Company’s patent portfolio,
      counter-terrorism applications, market acceptance of the Company’s products and
      services, demand for the Company’s products and services by the government,
      employees and management, patent and technology licensing, intent to broaden
      customer base, plans to develop new products and services, effectiveness of
      security measures, as well as expected revenue, cash and profitability, ability
      to realize backlog, recoverability of capitalized software, availability of
      equity capital and financing, effects of competition, research and development,
      consolidation in the financial services industry, government regulation,
      collections on customer receivables, and effects of recently-issued accounting
      pronouncements. 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, general
      or financial services market conditions, government agency funding limitations,
      other factors relating to government contracting including overhead rate
      determination; the ability to attract and retain technical and management
      personnel, commercial opportunities, financing, and other factors described
      in
“Risks That May Affect Future Results of Operations and/or Stock Price,” and in
      other documents we file with the Securities and Exchange Commission. Unless
      required by law, we do not undertake any obligation to update any
      forward-looking statements or risk factors.*





10
 *Index*




**Overview
      of Significant Matters**




**Financial
      Position**




This
      has
      been a year of transferring TekPortal customers responsibly to Intuit, Inc.,
      and
      rebuilding our commercial product base with entirely new software. In addition,
      the Company has been rebuilding its Government Contract R&D
      backlog.




At
      the
      end of 2006, Teknowledge had more than $771,000 in cash in the bank, albeit
      with
      significant reserves on the books. The cash number necessarily does not include
      the $1,050,000 in principal that was escrowed for 18 months as part of the
      $7M
      sale of TekPortal to Intuit, Inc, and which was received in February of 2007.
      In
      addition, during 2006, Teknowledge invested $1,407,000 in internally sponsored
      R&D, including its new ActionWeb TM product
      line. After significantly reducing overhead expense and paying off our loans,
      we
      are now well into Stage II of our recovery plan - rebuilding our revenue base
      and making our operations profitable again.




Teknowledge
      did not achieve profitability for the 2006 year, but the formula for doing
      so
      has not changed. It plans to return to profitability using a tried and true
      methodology - decreasing expenses and increasing revenues. We have already
      taken
      additional steps to decrease significantly our labor, rent, medical, and legal
      expenses. We are servicing our remaining TekPortal maintenance customers, and
      we
      transferred many maintenance customers to Intuit as planned. We continue to
      do
      services work for Intuit. We have new practices in place that are designed
      to
      increase revenue, increase engineering skills, and reduce our downside risk
      on
      new services contracts.




Teknowledge
      is implementing its plan to combine its software under development with
      next-generation data storage hardware and software integration solutions.
      Teknowledge won a Phase II Deductive Spreadsheets SBIR for $700,000 in 2006.
      We
      wrote a Phase I Helicopter Associate SBIR proposal in 2006, and were notified
      of
      a win on this Phase I proposal in 2007. We have several additional proposals
      in
      for new government contract work. We are conducting, with the government, the
      second stage of a field evaluation of our software wrappers security technology.
      We are also building a new ActionWeb based web services system that utilizes
      our
      alerts technologies. This is a next generation product designed to make it
      easier for large numbers of customers to deal with the torrent of data rushing
      at them by using a simple, knowledge-based web service for managing their
      information logistics.




Teknowledge
      is the right company to implement the ActionWeb product. For almost a quarter
      century, we have been continuously improving our ability to deliver
      knowledge-based software and services solutions. We already have most of the
      software pieces in place, either through contract work we have already done,
      or
      through third party license arrangements. We plan to reverse the traditional
      software development allocation of resources, and spend a large part of our
      attention working with customers to make their user experience rewarding, rather
      than just building software and hoping that customers will find it and like
      it.
      Teknowledge has been working with distributed computing and web services for
      almost a decade, and has next generation wrapping, alerts, ontology, and
      security related software. Teknowledge has a pioneering patent on distributed
      information logistics, which is about getting the right information to the
      right
      people at the right time. We believe that Teknowledge can do more than just
      deliver data. We can use our knowledge-based inference services to make informed
      judgments about the meaning and significance of critical pieces of information.
      Our intent is to combine our software with third party hardware to provide
      compelling value to customers. Teknowledge plans to continuously improve its
      ability to deliver software and hardware integration services. In addition,
      we
      plan to deliver value-added web services that help customers monitor critical
      variables in their operations, and enable them to act on changes to those
      variables in a timely manner.





11
 *Index*





The
      Company experienced a decline in revenue during 2006. The Company spent a great
      deal of time in 2006 working on the transition of TekPortal to Intuit, working
      on customer support projects, and investing $1.4M in internal R&D projects
      to replenish our software product line. Government Contract R&D revenue is
      still down, pending several new prospects that may result in additional R&D
      revenues. In the meantime, the Company has decreased its overhead and general
      and administrative (“G&A”) expenses. It is now focusing on winning billable
      integration services contracts and providing a stable ActionWeb platform for
      further product development.




**Government
      Contract R&D**




Teknowledge’s
      Government Contract R&D segment works in cutting edge research areas that we
      believe have significant application potential. The techniques for managing
      knowledge systematically have progressed significantly in the past two decades,
      and we are just beginning to unlock the business potential of systems that
      encode and process knowledge. The World Wide Web provides a high-powered
      distribution mechanism for these technologies, and much of the work Teknowledge
      does is focused on leveraging web-based opportunities. However, knowledge is
      still managed chaotically in most large organizations, with rapid change and
      turnover taking a toll on productivity. Today, computers mostly respond to
      us by
      executing our commands, rather than as interactive colleagues or associates
      that
      model who we are, the application domains that we work in, or the generic tasks
      that we perform. Teknowledge has been developing systems that address some
      of
      these features in web-based tutoring and semantic search application domains.
      We
      believe this remains a fruitful research area, and a substantial long-term
      opportunity for our business.





Teknowledge
      has successfully completed a Phase I DARPA Small Business Innovation Research
      (“SBIR”) contract it won in 2004 to develop a prototype of a deductive
      spreadsheet that adds symbolic or concept processing to commercial spreadsheets
      like Microsoft Excel ® .
      We
      believe this is an exciting proposition in a society where many people are
      uncomfortable with mathematical thinking or combining equations with qualitative
      reasoning. Teknowledge’s prototype spreadsheet is able to solve problems with
      nonmathematical concepts that embody nouns, verbs, plans and constraints. This
      is potentially a big opportunity with significant application specializations
      and extensions. Teknowledge has already built a demonstration system, and it
      started a Phase II $700K contract in the second quarter of 2006. There are
      opportunities to commercialize this technology as a plug-in application to
      Excel. Consistent with our evolving business model for leveraging selectively
      the software developed under R&D contracts, we may seek to license the
      technology to one or more companies that wish to embed the technology, or have
      significant sales pull, customer base, and marketing muscle.




Some
      of Teknowledge’s software development is supported by competitive contracts from
      the most sophisticated R&D sponsors in the world. Specifically, Teknowledge
      continues to improve its software wrappers, which have many security
      applications in protecting computers from new worms and viruses that may not
      have a known signature in an antivirus database. The Company has also developed
      a Standard Upper Ontology and Middle Ontology. These are ways of expressing
      knowledge formally that can be specialized for sophisticated semantic search
      solutions on the web, as well as computer-based problem solving and training
      solutions. Teknowledge continues to strengthen its model-based software
      capabilities, which can be used to design and configure software components
      to
      support target models of configurable products such as software radios and
      component software systems. The Company has also delivered prototype training
      software functionality that includes probabilistic Bayesian belief networks
      for
      modeling students or game users based on an analysis of their interactions
      with
      the computer. These and other R&D software capabilities put Teknowledge in a
      position to utilize next-generation functionality as infrastructure for
      government contracts, as well as potential commercial products, licenses, and
      applications.





Safe
      software wrappers encapsulate software modules, monitor their outputs and
      provide reporting and control over interfaces to other system resources. This
      software is more than a prototype and less mature than a product. It has many
      potential applications, including the ability to “lock down” a set of corporate
      computers and protects them from new viruses and worms that initially have
      no
      known operational signature. This system can monitor critical resources,
      identify potentially harmful instructions, and lock down selectively the access
      to critical resources. Teknowledge developed this capability several years
      ago,
      and has been improving it in new applications. This system could be used
      specifically to wrap email clients such as Microsoft Outlook ® and
      prevent attached viruses and worms from executing malicious instructions on
      the
      client machine.




Teknowledge
      has retained the right to license TekPortal software in intelligence, military,
      and homeland security application domains. One commercial customer sponsored
      a
      project in 2005 to use TekPortal software to aggregate images from multiple
      photo web sites. This application also has significance for aggregating images
      of potential terrorists and making them available to one or more agency web
      sites, with a variety of processing tools and permissions. There are also
      potential opportunities to leverage TekPortal in government security contract
      work that aggregates financial and other information for carefully selected
      targets.





12
 *Index*





Teknowledge
      generated $56,000 in government contract R&D revenue in the fourth quarter
      of 2006, compared to $260,000 in the fourth quarter of 2005. Most of this
      decrease was due to considerably lower backlog in 2006 and increased competition
      for government sponsored advanced R&D contracts. Replacing these large
      contracts rapidly is difficult due to long lead-times and potential funding
      delays. Teknowledge has submitted several new contract proposals to the
      government, which may or may not result in new awards. There are some signs
      of
      long-term improvement in new software R&D opportunities going forward,
      including interest in semantic web systems that utilize artificial intelligence
      techniques, advanced cyber security applications that leverage our software
      wrapper technology, and software systems that learn. In addition, we have
      launched a multi-year federal systems strategy to expand beyond contract R&D
      into integrating application solutions that can be fielded. The contract
      opportunities are much larger for integrated application solutions. In addition,
      the product potential is greater utilizing proven contract deliverables for
      fielded applications. There are far more government customers available for
      solution-oriented application integration than for R&D Teknowledge did win a
      $700,000 Phase II Deductive Spreadsheets SBIR and some small follow-on contracts
      in 2006, but it will take time to win new large government application
      integration contract awards, and awards take months to turn into funded
      contracts. Teknowledge will continue to propose on both prime and subcontract
      opportunities, and to deliver on R&D. While there may be a temporary
      decrease in government revenues, we believe that by addressing our financial
      position, investing in internal R&D, and writing competitive proposals for
      larger deployment programs, over time Teknowledge’s government sponsored
      applications development contracts business may regrow into a substantial
      revenue and technology generating business.




**Financial
      Solutions**




Since
      the
      September 2005 sale of the TekPortal asset to Intuit Inc., Financial Solutions
      revenues for 2006 were down from 2005, as expected. Teknowledge transferred
      many
      of its TekPortal maintenance customers to Intuit in 2006, and in conjunction
      with Intuit personnel, we are continuing to provide support services for other
      current banking customers. Most of these current financial customers will
      eventually transition to Intuit’s new versions of the software. We believe that
      we have excellent integration services capabilities, and strong customer
      references. We are planning to build out and train a team to provide new storage
      related integration services to financial and other institutions. Teknowledge
      is
      currently developing an initiative to combine its new ActionWeb software with
      next-generation data storage hardware and software integration solutions.




**Patent
      and Technology Licensing**




During
      2006, Teknowledge demonstrated the value of its patent portfolio by selling
      $1,000,000 in patent licenses. Patent agreement results over the past few years
      speak to real value in the #6,029,175 (‘175) patent. Our patent lawsuits against
      Inktomi, Akamai, and Cable & Wireless were related to the information
      caching claims in the ‘175 patent titled: “Automatic Detection of Changed Files
      By A Network Software Agent.” This patent also includes claims in the area of
      information alerts. Teknowledge sued Microsoft, Yahoo, and AOL/Time Warner
      for
      infringing on the alerts-related claims in the ‘175 patent. Teknowledge settled
      all of its extant patent lawsuits. The Microsoft case was settled in the third
      quarter of 2005.





Management
      believes that the Company’s patents are valid and have significant value. The
      Company believes that there are a large number of other potential infringers
      of
      the ‘175 patent. Teknowledge also has one patent pending related to its safe
      software wrappers. If granted, this could prove to be a valuable addition to
      Teknowledge’s patent portfolio. These opportunities are some of the reasons why
      we created a separate reporting segment for patents and technology licenses.
      We
      have taken most of the downside cost risk out of the current lawsuits by
      engaging the law firm of Goldstein and Faucett on a contingency payment basis.
      There is the risk that the patents will be invalidated and/or that legal
      proceedings will determine that no infringement is present for the defendants.
      However, the fact that so many substantial companies have reviewed our ‘175
      patent and each has chosen to purchase licenses at a time when the Company
      was
      under considerable financial stress, is an indicator of the strength of this
      patent. Teknowledge is now in a stronger financial position after the $7 million
      transaction with Intuit, and we intend to pursue infringers with renewed
      vigor.




**Risks
      That May Affect Future Results of Operations and/or Stock
      Price**




*Current
      cash flow may be insufficient to support current and future operations*





To
      support current and future operations, the Company is dependent upon revenues,
      credit facilities and its ability to obtain financing. Revenues decreased by
      28
      percent in 2006 to $2,930,000, compared to $4,048,000 in 2005. The ability
      of
      the Company to grow its revenues will depend on the Company’s success in winning
      new government R&D contracts, developing and selling new software products,
      integration services, and maintenance support to existing and new customers.
      As
      of December 31, 2006, Teknowledge had $771,000 in cash and cash equivalents,
      a
      decrease of $1,397,000 over the comparable period in 2005. The decrease in
      net
      cash at December 31, 2006 is attributed principally to the transition from
      TekPortal to other software and integration services, the need to invest in
      new
      product development, as well as the need to win and deliver on additional
      government contracts. The Company used net cash of $1,395,000 from its operating
      activities for the twelve months ended December 31, 2006, compared to $2,448,000
      used in the comparable period in 2005. The 2006 cash number necessarily does
      not
      include the $1,116,000 in principal and interest that was escrowed for 18 months
      as part of the $7M sale of TekPortal to Intuit, Inc, and which was received
      in
      February of 2007. In addition, during 2006, Teknowledge invested $1,407,000
      in
      internally sponsored R&D, including its new ActionWeb product line. The
      Company used $3,000 from investing activities in 2006 compared to $5,320,000
      provided in 2005. In 2006, there was no use of cash in financing activities
      compared to $865,000 used in 2005. Future growth is likely to be dependent
      on
      the Company’s success at improving revenues and cash flow.





13
 *Index*





Teknowledge
      is actively pursuing new contracts and integration services business, as well
      as
      patent and technology licenses. However, there can be no assurance that the
      Company will be able to generate increased revenue from new software and
      integration services or by licensing its patents and technology. The Company
      may
      not be able to develop successful new products and services, take advantage
      of
      future opportunities, or respond to competitive pressures or unanticipated
      requirements. The Company may be required to eliminate costs by reducing
      headcount further, which could result in less sales or development activities
      and adversely impact operations. In the event the Company raises capital by
      issuing equity securities from authorized shares, such financing will decrease
      the percentage equity ownership of existing stockholders, and depending on
      the
      price, at which the equity securities are sold, may result in significant
      economic dilution. The Board of Directors is also authorized under the Company’s
      Certificate of Incorporation to issue preferred stock with preferences and
      privileges senior to those of the common stockholders without common stockholder
      approval, though subject to applicable government regulations and stockholder
      approval rules. If the Company issues preferred stock in a financing, the rights
      of existing stockholders could be adversely impacted.




*The
      market for software and software services is highly competitive and changing
      rapidly*





The
      market for the Company’s services and software continues to evolve rapidly and
      is populated by substantial competitors who are continuously developing
      competing software products and services. As is typical for a new and rapidly
      evolving industry, demand and market acceptance for products and services are
      subject to a high level of uncertainty. As a result, many competitors have
      merged or dropped out of the market. Further, aspects of the business (including
      security, privacy, reliability, cost, ease of use, and quality of services)
      are
      undergoing rapid change. The Company is exposed to a higher risk of default
      and
      slower collections from small non-government clients, compared to relatively
      reliable government customers. Teknowledge is addressing this difference by
      broadening its customer base.




Teknowledge
      plans to grow its commercial business by selling through partnerships and by
      expanding into additional value-added capabilities or service offerings.
      Additional new ActionWeb product development will require incremental additional
      investments and that could strain technical, financial, and operational
      resources. The Company’s gross margins in new business areas may be lower than
      in its government contract business, and it may not be able to expand or
      maintain operations in a cost-effective or timely manner. Demand for the
      Company’s new and developing ActionWeb product line is currently unknown. If
      customers do not receive new products or services favorably, it could hurt
      the
      Company’s reputation and delay future expansion.





Within
      the software and integration services industry, Teknowledge believes some
      companies are consolidating, creating larger competitors with greater resources
      and a broader range of products. Some of Teknowledge’s competitors and potential
      competitors may have significant advantages over the Company, including
      extensive name recognition and marketing power, preferred vendor status with
      the
      Company’s existing and potential customers, and significantly greater financial,
      technical, marketing and other resources. These factors may give them the
      ability to offer free products or services to gain market share or to respond
      more quickly to new or changing opportunities, technologies, and customer
      requirements. The Company’s competitors may also highlight public disclosures of
      the Company’s previous adverse financial position, or package their products in
      a manner that may discourage potential customers from purchasing the Company’s
      products. Existing and potential competitors may establish cooperative
      relationships with each other or with third parties, or adopt unsustainable
      or
      aggressive pricing policies to gain market share. Security, privacy,
      reliability, cost, ease of use, and quality of service are the key competitive
      factors, and competitors are changing the way in which they are developing
      these
      factors; these changes may adversely affect cost of sales or the market
      acceptance of the Company’s software.





The
      demand for the Company’s services will depend upon broad acceptance of new
      methods of accessing and utilizing information over the Internet. An unstable
      economy and the resulting uncertainty can defer purchasing decisions by
      financial and other institutions, and there can be no assurance that these
      conditions will improve or that demand will return to previous levels. As the
      market continues to change, there can be no assurance that the Company will
      be
      able to recruit or retain the technical staff to develop and bring products
      to
      market, that these products will gain market acceptance, or generate significant
      revenue or profits. If Teknowledge’s products and services markets develop more
      slowly than expected, become saturated with competitors, or if the Company’s
      products do not achieve market acceptance, the Company’s business, financial
      condition, and results of operations may be materially and adversely affected.





14
 *Index*





Teknowledge’s
      customers are subject to economic changes that could reduce demand for the
      Company’s services. Industry consolidation, war, unforeseen events, recession,
      inflation, or acts of terrorism could occur and reduce consumer demand for
      the
      Company’s services. Any event of this kind, or implementation for any reason by
      customers of cost reduction measures, could result in significant decreases
      in
      demand for our products and services. Mergers and acquisitions are pervasive
      in
      today’s industries. Teknowledge’s existing or new customers may be acquired by
      or merged into other financial institutions, which already have their own
      software solutions or which may decide to terminate their relationship with
      the
      Company for other reasons. As a result, the Company’s revenue from related
      software services could decline if an existing customer is merged into or
      acquired by another company.





*Outsourcing
      may affect demand for domestic software services*





Most
      of
      Teknowledge’s software professionals have very specialized skills that are hard
      to replace. Some have U.S. government security clearances that are only open
      to
      U.S. citizens who are willing to undergo an extensive multi-year background
      investigation. Others have very specialized backgrounds in development and
      integration of complex software. Still others have very deep R&D backgrounds
      in artificial intelligence, training, or security. Teknowledge places a high
      value on employee loyalty, making it possible to develop trust with employees
      over a long period of time. None of these advantages are currently operating
      in
      the outsourcing market for software development. Outsourcing does provide
      software engineering skills at a fraction of the cost of U.S. based labor.
      The
      use of outsourced labor appears to be more common practice in the commercial
      arena; however, the above factors, combined with increasing concern about
      information security risks in industry may serve to minimize the use of
      outsourcing for mission critical and security sensitive applications.





*Increasing
      government regulation of the Internet could adversely affect the Company’s
      business*





Numerous
      federal agencies have recently adopted rules and regulations protecting consumer
      privacy and establishing guidelines for institutions to follow in selecting
      technology vendors for solutions offered by the Company. The Company believes
      its business does not currently subject it to any of these rules or regulations
      that would adversely affect its business. However, these rules and regulations
      are new and may be interpreted to apply to the Company’s business in a manner
      that could make its business more onerous or costly. Moreover, institutions
      must
      generally comply with these laws and regulations, which may adversely impact
      demand for the Company’s products.





*Teknowledge’s
      services must integrate with complex data processing systems*





Teknowledge’s
      services must integrate third-party products with complex data processing
      systems at our customer’s facilities. The Company generally recognizes revenue
      on a percentage-of-completion basis, so its revenue is often dependent on its
      ability to complete implementations within the time periods that are established
      for its projects. Teknowledge relies on a combination of internal implementation
      teams and outsourced implementation teams for its implementations. If these
      teams encounter significant delays in implementing the Company’s solutions for a
      customer or fail to implement the solutions effectively or at all at a
      customer’s facility, the Company may not be able to recognize any revenue from
      the contract or be required to recognize a loss from the contract, if revised
      project cost estimates exceed revenue from the contract. In addition,
      Teknowledge may incur monetary damages or penalties if we are not successful
      in
      completing projects on schedule.





*Teknowledge’s
      software may contain undetected errors or defects*





Teknowledge
      has a quality assurance program to test its complex software, but its software
      could still contain undetected errors or defects that may be discovered at
      any
      point in the life of the product. The Company has in the past discovered and
      corrected software errors. After implementation, errors may be found from time
      to time in the Company’s new or enhanced software or services, or in products or
      services it resells for strategic partners. These errors could cause the Company
      to lose revenues or cause a delay in market acceptance of its solutions or
      could
      result in liability for damages or injury to its reputation. The Company’s
      software is often used in transaction processing systems that include other
      vendors’ products and, as a result, its products must integrate successfully
      with these existing systems. System errors, whether caused by the Company’s
      software or the software of another vendor, could adversely affect the market
      acceptance of its software, and any necessary modifications could cause the
      Company to incur significant expenses. Since the Company’s software is used to
      deliver services that are integral to its customers’ businesses, errors,
      defects, or other performance problems could potentially result in financial
      or
      other damages to its customers. The Company and its partners do conduct tests
      of
      its software, but any product liability litigation arising from errors, defects,
      or problems, even if it were unsuccessful, would be time-consuming and costly
      to
      defend. Existing or future laws or unfavorable judicial decisions could
      potentially negate any limitation of liability provisions that are included
      in
      the Company’s license agreements.





15
 *Index*





*Teknowledge’s
      network infrastructure could be vulnerable to security
      breaches*




Despite
      the Company’s security measures, the core of its network infrastructure could be
      vulnerable to unforeseen computer problems and security breaches. Network or
      Internet security problems could harm the Company’s reputation and business.
      Although the Company has taken steps to mitigate much of the risk, it may in
      the
      future experience interruptions in service as a result of the accidental or
      intentional actions of Internet users, current and former employees, or others.
      Unknown security risks may result in liability to the Company and also may
      deter
      financial organizations from utilizing the Company’s services. Although the
      Company intends to continue to implement and establish security measures, there
      can be no assurance that measures it has implemented will not be circumvented
      in
      the future, which could have a material adverse effect on its business,
      financial condition, or results of operations. The occurrence of any of these
      problems could reduce product demand from potential customers and cause existing
      customers to terminate their license or data center contracts with the Company.
      These problems could also require the Company to spend significant capital
      to
      remedy any failure and could subject it to costly litigation with clients or
      their end users.





*Teknowledge
      may not adequately defend against unauthorized use of its proprietary
      technology*




The
      Company’s success depends upon its proprietary technology and information. The
      Company relies on a combination of patent, copyright, trademark and trade secret
      laws, and confidentiality procedures to protect its proprietary technology
      and
      information. It is difficult to police unauthorized use of software and
      litigation is costly and time consuming. The steps the Company has taken to
      protect its services and products may not prevent misappropriation of its
      technology. Any misappropriation of the Company’s proprietary technology or
      information could reduce any competitive advantages it may have or result in
      costly litigation. The laws of some foreign countries may not protect the
      Company’s proprietary technology as well as the laws of the United States. The
      Company’s ability to protect its proprietary technology abroad may not be
      adequate.




*Service
      revenue is partially dependent on government-sponsored contract
      R&D*




Much
      of
      Teknowledge’s service revenue has historically been derived from
      government-sponsored contract R&D projects. However, current backlog is low,
      and dependence on R&D contracts can be risky because the contracts are
      subject to administrative, legislative, and political interruptions or
      terminations, which may jeopardize the flow of funds. There can be no assurance
      that the government will continue to seek services at the current level in
      the
      future. Although the Company expected an increase in proposals related to
      homeland security in 2004-2006, the level of Broad Area Announcement requests
      for advanced software R&D proposals in its target areas was lower than
      expected. There can be no assurance there will be an increase in relevant
      software R&D opportunities in the future. The Company faces increased
      competition for government projects and this may continue until the general
      economy improves.





The
      typical cost-type government contract that Teknowledge performs has a regulated
      fixed fee, which limits the Company from improving profit margins on these
      contracts. In addition, Federal Acquisition Regulations exclude from
      reimbursement “unallowable” expenses, which the Company considers a regular part
      of the business, such as advertising expense. In addition, almost all of
      Teknowledge’s government contracts contain termination clauses which permit
      contract termination if the Company defaults or at the contracting party’s
      discretion.





*Periodic
      rate changes and audits on government contracts may cause cost
      adjustments*




The
      majority of Teknowledge’s service revenue has historically been derived from
      government-sponsored contract R&D projects. Dependence on R&D contracts
      can be risky because the contracts are subject to administrative, legislative,
      and political interruptions, which may jeopardize the flow of funds. There
      can
      be no assurance that the Company’s proposals will be competitive, or that the
      government will continue to seek services at the current level in the future.
      Another uncertainty is that the Company’s revenues, costs, and earnings on
      government contracts are determined based on estimated overhead rates derived
      from forecasted annual costs. The Company’s actual experience in headcount
      growth, billable efficiency, and costs inevitably varies somewhat from original
      estimates and necessitates periodic adjustments to overhead rates and revenues.
      An adjustment of a few percentage points may translate into several hundred
      thousand dollars in rate adjustments or reserves. Rate adjustments are made
      on a
      cumulative basis at least annually, but the resulting revenue and income effects
      are recognized in the period of the adjustments. The Company is also subject
      to
      periodic reviews of prior year costs and expenses by audit agencies of the
      Federal Government. As a result of these audits, the Company may be exposed
      to
      cost adjustments, which are applied on a retroactive basis to the government
      contracts completed in those years. These adjustments can have a significant
      negative or positive effect on the results of operations and cash reserves
      in
      the period in which the adjustment is realized. In order to address the possible
      exposure from prior year rate adjustments, Teknowledge has established a rate
      adjustment reserve for such contingencies, and the amount of the rate adjustment
      reserve is reviewed and adjusted at least annually. During 2004, the **** Defense
      Contract Audit Agency (“DCAA”) finished its preliminary audit of the 2001
      overhead rates and identified potential cost recoveries, principally from the
      treatment of software amortization costs. The Company aggregated these costs
      for
      all open years from 2001-2005 to determine the appropriateness of the reserve.
      [See discussion of government overhead rate reserve in Part II, Item 6,
“Critical Accounting Policies and Estimates”.] As a result of this review,
      Teknowledge determined that additional reserves of $1,500,000 should be accrued
      in 2004 to provide for a potential negative result if the Company is
      unsuccessful in its contract appeal process. The cumulative reserve at December
      31, 2006 was $2,248,000.





16
 *Index*





*Loss
      of a large customer may affect financial results*




The
      Company has in the past, and probably will in the future, rely on large sales
      to
      certain customers. Loss of a single large customer could have a material impact
      on the sales revenue and profitability of the Company.




*Teknowledge’s
      success depends on retaining sufficient technical staff and attracting
      additional technical staff*




The
      Company recognizes that the loss of one or more key management and technical
      personnel, who are employed on an at-will basis, could adversely affect the
      Company’s business. The Company relies on its executives and business managers
      for the acquisition and negotiation of new business, the management of services
      contracts and product development, and the management of ongoing operations.
      A
      proportion of the technical support base for operations is provided by outside
      consultants, and it is anticipated that this trend will continue in the future.
      The use of outside consultants allows the Company to expand or constrict its
      operations quickly both inside and outside the U.S.





*Teknowledge
      will incur increased costs as a result of the implementation of new rules,
      regulations, and pronouncements from the SEC, including the provisions of the
      Sarbanes-Oxley Act of 2002*




Recently
      enacted and proposed changes in the laws and regulations affecting public
      companies, including the provisions of the Sarbanes-Oxley Act of 2002, rules
      adopted or proposed by the SEC and new accounting pronouncements, will result
      in
      increased costs to us as we evaluate the implications of these laws, regulations
      and standards and respond to their requirements. In 2005, the Company was
      delisted from the Nasdaq SmallCap Market due to its low stockholders’ equity and
      past financial performance. Nonetheless, to maintain high standards of corporate
      governance and public disclosure, we intend to invest substantial resources
      to
      comply with evolving standards. This investment may result in increased G&A
      expenses and divert management time and attention from strategic revenue
      generation and cost management activities. In addition, these new laws and
      regulations could make it more difficult or more costly for us to obtain certain
      types of insurance, including director and officer liability insurance, and
      we
      may be forced to accept reduced policy limits and coverage or incur
      substantially higher premiums to obtain the same or similar coverage. The impact
      of these events could also make it more difficult for us to attract and retain
      qualified personal to serve on our board of directors, our board committees
      or
      as executive officers. We are taking steps to comply with the recently enacted
      laws and regulations in accordance with the deadlines by which compliance is
      required, but cannot predict or estimate the amount or timing of additional
      costs that we may incur to respond to their requirements.




**Critical
      Accounting Policies and Estimates**




Certain
      accounting policies are particularly important to the portrayal of the Company’s
      financial position and results of operations. These policies require the
      application of significant judgment by our management team. As a result, they
      are subject to an inherent degree of uncertainty. In applying those policies,
      management uses its judgment to determine the appropriate assumptions to be
      used
      in the determination of estimates. Those estimates are based on the Company’s
      historical experience, terms of existing contracts, observance of trends in
      the
      industry, information provided by its customers, and information available
      from
      other outside sources, as appropriate. Teknowledge’s significant accounting
      policies and estimates include:





*
            Revenue
                recognition;


*
            Allowance
                for doubtful accounts;


*
            Software
                development costs; and


*
            Determination
                of government indirect rate
                reserves.





*Revenue
      Recognition*





Revenue
      on software licenses and services is recognized when persuasive evidence of
      an
      arrangement exists, the price is fixed or determinable, delivery has occurred,
      and there is a reasonable assurance of collection on the resulting receivable.
      Teknowledge may record license revenues as a result of legal settlements if
      the
      settlement provides for the issuance of a license. Teknowledge customarily
      obtains written purchase authorizations from customers for a specific product
      at
      a fixed price and considers delivery to have occurred at the time of shipment.
      The software is delivered to the customer electronically or on a compact disk.
      Revenue is typically recognized on delivery of product software; however, if
      the
      software is subject to customer acceptance or contract terms that do not satisfy
      all of the above-mentioned criteria, revenue is recognized upon customer
      acceptance or when all revenue recognition criteria have been met. Occasionally,
      customer contracts contain refund or warranty clauses that could affect revenue
      recognition. Teknowledge evaluates these clauses carefully; however, the Company
      has not experienced a refund or warranty recall and the likelihood of such
      an
      event is not predictable nor is it judged material at this time. Revenue from
      software consulting services is generally recognized on a time and materials
      basis; however, depending on the terms of the contract, the service element
      may
      be recognized on a percentage-of-completion basis. Revenue recognized under
      the
      percentage-of-completion basis requires the use of project cost estimates.
      Project cost estimates are revised periodically and changes affecting the amount
      of revenue recognized are recorded when they become known. Revenue from R&D
      contracts is generally recognized over applicable contractual periods as
      specified by each contract and as costs related to the contracts are incurred.





17
 *Index*





*Allowance
      for Doubtful Accounts*





Teknowledge
      provides an allowance for doubtful accounts based on historical payment
      experience for its nongovernmental customers, age of unpaid amounts, and a
      review of significant past due accounts. Estimates of uncollectible amounts
      are
      revised each period and changes are recorded when they become known. The Company
      generally does not provide an allowance for receivables from government
      customers because the Company has historically experienced virtually no
      collection issues. The Company has established a rate reserve to cover potential
      losses associated with adjustments to its audited government rates.





*Software
      Development Costs*





The
      eligible costs incurred in the development of our commercial software are
      capitalized. Teknowledge periodically reviews these costs to ensure they are
      recorded at the lower of net amortized cost or net realizable value. Net
      realizable value is determined using estimated future cash flows related to
      sales of the underlying technology. Had different assumed cash flows been used,
      materially different amounts of the carrying amount of these costs could have
      been reported.





Teknowledge
      evaluates the expected future revenues from software products before undertaking
      software development. Only those projects that are considered potentially
      profitable after including the costs to develop the software are pursued beyond
      the planning stage. The Company capitalizes software development costs from
      the
      point of technological feasibility and after completion of the detail program
      design. All costs incurred prior to determination of technological feasibility
      are expensed. Teknowledge solicits feedback from its customers to help identify
      potential enhancements that add value to key products. The Company in turn
      evaluates these potential enhancements to determine which, if any, will be
      incorporated into the next version. The software development process proceeds
      from module to module until the product manager determines that an adequate
      number of functionalities have accumulated to earn release status. A typical
      version may encompass up to a dozen functional modules, most of which could
      be
      used separately, but which are not practical to market individually because
      of
      cost and market constraints. The Company may add high-value, low-risk
      development modules to address particular customer needs, but only after
      assessing technical risk and program design issues. These optional features
      are
      considered low-risk development enhancements to the original functionality.





The
      Company completed V3.2 of TekPortal in the second quarter of 2005 and it was
      released to customers. Capitalized costs include direct and indirect labor
      costs
      and applicable overhead, but exclude G&A costs. The Company regularly
      examines its procedures for accumulating economic life of the product, which
      is
      estimated at three years. Capitalized software development costs are reviewed
      and evaluated periodically to determine recoverability. Should the Company
      determine that all or part of its capitalized software development costs are
      not
      recoverable, an adjustment to the capitalized software costs would be charged
      to
      income in the period such determination is made. Management evaluated the
      performance of its TekPortal product through December 31, 2004, and determined
      that an adjustment to the net realizable value of the development asset was
      required because the licenses, maintenance, and related services revenues,
      net
      of future costs of completing and disposing of the product, including
      maintenance and required customer support, did not meet management’s financial
      objectives. As a consequence, the unamortized value of previously capitalized
      software development costs at December 31, 2004 was reduced by $1,753,000.
      The
      Company began amortizing V3.2 of TekPortal in June 2005. At August 22, 2005,
      the
      Company concluded the sale of its TekPortal software asset and transferred
      the
      development software to Intuit Inc. As a consequence of the sale, the
      unamortized value of TekPortal versions 3.2 and the version 3.3 of $2,012,000
      was disposed as part of the net sale of the TekPortal software asset in the
      third quarter of 2005.





18
 *Index*





*Determination
      of Government Indirect Rate Reserves*




The
      Company’s revenues, costs, and earnings on government contracts are determined
      based on direct cost and estimated overhead “indirect” rates derived from
      forecasted annual costs. The Company’s actual experience in headcount growth,
      billable efficiency, and costs typically vary from original estimates and
      necessitate periodic adjustments to overhead rates and revenues. Such
      adjustments are made on a cumulative basis whereas the resulting revenue and
      income effects are recognized in the period of the adjustments. The Company
      is
      also subject to periodic reviews of prior year costs and expenses by audit
      agencies of the Federal Government. As a result of these audits, the Company
      may
      be exposed to annual cost adjustments that are applied on a retroactive basis
      to
      the government contracts completed in prior years. These adjustments can have
      a
      negative or positive effect on the results of operations and cash reserves
      in
      the period in which the adjustment is realized. In order to address the possible
      exposure to rate adjustments in prior years, Teknowledge established a rate
      adjustment reserve for potential government cost recovery for the then open
      and
      unaudited years of 2001-2005. The cumulative reserve, including earned retained
      fee of $227,000, is $2,248,000 at December 31, 2006.





On
      September 30, 2004, the government suspended payment on three of Teknowledge’s
      contracts pending repayment of projected differences between the “actual”
overhead rates used in the billings and the proposed overhead rates submitted
      to
      the government for the years 2001-2003. Based on the original rate data
      Teknowledge provided to the government for those years, the government audit
      agency, DCAA, indicated that Teknowledge owes $813,000 in gross charges. Prior
      to this, Teknowledge requested a review of the treatment of subcontractor costs
      in the previously submitted overhead cost proposals. Teknowledge believes the
      prior treatment unfairly allocated substantial amounts of internal G&A
      expenses to outside subcontractors and has requested an equitable redistribution
      of these costs to a separate pool for the unaudited years. A similar treatment
      has already been approved for 2004, but the government has so far denied
      Teknowledge’s request to make the change effective for all the unaudited years.
      The change in the treatment of subcontractor costs, if accepted by the
      government, could reduce the overall exposure to the Company by $1,022,000.
      On
      October 5, 2004, the government released for payment the three contracts that
      were on suspension, contingent on the establishment of a long-term payment
      schedule between the two parties. The payment terms and conditions will be
      determined after a review of the Company’s financial viability, and its cash
      reserves and forecast cash flows from all sources through 2006. The Company
      believes it could have adequate cash resources to establish a mutually workable
      payment schedule, depending on the agreements reached, and the Company’s
      financial position at that time. The Company is prepared to make good faith
      payments while it negotiates for the successful resolution of the treatment
      of
      the subcontractor costs and any related rate issues. These payments would be
      charged against the rate reserve and not earnings.





During
      the fourth quarter of 2004, the government issued a preliminary audit report
      and
      findings for the overhead costs incurred in 2001. The government questioned
      the
      Company’s treatment of amortization on previously capitalized software
      development costs for the Company’s dual-use TekPortal product. The Company
      allocated approximately 30 percent of 2001 amortization costs to the government
      segment, which the Company believed was a fair allocation to the government
      for
      the benefit from the technology developed in 2000. The government subsequently
      rejected this argument, denying any allocation to the government either directly
      or indirectly because of the product’s short history of largely commercial sales
      and other technical issues. At the time the product V1.0 was originally
      developed in 2001, the Company intended to sell its product to commercial and
      government customers. As evidence of this intent, the Company provided the
      auditors copies of two government proposals that utilized TekPortal’s
      information aggregation software. In addition, the Company has a long history,
      going back to the 1980s, of selling previously developed products like M.4
      to
      the government. Therefore, the Company believes that it was reasonable to assume
      that the government would benefit in the development of Teknowledge products
      and
      that allocating 30 percent of the development costs was a realistic
      consideration based on Teknowledge’s long history of product development. This
      is also consistent with the government’s interest in encouraging government
      contractors to develop from internal R&D, commercial products that can be
      utilized for government purposes. The government excluded 100 percent of
      TekPortal development costs, claiming since there were no TekPortal sales to
      the
      government during the applicable period; therefore, the production costs should
      not have been allocated to the government. The government position appears
      to be
      inconsistent with the intent of FAS86, which describes a process of allocating
      costs over estimated revenues that the Company believes would apply to revenues
      from the potential sales of the TekPortal software in the government arena.
      The
      Company contests the government’s exclusion of a portion of TekPortal software
      development costs.





The
      Company periodically evaluates its exposure from the government’s suggested cost
      treatment of software development costs for the audited years of 2001-2003
      and
      the unaudited years of 2004-2006, assuming all amortization costs were included
      in the G&A base pool. At December 31, 2004, after consulting with outside
      counsel, and given the relative absence of court precedent in this area,
      management determined there was a potential estimated cost exposure, as a result
      of a negative outcome from the aforementioned issue, of $1,500,000. The Company
      believes that a considerably lower amount is entirely possible and it plans
      to
      negotiate with the government for the most favorable result. In the third
      quarter of 2005, the Company requested from the government that an Alternative
      Dispute Resolution (“ADR”) procedure be established to evaluate the outstanding
      issues and to accelerate the review process. The government responded with
      a
      combination of two notices, one dated December 6, 2005 and the other January
      19,
      2006 indicating that Teknowledge should pay the outstanding balance on the
      $810,000 referenced above as part of the 2001 audit results. On April 20, 2006,
      the Company filed a complaint in the United States Court of Federal Claims
      under
      the Contract Disputes Act of 1978 challenging the government’s Notice of Intent
      to Disallow Costs for 2001. The complaint seeks to reverse the decision of
      the
      Defense Contract Management Agency’s (“DCMA”) Administrative Contracting
      Officer’s (“ACO”) in disallowing $285,000 in reimbursable overhead costs for
      2001 related to the amortization of the Company’s capitalized software
      development costs. If the Company prevails in this lawsuit, a substantial
      portion of the government rate reserve may be reversed, as it is related to
      the
      capitalized software amortization expense in question.





19
 *Index*





The
      Company continues to discuss alternative solutions with the government,
      including ADR, a long-term payment schedule, and a beneficial software licensing
      agreement; however, it is impossible to determine at this time the ultimate
      outcome of negotiations and the legal alternatives available to the Company.
      The
      Company has established a reserve to offset a potential negative outcome for
      the
      open years of 2001-2006. The Company believes that this reserve is reasonable;
      however, the final outcome may be more or less than this amount. Because this
      matter is based on the specific treatment of generally allowable costs, no
      penalties or interest charges are anticipated.




**Results
      of Operations**




Revenues
      in 2006 were $2,930,000 as compared to $4,048,000 in 2005. Overall revenues
      decreased 28% largely on a decline in  revenue
      from Government Contract R&D and Financial Solutions customers. Financial
      Solutions operations contributed 34% of total revenues in 2006, down from 50%
      in
      2005, and Patent and Technology Licensing contributed 34% of 2006 revenue,
      up
      from 11% in 2005. All of the Financial Solutions revenue was generated from
      the
      sale of TekPortal products and services. Revenues from government-sponsored
      contract R&D accounted for 32% of total revenues in 2006, compared to 39% in
      2005. The Company was unsuccessful in 2006 in replacing all of the government
      contracts that were completed during the year, largely because of changing
      government priorities and vigorous competition.




Included
      in Financial Solutions revenues are sales of TekPortal software licenses,
      consulting services, and post-contract customer support services. Financial
      Solutions revenue decreased 51% in 2006 to $985,000 largely as a result of
      less
      customer demand, compared to $2,010,000 for 2005. Revenue from license fees
      for
      TekPortal software was $14,000 in 2006, compared to $111,000 in 2005. Sales
      cycles and customer acceptance of new product offerings were slower than
      expected. Recurring revenue from maintenance on existing products was $366,000
      in 2006 compared to $598,000 in 2005. Revenues from resellers accounted for
      10%
      of Financial Solutions 2006 revenue compared to 41% in 2005.




On
      August
      22, 2005, Teknowledge concluded the sale of its TekPortal technology, an asset
      from its Financial Solutions business unit, to Intuit Inc. for $7,000,000.
      As
      part of the technology sale, Intuit was granted a license to each of
      Teknowledge’s six active patents, and acquired Teknowledge’s pending patent on
      Open Financial Exchange (“OFX”) technology. Teknowledge retained ownership of
      all of its current customer contracts and patents. It also received a license
      to
      apply TekPortal “dual-use” application software in the military, intelligence,
      and homeland security arenas. $1,050,000 of the gross proceeds of the asset
      sale
      were held in escrow as a reserve for indemnification claims for a period of
      eighteen months; these amounts, plus interest, were released from escrow and
      remitted to the Company in March 2007. The Company recorded proceeds of
      $5,950,000 that was partially offset by the disposal of the software asset’s
      book value of $2,012,000 and asset sale related legal and other direct expenses
      totaling $174,000. Teknowledge reported a net gain of $3,764,000 as a result
      of
      the asset sale. Teknowledge retained most of its TekPortal maintenance
      contracts, and in conjunction with Intuit personnel, we are continuing to
      provide maintenance services for our current banking customers. Many of these
      customers will eventually transition to Intuit’s new versions of the software.
      We believe that we have excellent integration services capabilities, and strong
      customer references. Teknowledge has launched an initiative to combine new
      hardware and software integration solutions. The Company is planning to build
      out and train a team to provide these new solutions to financial, government,
      and other institutions.




Revenues
      from Government Contract R&D were $945,000 in 2006, compared to $1,573,000
      in 2005. Some of Teknowledge’s contracts ended in 2006 and were not replaced
      immediately with new contracts. Replacing these large contracts was more
      difficult than expected for several reasons. First, much of the post 9-11
      increase in defense spending was focused on supporting war efforts directly,
      rather than on software R&D. Second, a higher percentage of the budget of
      some of our key government sponsors has focused on funding a few large teams
      with total solution packages, and competition for these contracts has increased.
      In order to be more competitive, Teknowledge’s role has sometimes shifted from
      contractor to subcontractor; further reducing revenue production. Third, the
      component solution contract dollars available have often been awarded in smaller
      increments through the Small Business Innovation Research programs. The future
      demand for government-sponsored contract R&D services will depend on a
      number of factors, including the quantity of competitive contract awards and
      sponsor priorities. In 2006, 87% of Government Contract R&D revenues were
      from the Department of the Air Force, compared to 29% in 2005.




The
      Company recorded revenues of $1,000,000 for Patents and Technology Licensing
      in
      2006 compared to $465,000 in 2005. The 2006 license revenue was the result
      of a
      single patent license to a large technology company.





20
 *Index*




The
      Company typically recognizes revenue from customer contracts as services are
      provided on a contract-by-contract basis. This accounting method may result
      in
      timing differences between the amount of revenue recognized on an accrual basis
      and the amount billed, which is subject to separate determination based on
      an
      analysis of contract deliverables and milestones. The difference between the
      revenue recognized on this basis and the amount billed to the customer is
      recorded in accounts receivable as unbilled receivables or as deferred revenue.
      Because of government retained fee balances, at December 31, 2006 approximately
      97% of unbilled receivables were for government-sponsored R&D contracts, and
      3% were for commercial contracts. This compares to 93% for government-sponsored
      R&D contracts at December 31, 2005.




Cost
      of
      revenues was $1,261,000 in 2006 compared to $3,442,000 in 2005, a decrease
      of
      63%. The cost of revenues as a percentage of total revenues was 43% in 2006
      compared to 85% in 2005. Approximately 33% of the 2006 cost of revenues is
      Government Contract R&D, 44% is Financial Solutions, and 23% is Patent and
      Technology Licensing, compared to 28%, 63%, and 9% in 2005. Besides the
      aforementioned adjustments to cost of revenues, the Company spent $253,000
      in
      2006 on IP related legal costs to defend its patents. A major component of
      cost
      of revenues, labor and labor related costs was down $954,000 over 2005.




The
      Company made no investment in the development of TekPortal software in 2006,
      compared to $452,000 invested in 2005. Because of the sale of the TekPortal
      product, the remaining amortization base of $2,012,000 was disposed as part
      of
      the net sale of the TekPortal software asset. In 2006, there was no amortization
      of previously developed assets. The Company capitalizes all eligible development
      activity. However, as it explores new ground, if the technical feasibility
      requirement of Statement of Financial Accounting Standards Board (“FASB”)
      Opinion No. 86 is not assured, R&D must be expensed in accordance with
      accounting policy. As a consequence, R&D expenses have increased from
      $505,000 in 2005 to $1,407,000 in 2006. There were no subcontractor costs in
      2006, compared to $226,000 in 2005. This is principally a result of a drop
      off
      in government revenue; however, a significant portion of the decline is traced
      to less reliance on outside subcontractors to support billable services work
      and
      more direct employee involvement. The Company often teams with subcontractors
      in
      government and  commercial
      proposals to enhance its chances of winning new contracts and the Company has
      pending contract proposals that include subcontractors. As the Company wins
      new
      contracts, subcontractor costs are likely to increase.




The
      gross
      profit (loss) for government-sponsored R&D in 2006 was $527,000 compared to
      600,000 in 2005, or 56% and 38%, respectively. The gross margin (“GM”) for
      Financial Solutions was $433,000 versus a loss of $160,000 in 2005. The GM
      for
      Patent and Technology Licensing was $710,000 versus $166,000 in 2005. The GM
      was
      affected by a decline in revenues in the Financial Solutions and Government
      Contract R&D reporting segments in 2006. The Government Contract R&D,
      Financial Solutions, and Patent & Technology Licensing GMs were 56%, 44%,
      and 71%, respectively for 2006. This compares to 38%, (8%), and 36%, for
      Government Contract R&D, Financial Solutions, and Patent & Technology
      Licensing in 2005.




General
      and administrative expenses (“G&A”), costs were $1,558,000 and $1,796,000 in
      2006 and 2005, respectively. G&A costs for 2006 were 53% of total revenues,
      versus 44% in 2005. Total G&A expenses decreased 13% over 2005. Due to a
      change in the product mix between government and commercial contracts, less
      G&A expense was absorbed by the Government contracts. Because of flexible
      overhead rate application in the government cost structure, government contracts
      are able to absorb a proportionate share of G&A expenses; however,
      commercial contracts are not as flexible in their pricing structure, therefore
      leaving them less able to absorb an increase in the G&A allocation.




Sales
      and
      marketing costs were $15,000 in 2006 as compared to $102,000 in 2005. Sales
      and
      marketing costs were 1% of total revenues in 2006 versus 3% in 2005. The
      Company’s sales and marketing efforts include applications engineering and
      technical support, direct sales efforts, as well as trade shows, demonstrations,
      and other traditional marketing activities. Teknowledge is now developing new
      software and a team to provide hardware and software integration services to
      financial and other institutions. During 2006, the Company reduced discretionary
      expenses, principally labor and labor related expenses.




Company-sponsored
      R&D costs in 2006 increased to $1,407,000 from $505,000 in the comparable
      period in 2005. R&D was 48% of total revenues in 2006 versus 12% in 2005. As
      work on some contracts slowed and the contract completion dates neared, some
      employees were diverted to internal R&D projects to develop new software.
      These figures do not include the majority of the R&D conducted by
      Teknowledge under contract to government customers, nor do they include software
      development costs that were capitalized during the period. Excluding overhead
      and other indirect costs, R&D conducted by the Company under contract to
      government customers was $945,000.




The
      Company spent $452,000 for the development of its TekPortal product during
      2005,
      compared to no expenditures in 2006. Generally, the Company’s long-term R&D
      expenditures are funded externally through government projects (and recorded
      as
      cost of revenues), which are expected to provide new technology and intellectual
      property. Teknowledge retains intellectual property rights on its contract
      R&D work.





21
 *Index*




Interest
      income was $58,000 in 2006 versus $23,000 in 2005. The Company experienced
      higher average cash balances coupled with higher average money market interest
      rates in 2006. There were no interest payments in 2006 compared to $55,000
      in
      2005 as a result of paying off bank debt after the sale of TekPortal to Intuit.




The
      effective tax rate was (4%) and 3% in 2006 and 2005, respectively.




In
      2006,
      Teknowledge’s net loss was $1,197,000, or $0.21 per share basic and diluted.
      This compares to net income of $1,855,000, or $0.32 basic and diluted earnings
      per share for 2005. Included in the income in 2005 was a $3,764,000 net gain
      on
      sale of TekPortal to Intuit.




**Liquidity
      and Capital Resources**




As
      of
      December 31, 2006, Teknowledge had approximately $771,000 in cash and cash
      equivalents, a decrease of $1,397,000 over the comparable result in 2005. Net
      cash at December 31, 2005 is attributed principally to the sale of the Company’s
      Financial System TekPortal Software product line in August 2005 for $7,000,000.
      Excluded from the sale proceeds was $1,050,000 placed in escrow to serve as
      a
      reserve for potential claims by the purchaser. The Company used net cash of
      $1,395,000 for its operating activities for the twelve-months ended December
      31,
      2006, compared to $2,448,000 used in the same period for 2005.  The  Company
      received $5,776,000 in proceeds from the sale of capitalized assets, net of
      sales costs and used $456,000 to invest in the development of software products
      and the purchase of fixed assets in 2005 compared to $3,000 invested in 2006.
      In
      2006, there was no cash flow from financing activities compared to $865,000
      consumed in the same period in 2005.




Teknowledge’s
      traditional sources of cash are revenues from continuing government and
      commercial services operations, intellectual property and patent licensing,
      and
      credit facilities.




As
      a
      condition of the software asset sale agreement concluded August 22, 2005,
      Teknowledge paid off its secured debt with Bridge Bank NA (the “Bank”) of
      $675,000 and all outstanding fees, and terminated its line of credit and
      financing arrangements with the Bank. Teknowledge is seeking a new financial
      arrangement that would provide a line of credit facility.




**Recently
      Issued Accounting Pronouncements**




In
      June
      2006, FASB issued FASB Interpretation FIN No. 48, "Accounting for Uncertainty
      in
      Income Taxes—an interpretation of FASB Statement No. 109", to address the
      accounting for uncertainty in income taxes recognized in an enterprise’s
      financial statements in accordance with FASB Statement No. 109, “Accounting for
      Income Taxes”. This Interpretation prescribes a recognition threshold and
      measurement attribute for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return. This
      Interpretation also provides guidance on derecognition, classification, interest
      and penalties, accounting in interim periods, disclosure, and transition. FIN
      No. 48 goes into effect for fiscal years beginning after December 15, 2006.
      We
      have not yet determined the final impact, if any, that the adoption of FIN
      No.
      48 will have on our financial position; however, we do not anticipate the change
      will have a material impact on our financial position, results of operations
      or
      cash flows.




In
      June
      2006, the FASB Emerging Issues Task Force ("EITF") issued EITF Issue No. 06-2,
      "Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB
      Statement No. 43, Accounting for Compensated Absences", to address whether
      certain compensation costs associated with a sabbatical or other similar benefit
      arrangement should be accrued over the requisite service period. EITF Issue
      No.
      06-2 goes into effect for fiscal years beginning after December 15, 2006. We
      have not yet determined the final impact, if any, that the adoption of EITF
      Issue No. 06-2 will have on our financial position; however, we do not
      anticipate the change will have a material impact on our financial position,
      results of operations or cash flows.




In
      September 2006, the Financial Accounting Standards Board ("FASB") issued FAS
      No.
      157, "Fair Value Measurements." This Statement defines fair value, establishes
      a
      framework for measuring fair value in generally accepted accounting principles
      (GAAP), and expands disclosures about fair value measurements. This Statement
      applies under other accounting pronouncements that require or permit fair value
      measurements, the Board having previously concluded in those accounting
      pronouncements that fair value is the relevant measurement attribute.
      Accordingly, this Statement does not require any new fair value measurements.
      However, for some entities, the application of this Statement will change
      current practice. FAS No. 157 goes into effect for fiscal years beginning after
      November 15, 2007. We have not yet determined the final impact, if any, that
      the
      adoption of FAS No. 157 will have on our financial position; however, we do
      not
      anticipate the change will have a material impact on our financial position,
      results of operations or cash flows.




In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements” (“SAB 108”). SAB 108 is effective for fiscal years ending on or
      after November 15, 2006 and addresses how financial statement errors should
      be
      considered from a materiality perspective and corrected. The literature provides
      interpretive guidance on how the effects of the carryover or reversal of prior
      year misstatements should be considered in quantifying a current year
      misstatement. Historically, there have been two approaches commonly used to
      quantify such errors: (i) the “rollover” approach, which quantifies the error as
      the amount by which the current year income statement is misstated, and (ii)
      the
“iron curtain” approach, which quantifies the error as the cumulative amount by
      which the current year balance sheet is misstated. The SEC Staff believes that
      companies should quantify errors using both approaches and evaluate whether
      either of these approaches results in quantifying a misstatement that, when
      all
      relevant quantitative and qualitative factors are considered, is material.
      The
      Company adopted SAB No. 108 in the fourth quarter of fiscal year 2006 and we
      have determined that it did not have a material impact on its consolidated
      financial statements.





22
 *Index*




**Long-Term
      Contractual Obligations**




**Payments
                due by period**Contractual
                obligations
            
            **Total**
            
            **Less
                than 1 year**
            
            **1-3
                years**
            
            **3-5
                years**
            
            **More
                than 5 years**Operating
                Lease Obligations
            
            $
            345,286
            
            $
            300,761
            
            $
            44,525
            
            
            -
            
            
            -







**Item
      7.** **Financial
      Statements**




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




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




Our
      Audit
      Committee periodically considers the selection of the Company’s independent
      registered public accountants. On February 25, 2005, after an evaluation process
      that included the receipt of proposals from several independent registered
      public accounting firms and upon recommendation of our Audit Committee, the
      Company’s Board of Directors approved the retention of Burr, Pilger & Mayer
      LLP (“BPM”) as Teknowledge’s independent registered public accounting firm and
      dismissed Grant Thornton LLP (“GT”) who was acting as the Company’s principal
      independent accountants. GT’s reports on Teknowledge’s consolidated financial
      statements for each of the fiscal years ended December 31, 2002 and 2003 did
      not
      contain an adverse opinion or disclaimer of opinion, nor were they qualified
      or
      modified as to uncertainty, audit scope or accounting principle. During the
      fiscal years ended December 31, 2002 and December 31, 2003 and for the
      subsequent interim periods, there were no disagreements with GT on any matter
      of
      accounting principles or practices, financial statement disclosure, or auditing
      scope or procedure which, if not resolved to GT’s satisfaction, would have
      caused GT to make reference to the subject matter in connection with its report
      on Teknowledge’s consolidated financial statements for such years. During the
      Company’s two most recent fiscal years and through February 25, 2005, none of
      the reportable events described in Item 304(a)(1)(iv) of Regulation S-B
      occurred, except that in connection with GT’s report on Teknowledge’s
      consolidated financial statements for the year ended December 31, 2003, GT
      recommended that the Company strengthen its internal controls over financial
      reporting and the Company made the following disclosure, which was included
      in
      Section 8A of its Form 10-KSB for its fiscal year ended December 31, 2003:




During
      Teknowledge’s two most recent fiscal years ended December 31, 2002 and December
      31, 2003, and through September 30, 2004, Teknowledge has not consulted with
      BPM
      regarding either (i) the application of accounting principles to a specified
      transaction, either completed or proposed, or the type of audit opinion that
      might be rendered on Teknowledge’s consolidated financial statements and BPM did
      not provide a written report to Teknowledge or oral advice that BPM concluded
      was an important factor considered by Teknowledge in reaching a decision as
      to
      accounting, auditing or financial reporting issues; or (ii) any matter that
      was
      either the subject of a disagreement, as that term is defined in Item
      304(a)(1)(iv) of Regulation S-B and the related instructions to Item 304 of
      Regulation S-B.




All
      of
      the above information included in this Item 8 was described in our from 8-K
      filed March 3, 2005 and amended on April 1, 2005.




**Item
      8A.** **Controls
      And Procedures**




(a) Evaluation
      of disclosure controls and procedures .
      Our
      principal executive officer and principal financial officer evaluated our
      disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
      under the Securities Exchange Act of 1934, as amended) as of the end of the
      period covered by this quarterly report. Based on this evaluation, our principal
      executive officer and principal financial officer concluded that these
      disclosure controls and procedures are effective and designed to ensure that
      the
      information required to be disclosed in our reports filed or submitted under
      the
      Securities Exchange Act of 1934 is recorded, processed, summarized and reported
      within the requisite time periods.





23
 *Index*




In
      connection with its audit of the Company’s consolidated financial statements for
      the year ended December 31, 2005, Burr, Pilger & Mayer LLP (“BPM”), the
      Company’s registered public accounting firm, advised the Audit Committee and
      management of internal control matters with respect to certain financial
      reporting controls that they considered to be a material weakness, which is
      described below. A material weakness is a control deficiency, or a combination
      of control deficiencies, that results in there being more than a remote
      likelihood that a material misstatement of the annual or interim financial
      statements will not be prevented or detected. The material weakness that we
      had
      identified at December 31, 2005 was as follows:




A
      material weakness existed in our control environment relating to inadequate
      staffing of our technical accounting function, including a lack of sufficient
      personnel with skills, training and familiarity with certain complex technical
      accounting pronouncements that have or may affect our financial statements
      and
      disclosures.




The
      Company considered these matters in connection with the year end closing process
      and the preparation of the December 31, 2006 consolidated financial statements
      included in this Form 10-KSB and also determined that no prior period financial
      statements were materially affected by such matters. In response to the
      observations made by BPM, in 2006 the Company implemented certain enhancements
      to its internal controls and procedures, which it believes addressed the matters
      raised by Burr, Pilger & Mayer LLP.




As
      described in Item 8A of our Form 10-KSB for the year ended December 31, 2003
      and
      in our Form 8-K filed March 3, 2005 and amended on April 1, 2005, our previous
      independent auditor Grant Thornton LLP (“Grant Thornton”), advised our Audit
      Committee and management regarding certain internal control matters that they
      considered to be reportable conditions as that term is defined under standards
      established by the American Institute of Certified Public Accountants. In
      response to the comments made by Grant Thornton in 2003, the Company implemented
      certain enhancements to its internal controls and procedures in the second
      quarter of 2004, which it believes address the matters raised by Grant Thornton.
      The enhancements included review of policies and procedures for processing
      and
      controlling accounting transactions, closer supervisory and review of revenue
      recognition practices, improved monitoring and control of closing procedures,
      including certain high value reserves and accruals, and the migration of
      important purchasing, billing, and contract administration functions to the
      most
      experienced staff. Where applicable, the Company utilized available automated
      and manual controls to further enhance existing controls. Some responsibilities
      assigned to a single desk were redistributed to multiple employees to enhance
      control. The Company believes that the control initiatives that began in the
      second quarter 2004 were effective in addressing the concerns raised by the
      predecessor accountants.




**Item
      8B.** **Other
      Information**





None.




PART
      III




**Item
      9.** **Directors,
      Executive Officers, and Corporate Governance; Compliance
      with Section 16(a) of the Exchange Act**




The
      following table lists the current directors of the Company:


Name
              
              Age
              
              Positions
                With
                  the Company
              
              Director
                Since*Class
                  I Director whose term expires at the 2007 Annual
                  Meeting*Dr.
                  Larry E. Druffel
              
              66
              
              Director
              
              1997*Class
                  II Directors whose term expires at the 2008 Annual
                  Meeting*Neil
                  A. Jacobstein
              
              52
              
              Chairman
                  of the Board, President, and CEO
              
              1993Benedict
                  O’Mahoney
              
              46
              
              V.P.
                  of Administration & Legal Affairs
              
              1999*Class III
                  Director whose term expires at the 2009 Annual
                  Meeting*Irwin
                  Roth
              
              75
              
              Director
              
              2005




24
 *Index*





Irwin
      T. Roth .
      Mr.
      Roth, 75, was elected to the Board of Directors on June 1, 2005. Mr. Roth fills
      the vacancy created by the departure of Mr. Lustig in April 2005. Irwin Roth
      is
      the Chairman of the Board and CEO of Auricast, Inc., a creator of personalized
      media publications. He is also the Chairman of the Board and CEO of ***V*** Entertainment, Ltd., a company focused on multi-broadcast music events; On-Line
      Entertainment Network, Inc., an Internet-based entertainment network featuring
      streaming audio; and Color Q, Inc., a fine-art reproduction and printing service
      firm. He is a Director of Com-Guard, Inc., a developer of PC security software.
      In past years, he has served as a director and officer of numerous companies.
      Mr. Roth has been a practicing attorney for over 45 years in New York City,
      where he specializes in securities and entertainment law. He received his B.A.
      degree in Political Science in 1952, and a Juris Doctor degree in 1955 from
      the
      University of Michigan.




Dr.
      Larry E. Druffel .
      Dr.
      Druffel, 66, was appointed to the Board of Directors in April 1997. Since 1996,
      he has served as President, Director, and most recently as Senior Research
      Associate of the South Carolina Research Authority (SCRA), a public, non-profit,
      information technology and R&D organization. He holds a Doctorate Degree in
      Computer Science from Vanderbilt University and a Master’s Degree in Computer
      Science from the University of London, and was a director of the Software
      Engineering Institute at Carnegie-Mellon University from 1986 to 1996. He is
      Chairman of the Board of the Advanced Technology Institute, a private non-profit
      corporation. Since 2001, he has served as a member of the Board of Directors
      of
      Environmental Enterprise Group, a private environmental clean up company.




Neil
      A. Jacobstein .
      Mr.
      Jacobstein, 52, has served as Chairman of the Board, Chief Executive Officer
      and
      President of Teknowledge since November 1999. He served as President, Chief
      Operating Officer, and a Director of Teknowledge from January 1993 to November
      1999. After joining Teknowledge in 1984, Mr. Jacobstein was promoted over a
      nine-year period to: Senior Knowledge Engineer, Manager of the Research and
      Advanced Development Group, Vice President and General Manager of Research
      and
      Advanced Systems Development, and Vice President and General Manager of the
      Knowledge Systems Division. Mr. Jacobstein initiated Teknowledge’s eCommerce
      business unit in 1996. He has served on the Technology Advisory Board of the
      U.S. Army’s Simulation, Training, and Instrumentation Command (now PEOSTRI).
      Prior to joining Teknowledge, Mr. Jacobstein was a Graduate Research Intern
      and
      consultant at Xerox PARC, and a Research Associate at CBNS. Mr. Jacobstein
      was
      the Chairman of the American Association for Artificial Intelligence’s
      17 th Innovative Applications of AI conference in July 2005. Since 1992, he has served
      as the Chairman of the Board of Directors of the Institute for Molecular
      Manufacturing, a private nonprofit organization. In 1999, Mr. Jacobstein was
      elected a Henry Crown Fellow in the Aspen Institute’s executive leadership
      program.




Benedict
      O’Mahoney .
      Mr.
      O’Mahoney, 46, is Vice President of Administration and Legal Affairs of
      Teknowledge. Mr. O’Mahoney was elected to the Board in November 1999. Mr.
      O’Mahoney joined the Company in 1996 as Corporate Counsel and he was promoted
      to
      Vice President of Administration and Legal Affairs in October 1999. From 1991
      to
      1996, Mr. O’Mahoney practiced intellectual property law, and he served as
      General Counsel for Slatt Mortgage Company from 1988 to 1995.




**Board
      Committees and Meetings**




The
      Company’s Board of Directors held six regular and six Finance and Audit
      Committee meetings during 2006. All members of the Board of Directors attended
      more than 75% of the meetings of the Board of Directors and the committees
      on
      which they served. Messrs. Druffel and Roth, the members of the Finance and
      Audit Committee, are considered independent directors.




The
      Board
      of Directors of Teknowledge has two standing committees: the Finance and Audit
      Committee and the Executive Committee. The outside Board members also serve
      as
      members of the Executive Committee, which reviews and approves executive
      compensation. The Nominating Committee is comprised of all four members of
      the
      Board of Directors.




The
      Finance and Audit Committee consists of two directors, each of whom, in the
      judgment of the Board, is an “independent director”. The Finance and Audit
      Committee acts pursuant to a written charter that has been adopted by the Board
      of Directors. The primary responsibility of the Finance and Audit Committee
      is
      to oversee the annual audit of the Company, to recommend to the Board the
      retention of independent accountants, and to monitor the Company’s internal
      accounting controls and procedures. The Finance and Audit Committee also reviews
      and pre-approves any non-audit services that may be performed by the independent
      public accountants and reviews the scope and results of their annual audit,
      including the audited financial statements for the Company. The Committee is
      also responsible for overseeing corporate governance issues, especially as
      they
      relate to the requirements of the Sarbanes-Oxley Act of 2002. The current
      members of the Finance and Audit Committee are Messrs. Roth and Druffel
      (Chairman).




**Director
      Compensation**




Directors’
      Fees. Each non-employee member of the Board of Directors is entitled to receive **** cash
      compensation totaling $10,000 per year, which is paid in quarterly increments
      of
      $2,500. Non-employees members are reimbursed for out-of-pocket expenses related
      to Board activities. Each non-employee member may elect to receive stock option **** grants
      in
      lieu of cash compensation in accordance with the terms of the Directors’ Option
      Plan described below. Employee
      directors are not compensated for their services as directors of the
      Company. **** In
      addition to their regular compensation, directors are entitled to be reimbursed
      for related travel, lodging, and other expenses in attending board and committee
      meetings.





25
 *Index*





Directors’
      Option Plan .
      The
      Company adopted a new Stock Option Plan for Non-Employee Directors that was
      approved by the stockholders at the 2002 Annual Meeting. The Directors’ Plan
      provides that each non-employee director shall be granted, on the date such
      director becomes a director, an initial option to purchase 3,000 shares of
      Common Stock, and on the date of each annual meeting thereafter, each continuing
      non-employee director shall be granted an additional option to purchase 3,000
      shares of Common Stock. In addition, prior to any quarter, the Board may elect
      to grant stock options to each non-employee director in lieu of the $2,500
      quarterly fee for service. The number of shares subject to each director fee
      option would be equal to (a) $2,500, divided by (b) the fair market value of
      a
      share of Common Stock on the first business day of the quarter, rounded down
      to
      the nearest whole share. Each stock option granted to a director is fully vested
      on the date of grant and has an exercise price per share equal to the fair
      market value of a share of Common Stock on the date of grant.




**Executive
      Officers**




In
      addition to Messrs. Jacobstein and O’Mahoney, profiled above, the following
      person serves as an executive officer of the Company.




Michael
      D. Kaplan, 45, has served as Vice President of Finance, Chief Financial Officer,
      and Secretary of the Company since his hire in September 2006. Mr. Kaplan
      previously held the position of Director of Finance at OnVantage, Inc. and
      at
      Think3, Inc., both located in Santa Clara, CA. Mr. Kaplan succeeds Dennis A.
      Bugbee, who left the Company in 2006 due to a serious illness.




**Code
      of Ethics**




We
      have
      adopted our Code of Ethics for the executives, officers, and managers of
      Teknowledge Corporation. Its purpose is to promote honest and ethical conduct
      and compliance with the law, particularly as related to the maintenance of
      the
      Company’s financial records and the preparation of financial statements filed
      with the Securities and Exchange Commission (the “SEC”). A copy of such code is
      attached as an exhibit to this annual report on Form 10-KSB for the year ended
      December 31, 2006.




**Item
      10.** **Executive
      Compensation**




The
      following table sets forth the compensation paid to the Chief Executive Officer
      and the two most highly compensated executive officers of the Company whose
      annual salary and bonus exceeded $100,000 for all services to the Company in
      the
      fiscal years ended December 31, 2006, 2005, and 2004.




**SUMMARY
      COMPENSATION TABLE**





Annual
                CompensationName
                and Principal Position
            Year
            Salary
              $(1)
            Bonus
              $Neil
                Jacobstein, Chair, President, & CEO
            2006
            268,000Chief
                Executive Officer
            2005
            209,737(2)2004
            253,213Benedict
                O’Mahoney, VP Administration
            2006
            157,500&
                Legal
            2005
            139,9542004
            140,916Dennis
                Bugbee, VP Finance and
            2006
            35,376(3)Chief
                Financial Officer
            2005
            147,6252004
            162,229





(1)
            Includes
                401(k) deferred compensation and 5% Company matching
                provision.


(2)
            Mr.
                Jacobstein voluntarily reduced his salary by $38,219 in 2005 in order
                to
                assist in the company’s recovery.


(3)
            Mr.
                Bugbee left the Company in early 2006 due to a serious illness. Michael
                D.
                Kaplan joined the Company in September 2006 as VP Finance and Chief
                Financial Officer.





26
 *Index*




**Fiscal
      Year-End Option Values**




The
      following table provides the specified information concerning unexercised
      options held as of December 31, 2006, by the persons named in the Summary
      Compensation Table above. There were no exercises of options by the executive
      officers named in the Summary Compensation Table above during the fiscal year
      ended December 31, 2006.


Name
              Number
                  of Securities Underlying Unexercised Options at FYE (Exercisable/
                  Unexercisable) (#)(1)
              Value
                  of Unexercised In-the-Money Options at FYE
                  (Exercisable/Unexercisable)($)Neil
                  Jacobstein, Chair, Pres, CEO
              350,000/-
              -/-Benedict
                  O’Mahoney, VP Administration & Legal
              172,000/-
              -/-Dennis
                  Bugbee, VP and CFO
              165,000/-
              -/-




**Item
      11.** **Security
      Ownership of Certain Beneficial Owners and Management and
      Related
      Stockholder Matters**




The
      following table sets forth certain information concerning the beneficial
      ownership of Common Stock as of December 31, 2006 **** by
      each
      of the directors and nominee for director of the Company, by each of the
      executive officers named in the Summary Compensation Table, and by all directors
      and executive officers of the Company as a group. There
      are
      no persons
      known to the Company to own beneficially more than 5% of the Common
      Stock of the
      Company that are not listed below.


Name
                  and Address of Beneficial Owner(1)
              Common
                  Stock Owned Beneficially(2)
              Percent(3)of
                  ClassNeil
                  A. Jacobstein(4)
              804,589(5)
              12.7%Benedict
                  O’Mahoney(4)
              172,000(6)
              2.7%Larry
                  E. Druffel(4)
              71,305(7)
              1.1%Irwin
                  Roth(4)
              24,719(8)
              *All
                  Directors and Executive Officers of the Company as a Group (4
                  Persons)
              1,072,613(9)
              16.9%





*  Less
      than
      1%





(1)
            Except
                as otherwise indicated, the persons named in this table have sole
                voting
                and investment power with respect to all shares of Common Stock shown
                as
                beneficially owned by them, subject to community property laws, where
                applicable, and to the information contained in the footnotes to
                this
                table.


(2)
            All
                share numbers have been adjusted to give effect to a one-for-five
                reverse
                stock split on December 22, 1998. Under the rules of the Securities
                and
                Exchange Commission, a person is deemed to be the beneficial owner
                of
                shares that can be acquired by such person within 60 days upon the
                exercise of options.


(3)
            Calculated
                on the basis of 6,343,778 shares outstanding as of December 31, 2006,
                provided that any additional shares of Common Stock that a stockholder
                has
                the right to acquire within 60 days after December 31, 2006 are deemed
                to
                be outstanding for purposes of calculating that stockholder’s percentage
                beneficial ownership.


(4)
            The
                address of all directors and executive officers is the Company’s Executive
                Offices located at 1800 Embarcadero Road, Palo Alto, California
                94303.


(5)
            Includes
                350,000 shares, which may be purchased upon the exercise of employee
                stock
                options that are currently exercisable or will become exercisable
                within
                60 days of December 31, 2006. Includes 24,000 shares owned by Mr.
                Jacobstein’s spouse; with respect to which, Mr. Jacobstein disclaims
                beneficial ownership.


(6)
            Includes
                172,000 shares that may be purchased upon the exercise of employee
                stock
                options that are currently exercisable or will become exercisable
                within
                60 days of December 31, 2006.


(7)
            Includes
                64,305 shares that may be purchased upon the exercise of director
                stock
                options that are currently exercisable or will become exercisable
                within
                60 days of December 31, 2006.


(8)
            Includes
                24,719 shares that may be purchased upon the exercise of director
                stock
                options that are currently exercisable or will become exercisable
                within
                60 days of December 31, 2006.


(9)
            Includes
                options for 608,024 shares that are currently exercisable or will
                become
                exercisable within 60 days of December 31,
                2006.





27
 *Index*




**Item
      12.** **Certain
      Relationships and Related Transactions, and Director Independence**




The
      Company had no related party transactions in the year ended December 31, 2006.
      Information regarding director independence is set forth under Item 9,
“Directors, Executive Officers, and Corporate Governance; Compliance with
      Section 16(a) of the Exchange Act.”




**Item
      13.** **Exhibits**




(a)(1)
      and (2): Financial Statements




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**2.1
            Asset
                Purchase Agreement between Teknowledge Corporation and Intuit Inc.
                dated
                August 17, 2005(11)3.1
            Amended
                and Restated Bylaws of Teknowledge Corporation(4)3.2
            Amended
                and Restated Bylaws of Teknowledge Corporation(4)3.3
            Certificate
                of Designation, Preferences and Rights of the Terms of the Series
                A
                Preferred Stock(2)4.1
            Rights
                Agreement dated January 29, 1996 between the Company and Registrar
                and
                Transfer Company as Rights Agent(2)10.1
            Change
                of Control Agreement, dated November 21, 1994, between Teknowledge
                Corporation and Frederick Hayes-Roth and Neil Jacobstein(1)*10.2
            Teknowledge
                Corporation 1998 Stock Option Plan(3)*10.3
            Credit
                facility agreement with Bridge Bank, N.A., dated February 28, 2002(5)10.4
            Modification
                and extension of credit facility agreement with Bridge Bank, N.A.,
                dated
                March 28, 2003(6)10.5
            Contract
                Termination letter between Teknowledge Corporation and BAE Systems,
                dated
                February 10, 2005(7)10.6
            Modification
                and extension of credit facility agreement with Bridge Bank, N.A.,
                dated
                March 28, 2005(9)10.7
            Modification
                and extension of credit facility agreement with Bridge Bank, N.A.,
                dated
                June 30, 2005(10)12.0
            Charter
                of the Finance and Audit Committee of the Board of Directors of
                Teknowledge Corporation14.0
            Code
                of Ethics16.1
            Letter
                from Grant Thornton LLP to the Securities Exchange Commission dated,
                April
                1, 2005 regarding change in independent public accountants(12)23.1
            Consent
                of Burr, Pilger & Mayer LLP, independent registered public accounting
                firm31.1
            Certification
                of Principal Executive Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act Of 200231.2
            Certification
                of Principal Financial Officer pursuant to Section 302 of the
                Sarbanes-Oxley Act Of 200232.1
            Certification
                of Principal Executive Officer pursuant to Section 906 of the
                Sarbanes-Oxley Act Of 200232.2
            Certification
                of Principal Financial Officer pursuant to Section 906 of the
                Sarbanes-Oxley Act Of 2002*
                Indicates management contract or compensatory plan, contract or
                arrangement





28
 *Index*




**References**




(1)
            Filed
                as an Exhibit to the Company’s Annual Report on Form 10-KSB, for the
                fiscal year ended December 31, 1994.(2)
            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.(3)
            Filed
                as an Exhibit to the Company’s Quarterly Report on Form 10-QSB, for the
                quarter ended September 30, 1998.(4)
            Filed
                as an Exhibit to the Company’s Annual Report on Form 10-KSB, for the
                fiscal year ended December 31, 1998.(5)
            Filed
                as an Exhibit to the Company’s Annual Report on Form 10-KSB, for the
                fiscal year ended December 31, 2002.(6)
            Filed
                as an Exhibit to the Company’s Annual Report on Form 10-KSB, for the
                fiscal year ended December 31, 2002.(7)
            Filed
                as an Exhibit to the Company’s Annual Report on Form 10-KSB, for the
                fiscal year ended December 31, 2003.(8)
            Filed
                as an Exhibit to the Company’s Annual Report on Form 10-KSB, for the
                fiscal year ended December 31, 2004.(8)
            Filed
                as an Exhibit to the Company’s Annual Report on Form 10-KSB, for the
                fiscal year ended December 31, 2005.(10)
            Filed
                as an Exhibit to the Company’s Quarterly Report on Form 10-QSB, for the
                quarter ended March 31, 2006.(11)
            Filed
                as an Exhibit to the Company’s Quarterly Report on Form 10-QSB, for the
                quarter ended June 30, 2006.(12)
            Filed
                as an Exhibit to the Company’s Quarterly Report on Form 10-QSB, for the
                quarter ended September 30, 2006.(13)
            Filed
                as an Exhibit to the Company’s Current Report on Form 8-K/A dated April 1,
                2005, Changes in Registrant’s Certifying Accountant.(14)
            Filed
                as an Exhibit to the Company’s Definitive Proxy Statement on Form DEF 14A
                dated October 20, 2005.(15)
            Filed
                as an Exhibit to the Company’s Definitive Proxy Statement on Form DEF 14A
                dated November 10, 2006.




(b)    
      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.




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




For
      the
      purposes of complying with the amendments to the rules governing Form S-8
      (effective July 13, 1990) under the Securities Act of 1933, the undersigned
      registrant hereby undertakes as follows, which undertaking shall be incorporated
      by reference into registrant’s Registration Statements on Form S-8 Nos.
      33-27291, 33-77874, 33-78984, 33-82720, 333-00261, 333-67623, 333-44334 and
      333-100196.




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





29
 *Index*




**Item
      14.** **Principal
      Accountant Fees and Services**




The
      Board
      of Directors has selected and the stockholders have ratified the accounting
      firm
      of Burr, Pilger & Mayer LLP (“BPM”) as independent public accountants to
      examine and report upon the Company’s consolidated financial statements for the
      year ended December 31, 2006. BPM has acted in such capacity since its
      appointment on February 25, 2005 starting with the 2004 fiscal year end reports.
      Stockholder ratification of the selection of BPM as the Company’s independent
      public accountants is not required by the by-laws or otherwise. If the
      stockholders do not ratify the selection of BPM, the Board of Directors will
      reconsider the selection of independent public accountants for the
      Company.




The
      following table sets forth the aggregate fees billed to the Company for the
      fiscal years ended December 31, 2006 and December 31, 2005 by Burr, Pilger
&
Mayer LLP.




2006
            
            2005Audit
                Fees
            
            $
            204,110
            
            $
            158,053Tax
                Fees
            
            $
            17,500
            
            $
            28,403




The
      Chairman of the Finance and Audit Committee pre-approves all audit and any
      permissible non-audit services. There were no non-audit services performed
      in
      2006. Audit fees include quarterly and annual review of SEC filings and
      financial results. The preparation of annual state and federal income tax forms
      is included in tax fees.




The
      Finance and Audit Committee has considered the role of BPM in providing
      consulting, tax services, and other non-audit services to the Company and has
      concluded that such services are compatible with BPM’s independence as the
      Company’s independent public outside accountants





30
 *Index*







**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
                CorporationDate:
                April 12, 2007
            
            By:
            */s/
                Neil Jacobstein*Neil
                JacobsteinChairman
                of theBoard
                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/
                Neil Jacobstein
            
            Chairman
                of the Board of Directors
            
            April
                12, 2007Neil Jacobstein
            
            and
                Chief Executive Officer(Principal
                Executive Officer)/s/
                Michael D.
                Kaplan
            
            Vice
                President Finance,
            
            April
                12, 2007Michael
                D. Kaplan
            
            Chief
                Financial Officer(Principal
                Financial and Accounting Officer)/s/
                Benedict
                O'Mahoney
            
            Director,
                Vice President,
            
            April
                12, 2007Benedict
                O'Mahoney
            
            Administration
                and Legal Affairs/s/
                Lawrence
                Druffel
            
            Director
            
            April
                12, 2007Lawrence
                Druffel/s/
                Irwin
                Roth
            
            Director
            
            April
                12, 2007Irwin
                Roth




31
 *Index*




TEKNOWLEDGE
      CORPORATION




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




INDEX
      TO
      CONSOLIDATED FINANCIAL STATEMENTS





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





PageReport
                of Independent Registered Public Accounting Firm
            33Consolidated
                Balance Sheet - December 31, 2006
            34Consolidated
                Statements of Operations and Comprehensive Income (Loss)- Years Ended
                December 31, 2006 and 2005
            35Consolidated
                Statements of Stockholders' Equity (Deficiency) - Years Ended December
                31,
                2006 and 2005
            36Consolidated
                Statements of Cash Flows - Years Ended December 31, 2006 and
                2005
            37Notes
                to Consolidated Financial Statements
            38-50




32
 *Index*





**REPORT
      OF INDEPENDENT REGISTERED** **PUBLIC ACCOUNTING FIRM**







To
      the
      Board of Directors and Stockholders of


Teknowledge
      Corporation








We
      have
      audited the accompanying consolidated balance sheet of Teknowledge Corporation
      and subsidiary (the “Company”) as of December 31, 2006, and the related
      consolidated statements of operations and comprehensive income (loss),
      stockholders' equity (deficiency), and cash flows for each of the two years
      in
      the period ended December 31, 2006. 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 the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. The Company is not required to
      have, nor have we been engaged to perform, an audit of the Company's
      internal control over financial reporting. Our audits included consideration
      of
      internal control over financial reporting as a basis for designing audit
      procedures that are appropriate in the circumstances, but not for the purpose
      of
      expressing an opinion on the effectiveness of the Company's internal control
      over financial reporting. Accordingly, we express no such opinion. An audit
      also
      includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the financial statements, assessing the accounting principles
      used and significant estimates made by management, as well as evaluating the
      overall financial statement presentation. We believe that our audits provide
      a
      reasonable basis for our opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of Teknowledge
      Corporation and subsidiary as of December 31, 2006, and the results of
      their operations and their cash flows for each of the two years in the period
      ended December 31, 2006, in conformity with accounting principles generally
      accepted in the United States of America.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. As discussed in Note 1 to the
      consolidated financial statements, the Company’s operating results and net
      capital deficiency raises substantial doubt about its ability to continue as
      a
      going concern. Management’s plans in regard to these matters are also described
      in Note 1. The consolidated financial statements do not include any adjustments
      that might result from the outcome of this uncertainty.





/s/
      Burr,
      Pilger & Mayer LLP


San
      Jose,
      California


March
      30,
      2007





33
 *Index*




TEKNOWLEDGE
      CORPORATION


CONSOLIDATED
      BALANCE SHEET


AS
      OF
      DECEMBER 31, 2006





2006**ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            771,112Receivables:Billed,
                net of allowance of $7,100
            
            
            361,439Unbilled
                & other receivables
            
            
            275,434Total
                receivables
            
            
            636,873Prepaids
                and other current assets
            
            
            137,001Total
                current assets
            
            
            1,544,986Long
                term government unbilled receivable
            
            
            227,000Fixed
                assets, at cost:Computer
                and other equipment
            
            
            3,275,335Software
            
            
            440,540Furniture
                and fixtures
            
            
            33,124Leasehold
                improvements
            
            
            6,428Total
                fixed assets at cost
            
            
            3,755,427Less:
                Accumulated depreciation and amortization
            
            
            (3,744,921
            )Fixed
                assets, net
            
            
            10,506Total
                assets
            
            $
            1,782,492**LIABILITIES
                AND STOCKHOLDERS' DEFICIENCY**Current
                liabilities:Accounts
                payable
            
            $
            229,261Payroll
                and related liabilities
            
            
            208,919Government
                rate reserve
            
            
            2,248,305Other
                accrued liabilities
            
            
            97,213Total
                current liabilities
            
            
            2,783,698Commitments
                and contingencies (see Notes 4 and 10)Stockholders'
                deficiency:Preferred
                stock, $.01 par value, authorized 2,500,000 shares, including Series
                A
                Convertible Preferred Stock, none issued
            
            
            -Common
                stock, $.01 par value, authorized 25,000,000 shares,5,735,754 shares
                issued and outstanding
            
            
            57,358Additional
                paid-in capital
            
            
            1,926,521Accumulated
                deficit since January 1, 1993
            
            
            (2,985,085
            )(following
                quasi-reorganization)Total
                stockholders' deficiency
            
            
            (1,001,206
            )Total
                liabilities and stockholders' deficiency
            
            $
            1,782,492




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





34
 *Index*




TEKNOWLEDGE
      CORPORATION


CONSOLIDATED
      STATEMENTS OF OPERATIONS


AND
      COMPREHENSIVE INCOME (LOSS)





**Twelve
                Months ended Dec 31,**2006
            
            2005Revenues:Software
                services and licenses
            
            $
            1,930,262
            
            $
            3,583,004Patent
                licenses
            
            
            999,999
            
            
            465,000Total
                revenues
            
            
            2,930,261
            
            
            4,048,004Cost
                of revenues:Software
                services and licenses
            
            
            970,206
            
            
            3,143,092Patent
                licenses
            
            
            290,389
            
            
            298,997Total
                cost of revenues
            
            
            1,260,595
            
            
            3,442,089Gross
                profit
            
            
            1,669,666
            
            
            605,915Operating
                expense:General
                and administrative
            
            
            1,558,384
            
            
            1,795,817Research
                and development
            
            
            1,406,839
            
            
            505,452Sales
                and marketing
            
            
            14,858
            
            
            101,853Gain
                on sale of assets
            
            
            -
            
            
            (3,733,248
            )Total
                operating expenses (income)
            
            
            2,980,081
            
            
            (1,330,126
            )Income
                (loss) from operations
            
            
            (1,310,415
            )
            
            1,936,041Interest
                and other income (expense), net
            
            
            65,310
            
            
            (30,752
            )Income
                (loss) before provision (benefit) for income taxes
            
            
            (1,245,105
            )
            
            1,905,289Provision
                for income tax (benefit)
            
            
            (48,208
            )
            
            50,000Net
                income (loss) and comprehensive income (loss)
            
            
            (1,196,897
            )
            
            1,855,289Earnings
                (loss) per share:-
                Basic
            
            $
            (0.21
            )
            $
            0.32-
                Diluted
            
            $
            (0.21
            )
            $
            0.32Shares
                used in computing earnings (loss) per share:-
                Basic
            
            
            5,735,754
            
            
            5,735,754-
                Diluted
            
            
            5,735,754
            
            
            5,883,519





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





35
 *Index*




TEKNOWLEDGE
      CORPORATION


CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIENCY)




**Common
                Stock Shares Issued**
            
            **Par
                Value**
            
            **Additional
                Paid-in Capital**
            
            **Accumulated
                Deficit**
            
            **Total**Balance,
                January 1, 2005
            
            
            5,735,754
            
            $
            57,358
            
            $
            1,904,847
            
            $
            (3,643,477
            )
            $
            (1,681,272
            )Issuance
                of warrants
            
            
            
            
            
            
            
            
            13,458
            
            
            
            
            
            13,458Net
                income
            
            
            -
            
            
            -
            
            
            -
            
            
            1,855,289
            
            
            1,855,289Balance,
                December 31, 2005
            
            
            5,735,754
            
            
            57,358
            
            
            1,918,305
            
            
            (1,788,188
            )
            
            187,475Stock-based
                compensation
            
            
            
            
            
            
            
            
            8,216
            
            
            
            
            
            8,216Net
                loss
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,196,897
            )
            
            (1,196,897
            )Balance,
                December 31, 2006
            
            
            5,735,754
            
            $
            57,358
            
            $
            1,926,521
            
            $
            (2,985,085
            )
            $
            (1,001,206
            )





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





36
 *Index*





TEKNOWLEDGE
      CORPORATION


CONSOLIDATED
      STATEMENTS OF CASH FLOWS




**Twelve
                Months ended Dec 31,****2006**
            
            **2005**Cash
                flows from operating activities:Net
                income (loss)
            
            $
            (1,196,897
            )
            $
            1,855,289Adjustments
                to reconcile net income (loss) to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            18,811
            
            
            213,385Amortization
                of warrants and options
            
            
            13,641
            
            
            25,299Gain
                on sale of assets
            
            
            -
            
            
            (3,733,248
            )Provision
                for doubtful accounts
            
            
            (34,356
            )
            
            18,590Decrease
                (increase) in operating assets:Receivables
            
            
            87,007
            
            
            926,300Prepaids
                and other current assets
            
            
            7,379
            
            
            (49,348
            )Increase
                (decrease) in operating liabilities:Accounts
                payable
            
            
            (69,968
            )
            
            (1,365,980
            )Other
                accrued liabilities
            
            
            (220,373
            )
            
            (338,184
            )Net
                cash used in operating activities
            
            
            (1,394,756
            )
            
            (2,447,897
            )Cash
                flows from investing activities:Proceeds
                from sale of asset
            
            
            -
            
            
            5,775,980Capitalization
                of software development costs
            
            
            -
            
            
            (452,169
            )Purchase
                of fixed assets
            
            
            (2,640
            )
            
            (3,736
            )Net
                cash provided by (used in) investing activities
            
            
            (2,640
            )
            
            5,320,075Cash
                flows from financing activities:Net
                repayment on line of credit
            
            
            -
            
            
            (864,841
            )Net
                cash used in financing activities
            
            
            -
            
            
            (864,841
            )Net
                decrease in cash and cash equivalents
            
            
            (1,397,396
            )
            
            2,007,337Cash
                and cash equivalents at beginning of period
            
            
            2,168,508
            
            
            161,171Cash
                and cash equivalents at end of period
            
            $
            771,112
            
            $
            2,168,508Supplemental
                disclosure of cash flow information:Cash
                paid for interest
            
            $
            -
            
            $
            54,809Cash
                paid for income taxes
            
            $
            13,105
            
            $
            1,799





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





37
 *Index*




TEKNOWLEDGE
      CORPORATION


NOTES
      TO
      CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
      31, 2006




**1.** **History
      and Business**




Teknowledge
      Corporation (the “Company”) was incorporated on July 8, 1981 under the laws of
      the State of Delaware and is the surviving corporation of the merger of American
      Cimflex Corporation and Teknowledge Inc., which was consummated in 1989. 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.




The
      Company sells software and service solutions and plans to deliver value-added
      web services that help customers monitor critical variables in their operations,
      and enable them to act on changes to those variables in a timely manner. It
      also
      provides contract research and development (“R&D”) services, primarily to
      the U.S. Government. Teknowledge designs intelligent transactions that deliver
      flexible, secure, and knowledge-based interactions with customers. These
      transactions enable organizations to codify their knowledge, use it to interpret
      data, and provide value-added services to end-users.




The
      consolidated financial statements of the Company have been prepared on a going
      concern basis, which contemplates the realization of assets and the discharge
      of
      liabilities in the normal course of business for the foreseeable future. The
      Company had a working capital deficiency and an accumulated deficit of
      $2,985,085 at December 31, 2006. Accordingly, the Company's ability to continue
      as a going concern is in substantial doubt and is dependent on the Company
      generating cash flows that are adequate to sustain the operations of the
      business and maintain its obligations with respect to secured and unsecured
      creditors, none of which is assured. The consolidated financial statements
      do
      not give effect to any adjustments which would be necessary should the Company
      be unable to continue as a going concern and, therefore, be required to realize
      its assets and discharge its liabilities in other than the normal course of
      business and at amounts different from those reflected in the consolidated
      financial statements.





Management
      is currently implementing strategies designed to increase revenues, contain
      costs and improve the financial results of the Company’s operations. For
      example, having demonstrated the value of its patent portfolio in 2006 with
      the
      sale of a $1,000,000 patent license, the Company is now focusing some of its
      resources on selling a substantial number of patent licenses in 2007.
      Additionally, the Company recently signed several value-added reseller
      agreements with major storage hardware suppliers that can be used to augment
      its
      proprietary technology and help grow a robust professional services
      division.




**2.** **Summary
      of Significant Accounting Policies**




Use
      of
      Estimates in the Preparation of Financial Statements




The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America 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.
      Specifically, the Company makes estimates and assumptions when recording the
      allowance for doubtful accounts, the valuation allowance for deferred tax
      assets, and realizability of capitalized software development costs, government
      contract rate reserve, and percentage of completion revenue recognition.




Principles
      of Consolidation




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.




Cash
      and Cash Equivalents




The
      Company considers all highly liquid debt securities, with original maturity
      dates of less than 90 days, cash equivalents. As of December 31, 2006, the
      Company’s funds were invested in three banks and one brokerage firm.





38
 *Index*




Non-cash
      Transactions




Investing
      and financing activities that do not have a direct impact on current cash flows
      are excluded from the statement of cash flows.





During
      the years ended December 31, 2006 and 2005, non-cash charges for issuance of
      warrants of $0 and $13,458, were excluded from the statements of cash
      flows.






Receivables




Receivables
      as of December 31, 2006 consist of the following:





Commercial
                customers:Billed
                receivables
            
            $
            136,149Unbilled
                receivables
            
            
            15,248151,397U.S.
                Government:Billed
                receivables
            
            
            232,390Unbilled
                receivables
            
            
            260,186Unbilled
                receivables - long-term
            
            
            227,000719,576Gross
                receivables
            
            
            870,973Allowance
                for doubtful accounts
            
            
            (7,100
            )Total
                receivables, net
            
            
            863,873Less
                current receivables, net
            
            
            (636,873
            )Total
                long term government unbilled receivables
            
            $
            227,000





Approximately
      $227,000 of unbilled government retained fees are not expected to be billed
      in
      2007.




Concentration
      of Credit and Customer Risk




In
      2006
      and 2005, approximately 32% and 39% of the Company’s total revenues,
      respectively, were recorded in connection with U.S. Government contracts,
      principally of the cost-plus-fixed-fee type. In 2006, 87% of total revenues
      were
      from the Department of the Air Force. In 2005, 29% of total revenues were from
      the Department of the Air Force. In 2006, 34% of total revenue was attributed
      to
      the Financial Solutions segment and 34% to Patent licenses. In 2006, no
      Financial Solutions customers accounted for more than 10% of the Financial
      Solutions revenues, and thus of the total Company’s revenues. At December 31,
      2006, 61% and 19% of Financial Solutions accounts receivable were attributable
      to MBNA and Intuit, respectively.




The
      majority of the Company’s accounts receivable are from financial services
      companies and the Federal Government. Credit is extended based on evaluation
      of
      a customers’ financial condition, and collateral is not generally required.
      Accounts receivable are generally due within 30 to 90 days and are stated at
      amounts due from customers net of an allowance for doubtful accounts. Accounts
      outstanding longer than the contractual payment terms are considered past due.
      The Company determines its allowance by considering a number of factors,
      including the length of time trade accounts receivable are past due, the
      Company’s previous loss history, the customer’s current ability to pay its
      obligation to the Company, and the condition of the general economy and the
      industry as a whole. The Company writes-off accounts receivable when they become
      uncollectible, and payments subsequently received on such
      receivables  are
      credited to the allowance for doubtful accounts. The Company has not experienced
      a credit loss from a government customer nor does it anticipate such losses,
      and
      has not provided an allowance for doubtful accounts against government
      receivables. The Company provides reserves for anticipated disallowed direct
      and
      indirect costs reimbursements.




Financial
      instruments that potentially subject the Company to concentration of credit
      risk
      consist principally of trade receivables. The amounts reported for cash and
      cash
      equivalents, receivables, accounts payable, and accrued liabilities approximate
      the fair value due to their short maturities. As of December 31, 2006, the
      Company had $461,000 in cash on deposit in a bank that was in excess of Federal
      Deposit Insurance Corporation (“FDIC”) limits of $100,000.





39
 *Index*




Fixed
      Assets




Furniture
      and equipment is 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. Depreciation costs
      were
      $19,000 in 2006 and $32,000 in 2005. Third party software is amortized over
      their estimated useful lives of three years and computers and equipment are
      depreciated over their estimated useful lives of two years. Both third party
      software and computers and equipment are depreciated using straight-line method
      over their estimated useful lives.




Government
      Rate Reserve




The
      Company’s revenues, costs, and earnings on government contracts are determined
      based on direct cost and estimated overhead “indirect” rates derived from
      forecasted annual costs. The Company’s actual experience in headcount growth,
      billable efficiency, and costs typically vary from original estimates and
      necessitate periodic adjustments to overhead rates and revenues. Such
      adjustments are made on a cumulative basis whereas the resulting revenue and
      income effects are recognized in the period of the adjustments. The Company
      is
      also subject to periodic reviews of prior year costs and expenses by audit
      agencies of the Federal Government. As a result of these audits, the Company
      may
      be exposed to annual cost adjustments that are applied on a retroactive basis
      to
      the government contracts completed in prior years. These adjustments can have
      a
      negative or positive effect on the results of operations and cash reserves
      in
      the period in which the adjustment is realized. The Company provides reserves
      for anticipated disallowed direct and indirect costs reimbursements.




Income
      Tax Liabilities




Income
      tax expense includes U.S. and state income taxes. Certain items of income and
      expense are not reported in tax returns and financial statements in the same
      year. The tax effect of such temporary differences is reported as deferred
      income taxes.




Revenue
      Recognition




The
      Company derives revenue from research and development contracts (Government
      Contract R&D) with the U.S. Government and from sales of software products
      and services for Financial Solutions, patent and technology licensing, and
      commercial business applications of government Security Systems to commercial
      customers.




(a)  Contract
      Revenue




The
      Company principally uses the percentage-of-completion method of accounting
      for
      contract revenues for both government and commercial projects. 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. For contracts that do not meet the criteria for the
      percentage-of-completion method, the Company recognizes contract revenue on
      a
      completed contract basis. 15% of the fee for government contracts, which is
      approximately one percent of the total contract award, is retained and may
      be
      billed after the final indirect rates are submitted to the government. The
      final
      indirect rates are not submitted to the government until they have been reviewed
      and approved by the Defense Contract Audit Agency (“DCAA”). Revenue on the
      retained fee is recognized as earned but not billed until the final indirect
      rates have been approved by the DCAA. The Company has not received final
      overhead rate approval from government agencies for costs incurred during the
      fiscal years 2001 through 2006. Accordingly, the Company has recorded a rate
      adjustment reserve of $2,248,000 related to potential audit agency adjustments
      to the Company’s indirect overhead rates.




(b)  Software
      License and Services




The
      Company derives revenue as follows: (i) sale of software licenses to end users,
      and (ii) services which include consulting, training, and post-contract customer
      support (“PCS”). The Company has established standards for ensuring that the
      Company recognizes revenue consistently, and in accordance with the American
      Institute of Certified Public Accountants (“AICPA”) Statement of Position 97-2,
      Software Revenue Recognition (“SOP 97-2”), as amended by SOP 98-9.




Under
      SOP
      97-2, the Company records revenue from licensing of software products to
      end-users when both parties sign a license agreement, the fee is fixed or
      determinable, collection is reasonably assured and delivery of the product
      has
      occurred. When the agreements include PCS, these amounts are recognized ratably
      over the period of the contracts, which is generally twelve months.





40
 *Index*




Generally,
      the Company provides payment terms that range from thirty to ninety days from
      the invoice date. Accordingly, payment terms that exceed ninety days are not
      considered fixed or determinable and revenue is recognized as payments become
      due.




When
      contracts contain multiple elements, and for which vendor specific objective
      evidence (“VSOE”) of fair value exists for the undelivered elements, the Company
      recognizes revenue for the delivered elements based upon the residual method.
      VSOE is generally the price for products sold separately or the renewal rate
      for
      PCS. Undelivered elements consist primarily of PCS and other services such
      as
      consulting, mentoring and training. Services are generally not considered
      essential to the functionality of the software. The Company recognizes revenue
      allocated to PCS ratably over the period of the contracts, which is generally
      twelve months. For revenue related to consulting services, the Company
      recognizes revenue as the related services are performed. In instances where
      services are deemed essential to the software, both the software license fee
      and
      consulting fees are recognized using the percentage-of-completion method of
      contract accounting as required under SOP 81-1.




The
      portion of fees related to either products delivered or services rendered which
      are not earned under our Company’s standard payment terms are reflected in
      deferred revenue and in unbilled receivables.




Significant
      management judgments and estimates must be made in connection with determination
      of the revenue to be recognized in any accounting period. If the Company made
      different judgments or utilized different estimates for any period, material
      differences in the amount and timing of revenue recognized could result.




If
      the
      Company enters into a licensing agreement with a party as a result of a patent
      and intellectual property settlement, revenue is recognized at the time the
      agreement is signed. Revenue will not be recognized for settlements that do
      not
      result in a licensing agreement. License revenues are established from a
      standard pricing structure that determines the price of the license in relation
      to the settlement amount. If the amount of the settlement is greater than the
      standard license price, then the amount of the settlement that exceeds the
      standard price will be included in other income.




Stock-Based
      Compensation Volatility




Stock-based
      compensation is calculated using the modified Black-Scholes option pricing
      model. The volatility component is based on the Company’s historical share price
      performance over the preceding 5 years. In 2006, a volatility measurement of
      166% was used in calculating stock-based compensation expense.




Depreciation
      and Amortization Expense




Property
      and equipment is stated at cost and depreciated using the straight-line method
      over the shorter of the estimated life of the asset or the lease term. Computer
      software developed or obtained for internal use is depreciated using the
      straight-line method over the estimated useful life of the software, generally
      three years or less.




Intangible
      assets are amortized using the straight-line method over their estimated period
      of benefit. We evaluate the recoverability of intangible assets periodically
      and
      take into account events or circumstances that warrant revised estimates of
      useful lives or that indicate that impairment exists. All of our intangible

      assets are subject to amortization. No impairments of intangible assets have
      been identified during any of the periods presented.




Research
      and Development Costs




Research
      and development (“R&D”) expenses are comprised of expenses related to
      internal R&D, third-party R&D activities (“Contract R&D”), and
      purchased R&D costs arising from the company’s business development
      activities.




Internal
      R&D costs are expensed as incurred in compliance with FASB Statement No. 2
      (“FAS-2”), “Accounting for Research and Development Costs.” Equipment,
      facilities, materials, and intangibles bought that have alternative future
      benefit in R&D activities are capitalized. Any resulting depreciation or
      amortization expense on such assets is presented as an R&D expense. When
      there is no future alternative use, the costs are immediately expensed. R&D
      costs include employee salaries directly tied to R&D efforts, and directly
      allocable indirect costs for R&D efforts. R&D costs for software
      development are expensed up until technological feasibility has been
      established. During 2006 and 2005, internal R&D costs of $1,407,000 and
      $505,000 respectively were expensed.





41
 *Index*




Contract
      R&D costs are expensed as cost of revenues at the point when revenue is
      recognized on work performed under contract for the Company’s customers. During
      2006 and 2005, contract R&D costs of $418,000 and $973,000 respectively were
      recognized as cost of revenues.




Capitalized
      Software Development Costs




Teknowledge
      capitalizes software development costs once technological feasibility is reached
      and continuing until general availability of the product. During 2006 and 2005,
      software development costs of $0 and $452,000 were capitalized respectively.
      Amortization costs were $0 in 2006, and $181,000 in 2005. Amortization is
      included in cost of revenues in the accompanying consolidated statements of
      operations. The Company’s policy is to amortize capitalized software development
      costs by the greater of (a) the ratio of current gross revenues for a product
      to
      anticipated gross revenues for that product, or (b) the straight-line method
      over the estimated economic life of the product, which is estimated at three
      years.




Earnings
      Per Share




Basic
      earnings (loss) per share is calculated by dividing net income (loss) by the
      weighted average shares of common stock outstanding during the period. Diluted
      earnings (loss) per share is calculated by dividing net income (loss) by the
      weighted average shares of outstanding common stock and potential common stock
      outstanding during the period. Potential common stock consists of shares
      issuable upon the exercise of outstanding common stock options or warrants.
      All
      potential common stock is excluded from the calculation if the effect is
      anti-dilutive.




A
      summary
      of the earnings (loss) per share calculation for the years ended December 31,
      2006 and 2005 is as follows:




**2006**
            
            **2005**(in
                thousands, except per share amounts)Net
                income (loss) available to common shareholders:Numerator:
                Net income (loss)
            
            $
            (1,197
            )
            $
            1,855Denominator
                for basic net income (loss) per share:Weighted
                average common shares outstanding
            
            
            5,736
            
            
            5,736Shares
                used in basic per share calculation
            
            
            5,736
            
            
            5,736Effect
                of dilutive securities:Warrants
            
            
            -
            
            
            16Employee
                stock options
            
            
            -
            
            
            132Diluted
                weighted average common shares
            
            
            5,736
            
            
            5,884Basic
                net income (loss) per share
            
            $
            (0.21
            )
            $
            0.32Diluted
                net income (loss) per share
            
            $
            (0.21
            )
            $
            0.32







In
      2006,
      1,261,943 options and warrants to purchase shares of common stock were excluded
      from the computation of diluted loss per share as all such securities were
      antidilutive due to the company’s loss in 2006. In 2005, 373,471 options and
      56,750 warrants to purchase shares of commons stock were excluded from the
      computation of diluted earnings per share because the options’ and warrants
      exercise price was greater than the average market price of the common shares
      and anti-dilutive.




Recently
      Issued Accounting Pronouncements




In
      June
      2006, FASB issued FASB Interpretation FIN No. 48, "Accounting for Uncertainty
      in
      Income Taxes—an interpretation of FASB Statement No. 109", to address the
      accounting for uncertainty in income taxes recognized in an enterprise’s
      financial statements in accordance with FASB Statement No. 109, Accounting
      for
      Income Taxes. This Interpretation prescribes a recognition threshold and
      measurement attribute for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return. This
      Interpretation also provides guidance on derecognition, classification, interest
      and penalties, accounting in interim periods, disclosure, and transition. FIN
      No. 48 goes into effect for fiscal years beginning after December 15, 2006.
      We
      have not yet determined the final impact, if any, that the adoption of FIN
      No.
      48 will have on our financial position; however, we do not anticipate the change
      will have a material impact on our financial position, results of operations
      or
      cash flows.





42
 *Index*




In
      June
      2006, the FASB Emerging Issues Task Force ("EITF") issued EITF Issue No. 06-2,
      "Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB
      Statement No. 43, Accounting for Compensated Absences", to address whether
      certain compensation costs associated with a sabbatical or other similar benefit
      arrangement should be accrued over the requisite service period. EITF Issue
      No.
      06-2 goes into effect for fiscal years beginning after December 15, 2006. We
      have not yet determined the final impact, if any, that the adoption of EITF
      Issue No. 06-2 will have on our financial position; however, we do not
      anticipate the change will have a material impact on our financial position,
      results of operations or cash flows.




In
      September 2006, the Financial Accounting Standards Board ("FASB") issued FAS
      No.
      157, "Fair Value Measurements." This Statement defines fair value, establishes
      a
      framework for measuring fair value in generally accepted accounting principles
      (GAAP), and expands disclosures about fair value measurements. This Statement
      applies under other accounting pronouncements that require or permit fair value
      measurements, the Board having previously concluded in those accounting
      pronouncements that fair value is the relevant measurement attribute.
      Accordingly, this Statement does not require any new fair value measurements.
      However, for some entities, the application of this Statement will change
      current practice. FAS No. 157 goes into effect for fiscal years beginning after
      November 15, 2007. We have not yet determined the final impact, if any, that
      the
      adoption of FAS No. 157 will have on our financial position; however, we do
      not
      anticipate the change will have a material impact on our financial position,
      results of operations or cash flows.




In
      September 2006, the Securities and Exchange Commission (“SEC”) issued Staff
      Accounting Bulletin No. 108, “Considering the Effects of Prior Year
      Misstatements when Quantifying Misstatements in Current Year Financial
      Statements” (“SAB 108”). SAB 108 is effective for fiscal years ending on or
      after November 15, 2006 and addresses how financial statement errors should
      be
      considered from a materiality perspective and corrected. The literature provides
      interpretive guidance on how the effects of the carryover or reversal of prior
      year misstatements should be considered in quantifying a current year
      misstatement. Historically, there have been two approaches commonly used to
      quantify such errors: (i) the “rollover” approach, which quantifies the error as
      the amount by which the current year income statement is misstated, and (ii)
      the
“iron curtain” approach, which quantifies the error as the cumulative amount by
      which the current year balance sheet is misstated. The SEC Staff believes that
      companies should quantify errors using both approaches and evaluate whether
      either of these approaches results in quantifying a misstatement that, when
      all
      relevant quantitative and qualitative factors are considered, is material.
      The
      Company adopted SAB No. 108 in the fourth quarter of fiscal year 2006 and we
      have determined that it did not have a material impact on its consolidated
      financial statements.




**3.** **Other
      Accrued Liabilities**




Other
      accrued liabilities as of December 31, 2006 consist of the following:




Deferred
                revenue
            
            $
            100,567Other
            
            
            (3,354
            )$
            97,213









**4.** **Lease
      Commitments**




The
      Company leases facilities and equipment under non-cancelable operating leases.
      As of December 31, 2006, the Company had facility leases with durations of
      more
      than one year in the following locations:




Location
            
            ExpiresPalo
                Alto, California
            
            October
                31, 2007Marina
                Del Rey, California
            
            May
                5, 2008




The
      remaining obligations under these leases are as follows:




Year
                Ending December 31,2007
            
            $
            300,7612008
            
            
            44,525$
            345,286




43
 *Index*




Rent
      expense for the years ended December 31, 2006 and 2005 totaled approximately
      $351,000 and $314,000, respectively.




**5.** **Income
      Taxes**




The
      Company accounts for income taxes using an asset and liability approach for
      computing deferred income taxes based on enacted tax laws and rates applicable
      to the period in which the differences between the tax basis and financial
      reporting basis of assets and liabilities reverse.




The
      provision for income taxes differs from the statutory U.S. Federal income tax
      rate due to the following:





**2006**
            
            **2005**Provision
                (benefit) at U.S. statutory rate
            
            
            (34.0
            %)
            
            34.0
            %Change
                in valuation allowance
            
            
            30.1
            %
            
            (31.4
            %)Other
            
            
            
            
            
            -Effective
                tax rate
            
            
            (3.9
            %)
            
            2.6
            %





The
      components of the deferred income tax asset as of December 31, 2006 are as
      follows:





Net
                operating loss carryforwards
            
            $
            4,975,921Tax
                credit carryforwards
            
            
            979,170Cumulative
                temporary differences
            
            
            1,462,902Deferred
                tax asset
            
            
            7,417,993Valuation
                allowance
            
            
            (7,417,993
            )Net
                deferred tax asset
            
            $
            -







Management
      believes that sufficient uncertainty exists with regard to the realizability
      of
      the Company’s tax assets that a full valuation allowance is necessary. These
      factors include the lack of a significant history of consistent profits and
      a
      lack of carryback capacity to realize these assets.  The change in
      valuation allowance was $2.9 million and $3.6 million in 2006 and 2005,
      respectively. Given the Company’s pretax profit in 2005, all of which was
      generated in the U.S., the Company generated enough income to incur both
      California and the Federal Government current alternative minimum tax (“AMT”) on
      corporations. This situation did not recur in 2006 due to the Company’s pre-tax
      loss.




At
      December 31, 2006, the Company had Federal and state net operating loss
      carryforwards of approximately $14 million and $1 million respectively available
      to offset future taxable income. These loss carryforwards expire at various
      dates through the year 2024 as follows:





These
      loss carryforwards expire at various dates through the year 2024 as follows:





2007
            
            $
            9,000,0002008
            
            
            4,000,0002009
            
            
            -2010
                - 2024
            
            
            1,000,000$
            14,000,000





In
      2006,
      $7 million of net operating losses expired. 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 tax law provisions, including any change in ownership
      interest of the Company resulting from significant stock transactions.




**6.** **401(k)
      Plan**




The
      Company has a 401(k) plan and participants in the plan may make a contribution
      as a percentage of their gross wages subject to the applicable government
      limits. In 2006, the Company matched 5% of contributions on eligible wages.
      The
      Company’s matching contribution vests at 20% per year over a five-year period.
      The Company contributed approximately $94,000 and $153,000 to the plan during
      2006 and 2005, respectively.





44
 *Index*




**7.** **Stockholders’
      Equity (Deficiency)**




*Preferred
      Stock*


**


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




Under
      the
      Rights Agreement, stockholders will receive five Rights to purchase one
      one-hundredth of a share of Series A Preferred Stock for each outstanding share
      of the Company’s Common Stock of record 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 Series A 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
      Series A 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.




**8.** **Stock-Based
      Compensation**




Effective
      January 1, 2006, the Company adopted the provisions of Statement of Financial
      Accounting Standards (“SFAS”) No. 123 (revised 2004) (“SFAS No. 123R”), *“Share-Based
      Payment,”* which
      requires companies to measure and recognize compensation expense for all
      stock-based payments at fair value starting at grant date. All of the Company’s
      stock compensation is accounted for as an equity instrument. The Company
      previously applied Accounting Principles Board (“APB”) Opinion No. 25,
“Accounting for Stock Issued to Employees,” and related interpretations and
      provided the pro forma disclosures of SFAS No. 123, “Accounting for Stock Based
      Compensation.”




*Prior
      to the Adoption of SFAS No. 123R*




Teknowledge
      previously accounted for stock-based compensation using the intrinsic value
      method in accordance with the provisions of Accounting Principle Board Opinion
      No. 25, “Accounting for Stock Issued to Employees,” as allowed by SFAS No. 123,
“Accounting for Stock Based Compensation” (“SFAS No. 123”) as amended by SFAS
      No. 148, “Accounting for Stock Based Compensation — Transition and Disclosures,
      an Amendment of SFAS No. 123.” Under the intrinsic value method, Teknowledge did
      not recognize any compensation expense when the exercise price of stock options
      issued to employees and directors was equal to the fair market value of our
      common stock at the time the options were granted. Had compensation expense
      been
      recognized using the fair value-based method under SFAS No. 123, Teknowledge’s
      pro forma consolidated income and income per share would have been as follows
      (in thousands, except per share amounts):





**Year
                Ended December 31, 2005**Net
                income as reported
            
            $
            1,855Stock-based
                non employee compensation expense included in reported net
                income
            
            
            25Pro
                forma stock compensation expense computed under the fair value method
                for
                all awards
            
            
            (232
            )Pro
                forma net income
            
            $
            1,648Basic
                and diluted net income per share, as reported
            
            $
            0.32Pro
                forma net income per share, basic
            
            $
            0.29Pro
                forma net income per share, diluted
            
            $
            0.28





For
      purposes of the weighted average estimated fair value calculations, the fair
      value of each stock option grant is estimated on the date of grant using the
      Black-Scholes option pricing model and the following assumptions:





45
 *Index*




**Year
                Ended December 31,**
              **2005**Risk-free
                interest rate
            4%Expected
                life of option
            1.0
                yearExpected
                dividends
            0%Volatility
            200%Weighted
                average fair value at grant date
            $0.22





*Impact
      of the Adoption of SFAS No. 123R*




The
      Company elected to adopt the modified prospective application method as provided
      by SFAS No. 123R. The effect of recording stock-based compensation for the
      year
      ended December 31, 2006 was as follows (in thousands, except per share
      data):




**Year
                Ended December 31, 2006**Stock-based
                compensation expense by type of award:Employee
                stock options
            
            $
            3Total
                stock-based compensation
            
            
            3Tax
                effect on stock-based compensation
            
            
            -Net
                effect on net loss
            
            $
            3Effect
                on basic and diluted net loss per share
            
            $
            -





For
      purposes of calculating stock-based compensation expense, the fair value of
      each
      stock option grant is estimated on the date of grant using the Black-Scholes
      option pricing model and the following assumptions:





**Year
                Ended December 31,****2006**Risk-free
                interest rate
            5%Expected
                life of option
            1.0
                yearExpected
                dividends
            0%Volatility
            166%Weighted
                average fair value at grant date
            $0.20




The
      unrecorded deferred stock-based compensation balance related to stock options
      as
      of January 1, 2006 was $5,000 before estimated forfeitures and will be
      reclassified into additional paid-in-capital as it is expensed, as is required
      by the adoption of SFAS No. 123R. In the Company’s pro forma disclosures prior
      to the adoption of SFAS No. 123R, the Company accounted for forfeitures upon
      occurrence. SFAS No. 123R requires forfeitures to be estimated at the time
      of
      grant and revised if necessary in subsequent periods if actual forfeitures
      differ from those estimates. The Company has elected to use actual forfeitures
      during 2006 in order calculate the remaining unrecorded deferred stock-based
      compensation balance. The Company has calculated that the stock-based
      compensation for awards not expected to vest is $1,000, and therefore, the
      unrecorded deferred stock-based compensation balance related to stock options
      has been adjusted to approximately $4,000 after forfeitures.




During
      the year ended December 31, 2006, the Company granted 23,810 options that vested
      immediately to Teknowledge’s non-employee Board of Directors as compensation for
      services rendered in 2005. The Company also granted 6,000 options to
      non-employee Board of Directors that vest over a period of one year and 1,000
      employee options that vest over a period of five years. In 2006, the Company
      recorded stock-based compensation related to stock options of
      $3,000.





46
 *Index*




As
      of
      December 31, 2006, the unrecorded deferred stock-based compensation balance
      related to stock options was $1,000 and will be recognized over an estimated
      weighted average amortization period of 4.25 years.




*Stock-Based
      Compensation
      Plans*




The
      Company’s stock option plan for employees is called the Teknowledge Corporation
      1998 Stock Option Plan (the “1998 Plan”) and the stock option plan for Directors
      is called the 2002 Teknowledge Plan for Non-Employee Directors (the “Directors’
Plan”).




The
      aggregate number of shares issued under the 1998 Plan may not exceed 2,345,101
      shares of common stock and 1,181,182 shares were available for future grant
      as
      of December 31, 2006. 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 may not be less
      than the fair market value on the date of grant. For NSO, the exercise price
      of
      the common stock may not be less than 85% of the fair market value of the common
      stock on the date of grant. Options that were granted in 2006 vest immediately
      or by December 31, 2006. For 2004 and prior, the options vest in quarterly
      increments starting the second year of a four-year term and expire ten years
      after the grant date. Management will utilize cash bonuses instead of issuing
      options.




The
      aggregate number of shares issued under the Directors’ Plan may not exceed
      250,000 shares of common stock and 151,976 shares were available for future
      grant as of December 31, 2006. Under this plan, non-employee directors are
      entitled to receive annual option grants to purchase 3,000 shares of common
      stock on their initial election to the Board and thereafter on the anniversary
      date of their election to the Board. The Company, under the Directors’ Plan may
      grant options to purchase common stock in lieu of cash payments for directors’
fees. Options, which are granted at fair market value, are exercisable one
      year
      after the grant date and expire ten years from the grant date.




As
      of
      December 31, 2006, the following number of shares of common stock have been
      reserved for future issuance under both Plans:




Teknowledge
                Corporation 1998 Stock Option Plan
            
            
            1,181,1822002
                Stock Option Plan for Non-Employee Directors
            
            
            151,9761,333,158







Options
            
            Weighted
                Average Exercise Price
            
            Weighted
                Average Remaining Contractual Life
            
            Aggregate
                Intrinsic Value (000s)Outstanding
                at December 31, 2004
            
            
            1,000,095
            
            $
            3.52Granted
            
            
            1,141,596
            
            $
            0.39Exercised
            
            
            -
            
            
            -Forfeited
            
            
            (929,564
            )
            $
            2.54Outstanding
                at December 31, 2005
            
            
            1,212,127
            
            $
            1.34Granted
            
            
            30,810
            
            $
            0.21Exercised
            
            
            -
            
            
            -Forfeited
            
            
            (67,744
            )
            $
            2.29Outstanding
                at December 31, 2006
            
            
            1,175,193
            
            $
            1.26
            
            
            7.2
            
            $
            4Vested
                and expected to vest at December 31, 2006
            
            
            1,174,884
            
            $
            1.26
            
            
            7.2
            
            $
            4Exercisable
                at end of year
            
            
            1,166,973
            
            $
            1.26
            
            
            7.2
            
            $
            4




47
 *Index*




The
      following table summarizes information about stock options outstanding at
      December 31, 2006:





**Options
                Outstanding**
            
            **Options
                Vested & Exercisable**Range
                of Exercise Prices
            
            
            
            Weighted
                Average Contractual Life
            
            Weighted
                Average Exercise Price
            
            
            
            Weighted
                Average Exercise Price($'s)
            
            Options
            
            (Years)
            
            ($'s)
            
            Options
            
            ($'s)0.05  -  1.00
            
            
            851,649
            
            
            8.7
            
            
            0.36
            
            
            844,649
            
            
            0.361.01  -  2.00
            
            
            18,416
            
            
            6.4
            
            
            1.42
            
            
            17,666
            
            
            1.432.01  -  3.00
            
            
            104,321
            
            
            3.0
            
            
            2.13
            
            
            104,321
            
            
            2.133.01  -  4.00
            
            
            58,807
            
            
            3.2
            
            
            3.77
            
            
            58,337
            
            
            3.774.01  -  5.00
            
            
            136,000
            
            
            3.5
            
            
            4.85
            
            
            136,000
            
            
            4.855.01  - 12.00
            
            
            6,000
            
            
            3.0
            
            
            6.85
            
            
            6,000
            
            
            6.850.05  - 8.15
            
            
            1,175,193
            
            
            7.2
            
            
            1.26
            
            
            1,166,973
            
            
            1.26






**9.** **Interest
      and Other Income (Expense), net**




The
      composition of interest and other income (expense), net, is as follows:




**2006**
            
            **2005**Interest
                income
            
            $
            58,311
            
            $
            22,602Interest
                expense
            
            
            -
            
            
            (54,809
            )Other
            
            
            6,999
            
            
            1,455$
            65,310
            
            $
            (30,752
            )




**10.** **Contingencies**




Legal
      Proceedings




On
      April
      1, 2006, Teknowledge filed a lawsuit against the United States Government in
      the
      United States Court of Federal Claims. Teknowledge is requesting that the court
      rule as improper a contracting officer’s decision dated January 19, 2006 that
      Teknowledge must account for all Software Amortization costs as direct costs
      of
      the Financial Services overhead pool, and that Teknowledge may, pursuant to
      the
      Federal Acquisition Regulation (FAR), account for 31% of the Software
      Amortization costs as indirect costs of the government overhead pool and recover
      those costs. No trial date has been set. A Pretrial Scheduling Order was filed
      on October 10, 2006 mandating that the parties submit a Joint Status Report
      by
      October 15, 2007.




On
      October 6, 2006, Teknowledge was served with a lawsuit from Large Systems
      Specialists, Inc., a contractor of Teknowledge. The lawsuit was filed in the
      Superior Court of California, Santa Clara County, and claims breach of contract
      and requests damages in the amount of $343,583. The lawsuit is a result of
      Teknowledge contesting an invoice submitted on June 29, 2006 in the amount
      of
      $252,265.00. The invoice was submitted under a consulting services agreement
      and
      related software maintenance services agreement, and was submitted for alleged
      under-billing by Large Systems Specialists, Inc for the period February 4,
      2003
      to June 16, 2006. On October 31, 2006, Teknowledge invoked the arbitration
      clause of the subject agreements and stipulated to a Stay of Action Pending
      Arbitration. It is anticipated that an arbitration on the matter will be
      schedule during the second quarter of 2007.




The
      Company may be subject to legal proceedings and claims, either asserted or
      unasserted, which arise in the ordinary course of business. While the outcome
      of
      these claims cannot be predicted with certainty, management does not believe
      that the outcome of any of these legal matters will have a material adverse
      effect on the Company’s consolidated results of operations or consolidated
      financial position.





48
 *Index*




**11.** **Segment
      Reporting**




The
      Company operates three reporting segments, Financial Solutions, Government
      Contract R&D, and Patents and Technology Licensing. In 2006, Patents and
      Technology Licensing has become significant enough to merit its own separate
      reporting segment. The government sponsored Contract R&D segment includes
      R&D work in the following technical areas: computer software security,
      web-based training systems, distributed systems and knowledge systems. Technical
      personnel in the Government Contract R&D segment are sponsored by the
      government, and are organized into groups that support specific technical
      contracts and projects. The chief decision maker, the Company’s CEO, views the
      operating segments as a matrix of technical personnel, management, engineering
      services, technology, and other resources. The Company does not account for
      or
      report to the CEO its assets or capital expenditures by operating segment.
      Operating costs and expenses are managed by segment. Decisions about resource
      allocation are based primarily on contract requirements and utilization rates
      of
      the employees. Performance assessment for managers in any operating segment
      is
      based primarily on technical performance and overall profitability of the
      Company.




Financial
      information about segments (in thousands):




**Financial
                Solutions**
            
            **Government
                Contract R&D**
            
            **Patent
                & Technology licensing**
            
            
            
            **Total**Year
                ended December 31, 2006:Revenues
            
            $
            985
            
            $
            945
            
            $
            1,000
            
            
            (1)
            
            $
            2,930Cost
                of revenues
            
            
            552
            
            
            418
            
            
            290
            
            
            
            
            
            1,260Gross
                profit (loss)
            
            $
            433
            
            $
            527
            
            $
            710
            
            
            
            
            $
            1,670Year
                ended December 31, 2005:Revenues
            
            $
            2,010
            
            $
            1,573
            
            $
            465
            
            
            (2)
            
            $
            4,048Cost
                of revenues
            
            
            2,170
            
            
            973
            
            
            299
            
            
            
            
            
            3,442Gross
                profit (loss)
            
            $
            (160
            )
            $
            600
            
            $
            166
            
            
            
            
            $
            606





(1) The
      Patent and Technology revenues are the result of one patent and technology
      agreement in 2006.


(2) The
      Patent and Technology revenues are the result of two patent and technology
      agreements in 2005 arising from legal settlements.







Revenue
      for customers in the United States of America represented approximately 91%
      and
      91% in 2006 and 2005, respectively. Substantially all of the Company’s
      long-lived assets are in the United States.




**12.** **Disposal of Capitalized Software Asset** :




On
      August
      22, 2005, Teknowledge concluded the sale of its TekPortal technology, an asset
      from its Financial Solutions business unit, to Intuit Inc. for $7,000,000.
      As
      part of the technology sale, Intuit was granted a license to each of
      Teknowledge’s six active patents, and acquired Teknowledge’s pending patent on
      OFX technology. Teknowledge retained ownership of all of its current customer
      contracts and patents. It also received a license to apply TekPortal “dual-use”
application software in the military, intelligence, and homeland security
      arenas. $1,050,000 of the gross proceeds of the asset sale were held in escrow
      as a reserve for indemnification claims for a period of eighteen months; these
      amounts, plus interest, were released from escrow and remitted to the Company
      in
      March 2007.   The Company recorded proceeds of $5,950,000 that was
      partially offset by the disposal of the software asset’s book value of
      $2,012,000 and asset sale related legal and other direct expenses totaling
      $174,000.





49
 *Index*




**13.** **Unaudited Quarterly Financial Data**




**Quarterly
                Results Summary**(In
                thousands, except per share data)**First**
            
            **Second**
            
            **Third**
            
            
            
            **Fourth**
            
            **Total**Year
                ended December 31, 2006:Revenues
            
            $
            608
            
            $
            1,541
            
            $
            560
            
            
            
            
            $
            221
            
            $
            2,930Gross
                profit (loss)
            
            
            305
            
            
            998
            
            
            360
            
            
            
            
            
            6
            
            $
            1,669Net
                income (loss)
            
            
            (475
            )
            
            330
            
            
            (368
            )
            
            
            
            
            (684
            )
            $
            (1,197
            )Basic
                net income (loss) per share
            
            
            (0.08
            )
            
            0.06
            
            
            (0.06
            )
            
            
            
            
            (0.12
            )
            
            (0.21
            )Diluted
                net income (loss) per share
            
            
            (0.08
            )
            
            0.06
            
            
            (0.06
            )
            
            
            
            
            (0.12
            )
            
            (0.21
            )Year
                ended December 31, 2005:Revenues
            
            $
            1,631
            
            $
            963
            
            $
            916
            
            
            
            
            $
            538
            
            $
            4,048Gross
                profit (loss)
            
            
            399
            
            
            185
            
            
            (240
            )
            
            
            
            
            262
            
            
            606Basic
                net income (loss)
            
            
            (136
            )
            
            (417
            )
            
            2,742
            
            
            (1)
            
            
            (334
            )
            
            1,855Basic
                net income (loss) per share
            
            
            (0.02
            )
            
            (0.07
            )
            
            0.47
            
            
            
            
            
            (0.06
            )
            
            0.32Diluted
                net income (loss) per share
            
            
            (0.02
            )
            
            (0.07
            )
            
            0.47
            
            
            
            
            
            (0.06
            )
            
            0.32





(1) Q3
      2005
      includes $3,764,000 gain on sale of the TekPortal product to Intuit




**14.** **Subsequent
      Events**





On
      March
      1, 2007, the Company received $1,115,925 from an escrow account that had been
      maintained since the sale of the Company’s TekPortal product to Intuit in August
      2005. An amount of $1,050,000 of the sales price had been held in escrow for
      a
      period of eighteen months as a reserve for indemnification claims. As there
      were
      no eligible claims, the Company received the full amount of the escrow plus
      interest of $65,925.






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