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, 2005

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

# For the transition period fromto

# 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 ValueSeries 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: $4,048,004

The aggregate market value of Common Stock,
$0.01 par value per share, held by non-affiliates of the registrant was $1,305,923 on
March 17, 2006 (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 March 17, 2006, there were
5,735,754 shares of Common Stock, $0.01 par value per share, of the registrant
outstanding.

Documents Incorporated by
Reference
Part III of this report incorporates
certain information by reference from our Proxy Statement for the 2006 Annual Meeting of
Stockholders.



PART I

Item 1.  Description of
Business

Teknowledge
Corporation provides advanced software and services to transform data into customer value.
The Company was founded more than 24 years ago as a software technology company with the
vision of codifying and distributing knowledge via computers. Approximately 39 percent of
revenue in 2005 was primarily from cost plus fee-type government sponsored contract
research and development. The remaining 61percent was from Financial Solutions customers
(50%), and intellectual property licenses (11%). 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 http://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, 2005, was approximately 11% Patents and
Technology Licensing, 50% Financial Solutions and 39% Government Contract R&D compared
to 12% Patents and Technology Licensing, 38% Financial Solutions and 50% Government
Contract R&D in 2004. Year-to-year revenues from Financial Solutions operations
declined 36% from 2004. There was a 62% 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 81% of commercial revenues in 2005 and 76% in 2004.
In 2005, the remaining 19% of commercial revenue came from $465,000 of IP licenses.

In
terms of our financial position at the end of 2005, Teknowledge has experienced an
increase in net income and cash, as well as a downturn in revenue compared to 2004. The
increases can be largely attributed to the Companys sale of its TekPortal software
assets to Intuit Inc., which created a cash infusion of $5,950,000. These funds were used
to pay off the majority of the Companys debts, and improve its cash reserves.
Teknowledge paid off its bank debt completely in Q3 2005. It is no longer in default with
the bank as compared to 2004, when Teknowledge had significant adjustments and write-downs
at year-end, and the Company was not in compliance with its net income/loss covenant with
the bank. In addition to the cash infusion, the Company reported 2005 net income of
$1,855,000, and a positive balance in stockholders equity of $187,000. In 2004, the
Company reported net loss of ($5,897,000) and stockholders deficit of ($1,681,000).
Teknowledge ended 2005 with significantly more cash in the bank, $2,169,000, an increase
of $2,007,000 from December 31, 2004. These numbers are discussed in more detail in Part
II, Item 6: Results of Operations.

Operating Segments

Financial
Solutions. 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, at which time it will be remitted to Teknowledge, net of eligible
claims. 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.

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Financial
Solutions revenues for 2005 were down from the previous year (see Part II, Item 6: Results
of Operations). Teknowledge retained its TekPortal maintenance contracts, and in
conjunction with Intuit personnel, is continuing to provide maintenance services for our
banking customers. Teknowledge is now developing new software and a team to provide
hardware and software 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, help grow our revenues, and 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 symbolic spreadsheets that can add-in symbolic knowledge processing
capabilities to commercial spreadsheets like Microsoft Excel®. Teknowledge expects to
announce a Phase II follow-on contract in the second quarter of 2006.

Technical
personnel in the Government Contract R&D segment focus primarily on funded government
research, although many have 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, SBIR Program, and a variety of
government agencies. The contracts awarded provide Teknowledge with a very deep source of
technology for its own focused product development, patents, and licensing. In the last
two years, the government has funded over $5 million of 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 software to or 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 aggregation
that has significant application in both the commercial 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 its software to larger companies with additional development and
marketing resources as well as sales distribution. In 2005, 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 thieves are 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 of Internet or cyber security.

Training
Systems. Most corporate and government training today occurs either in traditional
classrooms, or over the Internet using the web 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

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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 Factory 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 2004, Teknowledge won several SBIR grants to provide
advanced computer-based tutoring systems over the Internet. 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 innovation and 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 seek opportunities to embed its
tutoring software in integrated solutions for commercial and government customers.

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.

Knowledge
Systems. Decision-makers have noticed that using satellite and World Wide Web information
systems is like standing in front of 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 fire hose of data. Teknowledge is advancing techniques for creating large
knowledge systems that can apply knowledge about how to utilize the information in a
database or an incoming stream of information. These knowledge systems are much larger and
more useful now than they have ever been. The power gained from applying knowledge-based
technology is much greater than in the past. Teknowledge was the prime contractor on an
Army sponsored effort to create 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, without reference to their meaning. Specialized techniques for
creating and applying knowledge have matured. There is 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 sources quickly and effectively. Several of the Companys Knowledge Systems
projects have an objective to develop a dynamic assessment of an evolving opportunity,
problem, or competitive position. This infrastructure could eventually serve as a basis
for pragmatic, web-based problem solving and sophisticated analysis of financial,
operational, or defense information.

Teknowledge
has a long-term project, pursued over several government contracts, 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
specializing associate systems software that amplifies human productivity with the ability
to apply knowledge systematically and effectively. Teknowledge has built six prototype
associate systems. The training and performance support capabilities of associate systems
may also be embedded in other value-added solutions in the future. Teknowledge sees this
as a significant opportunity that will evolve as the 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 II, Item 6).

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Patents
and Technology Licensing.  Teknowledge maintains an active intellectual property
program and currently holds 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.

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 for 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. Except as noted in the Legal
Proceedings section under the Microsoft counterclaim, Teknowledge has not been notified
that it may be infringing any patents or proprietary rights owned by third parties. There
can be no assurance that the Company would be able to enter into an acceptable license
under such third party 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 (see Part 1, Item 3: Legal
Proceedings).

Backlog

At
December 31, 2005, the expected order backlog was approximately $2.0 million, which
consisted of new orders for which work has not yet begun and revenue remaining to be
recognized on work in progress. Of the December 31, 2005 backlog, 71 percent is from
government customers, while 29 percent is from Financial Solutions customers. The
commercial segment contributed 61 percent of revenue during the twelve-month period ended
December 31, 2005. The Financial Solutions percentage contribution to backlog is lower
than from government customers because commercial contracts are typically less than nine
months in duration. Approximately 71 percent of the backlog consists of
government-sponsored programs that were awarded but not yet authorized for funding at
December 31, 2005. The government normally funds a contract in incremental amounts for the
tasks that are currently in production. The Company has requested additional funding on
two government contracts. If the funding is not received in a timely manner, the Company
may experience an interruption in its planned billing and cash collections during the
hiatus period between funding increments. Excluding expected new work; the Company expects
83 percent of the current backlog to be fulfilled during 2006.

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Sales and
Marketing

Teknowledges
employees, including managers, project leaders, the CTO, and the CEO, 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

Most
of Teknowledges R&D (except in Financial Solutions) was funded by R&D
contracts sponsored by the government. In our fiscal year 2005, the Financial Solutions
operating segment spent $452,000 developing new software for sale, which was not included
in the portion of the R&D costs reimbursed by the government. In 2005, the Company
recorded $1,573,000 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, mostly in the form of capitalized software product development. We anticipate
that the underlying TekPortal information aggregation engine will be reutilized in a
variety of government applications that are not in the financial arena. In addition, the
Company is working on new product prototypes related to the alerts functionality described
in its 175 patent.

The
Company invested $452,000 and $1,560,000 in TekPortal development costs in the years ended
December 31, 2005 and 2004, respectively. The Company capitalized these investments. The
Companys internally sponsored R&D expense for the years ended December 31, 2005
and 2004 was $505,000 and $185,000 respectively.

Government Contract
Administration

In
2005, approximately 86% of Teknowledges government revenues were primarily from cost
plus fee-type government-sponsored contract research and development. Since these R&D
contracts are typically made on a multi-year basis, 71% of Teknowledges December 31,
2005 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 priorities of the current
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.
During 1998, DARPA terminated two projects with Teknowledge due to a change in its program
priorities. One DARPA sponsored subcontract project was terminated in 2004, due to a mix
of factors, including the difficulty of supplying specific types of technical personnel
for extended on-site classified work in a remote location. 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.

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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
2001-2004 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, 2005 was $2,245,000.

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 its strong and
externally funded government R&D program.

Knowledge
processing systems are provided by iLog, CycCorp, BBN, 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. Financial software competitors include Yodlee, CashEdge, and
uMonitor. 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 19 full-time employees at December 31,
2005. 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, 51, 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 (now PEOSTRI). 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.

Dennis
A. Bugbee, 59, is Vice President of Finance, Chief Financial Officer, and Secretary. Mr.
Bugbee joined the Company in 1990 as the Division Controller for the Knowledge Systems
Division in Palo Alto, California. He was promoted to Director of Finance March 1, 1993
and shortly thereafter to the positions of Treasurer and Corporate Secretary. Prior to
joining the Company, Mr. Bugbee held the position of Accounting Manager with TRWs
Space and Defense Sector. He has over 30 years experience in finance and accounting. In
January of 2006, Mr. Bugbee was treated for a serious illness. He has been involved
regularly with this report; however, the Company is currently recruiting for a new
temporary CFO.

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.

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

Teknowledge
has an active patent licensing program. On August 19, 2002, Teknowledge entered into a
Contingency Fee Agreement and Power of Attorney in Damage Suit (the Fee
Agreement) with Goldstein & Faucett, L.L.P. (the Attorneys) for the
enforcement of its intellectual property rights, specifically U.S. Patent No. 6,029,175
entitled Automatic Retrieval of Changed Files by a Network Software Agent
(the 175 patent). Under the terms of the Fee Agreement, the Attorneys
agreed to pursue damages, compensation, and relief to which Teknowledge may be entitled
related to any infringement of the 175 patent, and Teknowledge will pay the
Attorneys fees and direct expenses out of any money collected from such efforts.

---



Pursuant
to the Fee Agreement, the Attorneys filed a Complaint in the United States District Court
for the District of Delaware on August 29, 2002 and named Akamai Technologies, Inc.,
Inktomi Corporation, and Cable & Wireless Internet Services, Inc. as defendants. On
November 22, 2002, the case was transferred to the United States District Court for the
District of Northern California. The Complaint stated a claim for patent infringement of
the 175 patent and sought reasonable royalties. The claims asserted in this
complaint concern the network cache technology features of the 175 patent, which can
be utilized to reduce latency and communication costs for members of a group with
interests in similar objects on a network.

The
Attorneys subsequently filed a Complaint on July 16, 2003 in the United States District
Court for the District of Northern California and named Yahoo! Inc., Microsoft
Corporation, and AOL Time Warner, Inc. as defendants. The Complaint stated a claim for
patent infringement of the 175 patent and sought reasonable royalties. The claims
asserted in this complaint concern the alert and notification features of the 175
patent, which can be utilized to deliver alerts to users concerning changes to data items
of interest on a web page or availability of software updates.

On
December 12, 2003, the District Court for the Northern District of California ruled that
the two cases be consolidated into a single action. Microsoft Corporation filed a
counterclaim on February 3, 2004, claiming that Teknowledge infringed on two of its
patents, one for electronic bill payments, and the other for information aggregation.
Teknowledge has settled with all of the defendants and counterclaimants on terms that
included payments to Teknowledge. These settlements have been disclosed in the previous
SEC Form 8-K filed October 4, 2004, SEC Form 8-K/A filed October 12, 2004, SEC Form 8-K
filed November 3, 2004, SEC Form 8-K filed February 22, 2005, and SEC Form 8-K filed
August 12, 2005.

The
Company may also be subject to other legal proceedings and claims, either asserted or
unasserted, which arise in the ordinary course of business. While the outcome of these
claims cannot be predicted with certainty, management does not believe that the outcome 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 2005 Annual Meeting of Stockholders was held on November 16, 2005.

The
proposal to elect two Class II Directors to serve for a three-year term was approved by
stockholders. The proposal received the following votes:

|                  
|------------------
|Benedict O'Mahoney
|Neil Jacobstein   

The
following directors continue:

|              |  | 
|------------- |  | 
|Larry Druffel |  | 
|Irwin Roth    |  | 

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, 2005 was
approved by the stockholders. This proposal received the following votes:

| |           |         |        
| | --------- | ------- | -------
| | For       | Against | Abstain
| | 5,058,525 | 91,551  | 14,440 

Proposal
No. 3 to approve and adopt an amendment to the Companys Stock Option Plan for
Non-employee Directors to increase the number of authorized shares from 75,000 to 250,000
was approved by the stockholders. This proposal received the following votes:

| |         |         |        
| | ------- | ------- | -------
| | For     | Against | Abstain
| | 576,615 | 276,414 | 38,978 

---



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 for the quarterly periods indicated.

|2005                                     |  | High | Low
|---------------------------------------- |  | ---- | ---
|First quarter, ended
March 31, 2005      |  |      | $  
|Second quarter, ended June 30,
2005      |  |      |    
|Third quarter, ended September 30,
2005  |  |      |    
|Fourth quarter, ended December 31,
2005* |  |      |    

|2004                                    |  | High | Low
|--------------------------------------- |  | ---- | ---
|First quarter, ended
March 31, 2004     |  |      | $  
|Second quarter, ended June 30,
2004     |  |      |    
|Third quarter, ended September 30,
2004 |  |      |    
|Fourth quarter, ended December 31,
2004 |  |      |    

As
of December 31, 2005, there were 735 holders of record of Common Stock.

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, 2005.

---



|                      |  |                                                                  | 
|--------------------- |  | ---------------------------------------------------------------- | 
|                     
|Plan category         |  | Number of securities to be                                       | 
|                      |  | issued upon exercise of outstanding options, warrants and rights | 
|                      |  |                                                                  | 
|                      |  | (a)                                                              | 
|                     
|Equity compensation   |  | 1,298,877(1)                                                     | 
|plans approved by     | 
|security holders      | 
|                     
|Equity compensation   |  | -                                                                | 
|plans not approved by | 
|security holders      | 
|                     
|Total                 |  | 1,298,877                                                        | 
|                     

|(1) |  | Consists of 1,178,263 shares
subject to options that are outstanding and shares available for future issuance under the
1998 Plan and 120,614 shares subject to options that are outstanding and shares available for future
issuance under the Director Plan.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(2) |  | Consists of 1,166,838 shares
that are reserved for issuance under the 1998 Plan and 129,386 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 or Plan of Operation

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 below in Certain Risk Factors 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.

---



Overview of Significant
Matters

Financial Position

The
business picture at Teknowledge has improved significantly since our 2004 annual report.
Teknowledge ended 2004 with total liabilities in excess of $5,600,000, and $161,000 in
cash. Our TekPortal product license business had become largely a services business, due
to the perceived financial risk in the Company. Our government business backlog had
diminished significantly. Our independent registered public accounting firm had indicated
in their 10-KSB opinion on our December 31, 2004 consolidated financial statements that
there was substantial doubt the Company would continue as a going concern. That concern
still exists at the end of 2005, but the debt picture has improved and our operating
conditions have changed.

We
wrote the following message in our 10-QSB for the second quarter of 2005: Based on
its current cash position, available credit, and projected cash flows from operations,
management believes the Company will not have sufficient funds to support operations for
the next twelve-month period unless it can secure additional funding, supplemental
financing, a large legal settlement, or cash from the sale of an asset. In the event
Teknowledge does not raise additional capital from increased revenues, equity financing,
intellectual property or an asset sale as expected, the Company will have to reduce costs
further, including headcount reductions, which would materially adversely affect on-going
operations and revenues; and if the Company obtains equity financing, it will likely
result in a significant dilution of existing stockholders. The Company has approached some
vendors about restructuring their debt through an informal work out plan. The Company is
also considering the sale of an intellectual asset or product line to provide ready cash.
However, if the Company is unsuccessful in restructuring its debt or obtaining additional
short-term cash inside or outside the Company, it may seek alternative remedies, including
seeking reorganization under Chapter 11 of the Federal bankruptcy code.

Teknowledge
did what we said we would do in our 10-QSB  raise cash. The extreme difficulty of
raising capital in our condition was reflected by the insistence from over a dozen
experienced investment bankers that we could only expect to raise a fraction of our total
market capitalization (then under $3,000,000), the stockholders would be severely diluted,
and that we would have to pay an investment banker 10 percent of our total transaction as
a fee. Instead, in the third quarter of 2005 we sold our TekPortal asset and some patent
licenses to Intuit for $7,000,000, more than twice the market capitalization of the
Company on the day the transaction was signed. The deal was concluded using mostly
executive resources, thus avoiding expensive investment banking fees normally associated
with a complicated asset sale. Teknowledge kept all of its current patents, its Financial
Solutions services contracts, and its government contract R&D business and technology.

Teknowledge
stockholders were not diluted as a result of the sale to Intuit, as we did not issue
stock. In the third quarter of 2005, we paid off our bank loan. We have paid off 82
percent off our accounts payable. We have settled our patent case with Microsoft. We

have
significantly decreased our labor and fringe expense base. At the end of 2005, Teknowledge
had more than $2.1 million dollars in cash in the bank, albeit with significant reserves
on the books. We have cleaned up our balance sheet significantly, and are now embarked on
Stage II  rebuilding our revenue base and making our operations profitable again.

Teknowledge
plans to return to profitability using a tried and true methodology  decreasing
expenses and increasing revenues. We have already taken the steps to decrease
significantly our labor, rent, medical, and legal expenses. We are servicing our existing
TekPortal maintenance customers, although we expect many of these customers to transition
to Intuits new version of the software. 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 developing an initiative to combine next-generation
data storage hardware and software integration solutions. We have several proposals in for
new government contract work, and we expect to get some of them. We are conducting with
the government the second stage of a field evaluation of our software wrappers security
technology. We are also building a web services system that utilizes our alerts
technologies. Finally, we are working on a new business plan for Teknowledges next
product 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 this plan. 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 90 percent of our
attention working with customers to make their user experience rewarding, rather than
building software and hoping that customers will find it and like it. Teknowledge has been
working with Grid 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 better 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.

The
Company experienced a decline in revenue over the past several months of 2005, excluding
the asset sale. The Company spent a great deal of time in the third and fourth quarters of
2005 working on the transition of TekPortal to Intuit, and working on customer support
projects. 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 to provide a stable 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, but we have a long
way to go 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 haphazardly 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 will likely start a Phase II
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 would seek
to license the technology to one or more large companies that 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 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 is completing 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.

---



Teknowledge
is engaged in the second phase of a pilot test of its safe software wrappers at a customer
site. 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 lockdown 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 steadily improving it in new applications. If the pilot
test goes well, we anticipate receiving additional contracts to deliver this system to the
government and possibly to large institutions in the commercial sector. 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 contract work that aggregates financial and other information for carefully
selected targets.

Teknowledge
generated $260,000 in government contract R&D revenue in the fourth quarter of 2005,
compared to $812,000 in the fourth quarter of 2004. Most of this decrease was due to
considerably lower backlog in 2005 and increased competition for government contracts.
Replacing these large contracts 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. The rewards may be greater in the applications solutions market, but it could
take most of 2006 to win new government application integration contract awards, and
awards take months to turn into funded contracts. In addition, our small size and prior
adverse financial position may limit our ability to qualify for large prime contracts. In
spite of this, we 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, 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

Financial
Solutions revenues for 2005 were down from the previous year. 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. We are planning to build out and train a team to provide new integration
services to financial and other institutions. Teknowledge is developing an initiative to
combine next-generation data storage hardware and software integration solutions.

Patent and Technology
Licensing

During
2005, Teknowledge demonstrated the value of its patent portfolio by obtaining $465,000 in
patent licenses as the result of settlements. Management believes that these settlement
numbers were low, necessitated by Teknowledges former cash position. However, the
results 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 (see legal
section: Part II of this report on Form 10-KSB).

---



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 provide settlements 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 51 percent in 2005
to $4,048,000, compared to $8,221,000 in 2004. The ability of the Company to grow its
revenues will depend on the Companys success in winning new government R&D
contracts, selling commercial services and maintenance support to existing and new
customers. As of December 31, 2005, Teknowledge had $2,169,000 in cash and cash
equivalents, an increase of $2,007,000 over the comparable period in 2004. The increase in
net cash at December 31, 2005 is attributed principally to the sale of the TekPortal
software asset to Intuit Inc. in August 2005. The Company used net cash of $2,448,000 from
its operating activities for the twelve months ended December 31, 2005, compared to
$796,000 generated in the comparable period in 2004. The Company provided $5,320,000 from
investing activities in 2005 compared to $1,587,000 used in 2004. In 2005, financing
activities used $865,000 compared to $94,000 used in 2004. Teknowledge is in the process
of establishing a new credit line with a bank. The Companys available cash and
anticipated credit facilities may not be adequate to sustain the business over the next 12
months. Future growth is likely to be dependent on the Companys success at improving
revenues and cash flow.

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. If the Company cannot raise funds on acceptable terms, the
Company may not be able to continue to support its existing operations or to develop 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 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. If customers
do not receive new products or services favorably, it could hurt the Companys
reputation and delay future expansion.

---



Within
the financial 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.

Teknowledges
customers in the Financial Solutions segment are in the financial services industry, which
is subject to economic changes that could reduce demand for the Companys services.
Consolidation in the financial services industry and unforeseen events, recession,
inflation, or acts of terrorism could occur and reduce consumer use of bank services. Any
event of this kind, or implementation for any reason by banks of cost reduction measures,
could result in significant decreases in demand for our products and services. Mergers and
acquisitions are pervasive in todays banking industry. Teknowledges existing
customers may be acquired by or merged into other financial institutions, which already
have their own financial Internet software solution or which 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 and financial services industry could adversely affect the Companys
business

Numerous
federal agencies have recently adopted rules and regulations protecting consumer privacy
and establishing guidelines for financial 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.

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 2004-2005, the level of requests for
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 may
cause cost adjustments

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 may vary from
original estimates and necessitate periodic adjustments to overhead rates and revenues.
Such adjustments are made on a cumulative basis whereby 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 negative or positive effect on the business. In order
to address the possible exposure from prior years, the Company has established a rate
adjustment reserve for such contingencies, and the amount of the rate adjustment reserve
is reviewed and adjusted periodically.

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. The Company was recently 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;
*   Valuation allowance against deferred tax assets;
*   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 as it did in 2004 and 2005. 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
shipment 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.

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.

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 open and unaudited years of 2001-2004. The
cumulative reserve, including earned retained fee of $266,000, is $2,245,000 at December
31, 2005.

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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 $750,000. 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 2005.
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. Teknowledges financial position improved in the
third quarter with the software asset sale; however, until the matter is resolved, 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 intends to contest 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 unaudited years of 2001-2004, 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. 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
under consideration. The Company has established a reserve of $2,245,000 to offset a
potential negative outcome for the open years of 2001-2004. 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 2005 were $4,048,000 as compared to $8,221,000 in 2004. Overall revenues decreased 51%
largely on a decline in revenue from Government Contract R&D customers. Financial
Solutions operations contributed 50% of total revenues in 2005, up from 38% in 2004, and
Patent and Technology Licensing contributed 11% of 2005 revenue. 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 39% of total revenues in 2005,
compared to 50% in 2004. The Company was unsuccessful in 2005 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 36% in 2005 to $2,010,000 largely as a result of less customer demand, compared
to $3,120,000 for 2004. Revenue from license fees for TekPortal software was $111,000 in
2005, compared to $335,000 in 2004. Sales cycles and customer acceptance of new product
offerings were slower than expected. Recurring revenue from maintenance on existing
products was $598,000 in 2005 compared to $683,000 in 2004. Revenues from resellers
accounted for 41% of Financial Solutions 2005 revenue compared to 18% in 2004.

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, at which time it will be remitted to Teknowledge, net of eligible claims. 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. For the third quarter ended September 30, 2005,
Teknowledge reported a net gain of $2,742,000 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 $1,573,000 in 2005, compared to $4,101,000 in 2004.
Some of Teknowledges contracts ended in 2005 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 2005, 29%
of total revenues were from the Department of the Air Force, compared to 37% in 2004.

The
Company recorded revenues of $465,000 for Patents and Technology Licensing in 2005
compared to $1,000,000 in 2004. The licenses were granted as a result of settlement
agreements between Teknowledge and four large technology companies.

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, 2005
approximately 93% of unbilled receivables were for government-sponsored R&D contracts,
and 7% were for commercial contracts. This compares to 94% for government-sponsored
R&D contracts at December 31, 2004.

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Cost
of revenues was $3,442,000 in 2005 compared to $11,029,000 in 2004, a decrease of 69%. The
cost of revenues as a percentage of total revenues increased to a positive 85% in 2005
compared to 134% in 2004, due to the write down of software assets of $1,753,000 and an
increase in the government rate reserve of $1,500,000 in 2004. Approximately 28% of the
2005 cost of revenues is Government Contract R&D, 63% is Financial Solutions, and 9%
is Patent and Technology Licensing, compared to 44%, 49%, and 7% in 2004. Besides the
aforementioned adjustments to cost of revenues, the Company spent $220,000 in 2005 on IP
related legal costs to defend its patents. A major component of cost of revenues, labor
and labor related costs was down more than $1,000,000 over 2004.

The
Company invested $452,000 in the development of TekPortal software in 2005, down 71% from
the $1,560,000 invested in 2004. Including the write down of $1,753,000, total
amortization charges were $3,966,000 in 2004. Without the adjustment, amortization charges
were considerably lower between years at approximately $2,032,000. 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 will not be any
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 $185,000 in 2004 to
$505,000 in 2005. Subcontractor costs were $226,000 in 2005, $365,000 less than 2004. 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 2005 was $600,000 compared to
($716,000) in 2004, or 38% and (17%), respectively. Affecting the gross margin
(GM) in 2004 was the aforementioned adjustment for the government rate reserve
of $1,500,000. The gross (loss) for Financial Solutions was ($160,000) versus ($2,324,000)
in 2004. The Financial Solutions 2004 GM was affected by the $1,753,000 write down of
previously developed software. The GM for Patent and Technology Licensing was $166,000
versus $232,000 in 2004. Besides the adjustments, the GM was affected by a decline in
revenues in the Financial Solutions and Government Contract R&D reporting segments in
2005. The Government Contract R&D, Financial Solutions, and Patent & Technology
Licensing GMs were 38%, (8%), and 36%, respectively in for 2005. This compares to (17)%,
(74%) and 23%, for Government Contract R&D, Financial Solutions, and Patent &
Technology Licensing in 2004.

General
and administrative expenses (G&A), costs were $1,796,000 and $1,737,000 in
2005 and 2004, respectively. G&A costs for 2005 were 44% of total revenues, versus 21%
in 2004. Total G&A expenses increased about 3% over 2004, $150,000 of which is
directly related to an increase in fees to maintain the Companys debt until the sale
of TekPortal product to Intuit. The sale allowed the Company to pay off all bank loans.
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 $102,000 in 2005 as compared to $324,000 in 2004. Sales and
marketing costs were 3% of total revenues in 2005 versus 4% in 2004. 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 2005, the
Company reduced discretionary expenses, principally labor and labor related expenses.

Company-sponsored
R&D costs in 2005 increased to $505,000 from $185,000 in the comparable period in
2004. R&D was 12% of total revenues in 2005 versus 2% in 2004. 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 $1,573,000.

The
Company spent $452,000 for the development of its TekPortal product during 2005, compared
to $1,560,000 in 2004, and this amount was capitalized (principally version 3.1 and 3.2 of
TekPortal). The Company does not expect to capitalize additional costs in the development
of the TekPortal products in 2006. The majority of 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.

---



Interest
income was $23,000 in 2005 versus $3,500 in 2004. The Company experienced higher average
cash balances coupled with higher average money market interest rates in 2005. Interest
payments decreased to $55,000 in 2005 from $83,000 in 2004 because of paying off bank debt
after the sale of TekPortal to Intuit.

The
effective tax rate was 3% and 15% in 2005 and 2004, respectively.

In
2005, Teknowledges net income was $1,855,000, or $0.32 and $0.32 per share basic and
diluted. This compares to net a loss of ($5,897,000), or ($1.03) basic and diluted
earnings per share for 2004. Included in the income in 2005 was a $3,764,000 net gain on
sale of TekPortal to Intuit. Included in the loss in 2004 was $4,021,000 of write-downs
and adjustments for previously developed software, tax assets, and government rate
reserves.

Liquidity and Capital
Resources

As
of December 31, 2005, Teknowledge had approximately $2,169,000 in cash and cash
equivalents, an increase of $2,007,000 over the comparable result in 2004. The increase in
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 $2,448,000 for its operating
activities for the twelve-months ended December 31, 2005, compared to $796,000 generated
in the same period for 2004. 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 $1,587,000 invested
in 2004. In 2005, financing activities consumed $865,000 compared to $94,000 in the same
period in 2004.

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

On
March 28, 2004, Teknowledge renewed its line of credit with the bank. The new agreement
extends the term of the line from one year to two years ending March 28, 2006 and
increases the credit limit from $3,000,000 to $4,000,000. Under the arrangement, the
Company may borrow a maximum of the lesser of $3,000,000 or 80 percent of eligible
receivables at an initial rate of 2.0 percent over the Wall Street Journal prime interest
rate (4.5% on December 31, 2005) with a floor of 4.25%. The line includes select financial
covenants tied principally to net income projections in the next two years. In conjunction
with the credit line, the Company requested and received a $1,000,000 term loan
sub-facility. The term loan is for a two-year term at an initial interest rate of 3.0
percent over the Wall Street Journal prime rate with a floor of 4.25%. Under the original
agreement, the Company must maintain a minimum cash balance with the bank of 75 percent of
the aggregate outstanding balance of all term loan advances and achieve pre-established
minimum net income performance standards on a quarterly basis. To secure the loans,
Teknowledge granted the bank a security interest in our assets, including accounts
receivable.

Effective
December 1, 2004, the loan agreement between Teknowledge and the bank was modified to
include the following changes: 1) the interest rate on the receivables facility was
increased from 2 to 3 percent over the Wall Street Journal Prime (WSJP), 2)
the cash support level in the bank required to maintain the term loan was raised from 75
to 100 percent, and 3) to supplement its existing cash reserves, the Company was obligated
to secure a cash infusion of at least $1,000,000 by December 31, 2004. Subsequent to the
effective date of the new agreement, Teknowledge concluded two IP licensing activities
totaling $1,000,000. In addition to periodic reporting requirement, Teknowledge provided
to the bank a near term quarterly income forecast that it is required to achieve with no
greater than 20% variance to the plan.

At
December 31, 2004, the Company was in compliance with the account receivable support
requirement. Because of significant adjustments and write-downs at year-end, the Company
was not in compliance with its net income/loss covenant with the bank. Subsequent to
year-end 2005, Teknowledge requested a covenant waiver, which was granted by the bank on
March 28, 2005. Due to the Companys risk profile, the bank increased the interest
rate on the line of credit from 3 to 6 percent over WSJP. At March 18, 2005, the
outstanding balance from the line of credit was $1,054,000 compared to $960,000 at
December 31, 2004. At least two large government contracts were waiting for funding at
December 31, 2004; they were subsequently funded in February of 2005. Because of the
delay, the Company borrowed $431,000 against the open receivables pending the receipt of
the funding. The customer released the funding in February and subsequently paid the
invoices.

---



In
the first quarter of 2005, Teknowledge increased its outstanding balance under its credit
facilities with the bank to $1,054,000 in anticipation of new government contract funding.
The Companys potential borrowing capacity fluctuates based on the amount of accounts
receivable generated from revenues and its financial requirements. At March 15, 2005, the
Company had utilized all of its available borrowing capacity.

On
June 30, 2005, the Company entered into a new agreement with Bridge Bank, N.A. for a
non-formula based loan facility (bridge advance) of $700,000 that expired on
August 31, 2005. The Company requested this facility while it pursued various options to
supplement the Companys cash reserves. During the loan period the Company incurred a
monthly processing fee from Bridge Bank of $40,000 for June, $50,000 for July, and $60,000
for August Teknowledge was subject to significant additional fees if the loan was not
retired by August 31, 2005. The Company also reduced the total amount of its facility with
the bank to $2,000,000 to save annual administrative fees. As a further condition of this
agreement, the Company granted the bank warrants to purchase 30,000 shares of stock at
$0.52 per share that are exercisable one year from the date of the agreement.

In
connection with the credit facilities dated March 28, 2003 and 2004 and the amended
facilities of September 1, 2004, March 28, 2005 and June 30, 2005, the Company granted
five warrants totaling 86,750 shares. The Company granted to the lender three increments
of 15,000 shares of Common Stock each one increment on March 28, 2005 of 11,750 shares and
the June 21, 2005 grant of 30,000 shares, at exercise prices of $3.00, $7.00, $2.50,
$1.50, and $0.52 per share, respectively. 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.

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 current financing arrangements
with the Bank. The Company is in the process of establishing a new financing arrangement
with a financing institution but the terms have not been finalized as of the date of this
filing. The Company believes it may not have sufficient cash to support operations for
twelve months, depending on operating revenues. Teknowledge is seeking a new financial
arrangement that would provide a line of credit facility.

Recently Issued Accounting Pronouncements

In
December 2004, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 123 (Revised 2005) Share-Based Payment that prescribes
the accounting for share-based payment transactions in which a company receives employee
services in exchange for (a) equity instruments of the company or (b) liabilities that are
based on the fair value of the companys equity instruments or that may be settled by
the issuance of such equity instruments. SFAS No. 123R addresses all forms of share-based
payment awards, including shares issued under employee stock purchase plans, stock
options, restricted stock and stock appreciation rights. SFAS No. 123R eliminates the
ability to account for share-based compensation transactions using APB Opinion No. 25,
Accounting for Stock Issued to Employees, that was previously allowed under
SFAS No. 123 as originally issued. Under SFAS No. 123R, companies are required to record
compensation expense for all share based payment award transactions measured at fair
value. In April 2005, the SEC delayed the effective date of SFAS No. 123R. Accordingly,
this statement is effective for the Company beginning January 1, 2006. In March 2005, to
further discuss the affects of SFAS No. 123R, the SEC released Staff Accounting Bulletin
No. 107 (SAB 107) to highlight the compliance issues for organizations that provide
non-employee share-base payment transactions and making the transition from a non-public
company to reporting by Generally Accepted Accounting Principles (GAAP.) The
Company has adopted SFAS No. 123 and APB Opinion No. 25; see Accounting for
Stock-Based-Compensations under Note 2. We have not yet determined the final impact, if
any, that the adoption of SFAS No. 123R 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
December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, (SFAS
153) an amendment of Accounting Principles Board Opinion No. 29. SFAS 153 replaces
the exception from fair value measurement for similar productive assets with that for
exchanges of nonmonetary assets that do not have commercial substance. The statement is
effective for the fiscal period beginning July 4, 2005 and we do not believe that the
adoption of SFAS 153 will have a significant effect on our financial statements

---



In
May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
CorrectionsA Replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS
No. 154 requires retrospective application to prior periods financial statements for
changes in accounting principal, unless it is impracticable to determine either the
period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires
that retrospective application of a change in accounting principle be limited to the
direct effects of the change. Indirect effects of a change in accounting principle, such
as a change in non-discretionary profit-sharing payments resulting from an accounting
change, should be recognized in the period of the accounting change. SFAS No. 154 also
requires that a change in depreciation, amortization, or depletion method for long-lived
non-financial assets be accounted for as a change in accounting estimate affected by a
change in accounting principle. SFAS No. 154 is effective for accounting changes and
corrections of errors made in fiscal years beginning after December 15, 2005. The
provisions of this statement are effective for us beginning January 1, 2006. We do not
anticipate that the adoption of SFAS No. 154 will have a material impact on our financial
position, results of operations or cash flows.

In
November 2005, FASB Staff Position (FSP) issued the FASB Statement of
Financial Accounting Standards (FAS) No. FAS 115-1 and 124-1 to address
determination of whether a financial asset is considered other than temporally impaired
(FAS 115-1), guidance for not-for-profit organization financial assets and the measurement
of loss, and also amends APB Opinion No. 18 regarding the Equity Method Calculations for
common stocks. FAS No. 115-1 and 124-1 goes into effects after December 15, 2005. We have
not yet determined the final impact, if any, that the adoption of FAS No. 115-1 and 124-1
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.

Long-Term Contractual Obligations

|                            |          | Payments due by period
|--------------------------- | -------- | ----------------------
|                            |          |                       
|                            |          | Less                  
|Contractual obligations     | Total    | than                  
|                            |          | 1 year                
|                            |          |                       
|Operating Lease Obligations | $643,000 | $308,000              

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:

---



In
connection with its audit of the Companys consolidated financial statements for the
year ended December 31, 2003, Grant Thornton LLP (Grant Thornton), the
Companys independent registered public accountants, advised the Audit Committee and
management of internal control matters with respect to certain revenue recognition
transactions, government overhead rate reserves, segregation of duties, and monitoring
controls that they considered to be reportable conditions as that term is defined under
standards established by the American Institute of Certified Public Accountants. The
Company considered these matters in connection with the year end closing process and the
preparation of the December 31, 2003 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 Grant Thornton, in 2004
the Company will implement certain enhancements to its internal controls and procedures,
which it believes address the matters raised by Grant Thornton.

In
particular, GT made the following observations:

| | 1. Revenue Recognition Policies and Procedures: Our revenue recognition policy should
more definitively address certain circumstances commonly encountered in our business,
including: (i) determining what constitutes persuasive evidence of an arrangement for
customer relationships; (ii) determining the percentage of completion of contracts
accounted for on the percentage of completion of method of accounting; and (iii) extended
payment terms. GT also observed that our personnel should have additional technical
knowledge and training to account for complex revenue transactions.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. Percentage of Completion Accounting and Customer Acceptance Clauses: In testing
certain of our material contracts, insufficient underlying documentation was available to
support: (i) managements estimates under the percentage-of-completion method of
accounting; (ii) support for customer acceptance; and (iii) hours expended or level of
effort provided by subcontractors.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. Government Overhead Rate Reserve: Formal documentation should be prepared with
respect to assessment and monitoring of the process by which we evaluate government
overhead rates.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. Closing Process and Monitoring Controls: Due to the departure of key financial
personnel, timely review was not performed with respect to: (i) review and booking of
revenue arrangements; (ii) consistency in calculating the government overhead rate reserve
and (iii) consistency in calculating the software capitalization overhead rate.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

As
a result of GTs observations, Teknowledge made certain enhancements to its internal
control procedures to improve its polices and procedures and to address these items though
improvements in training procedures, assignment of duties, internal control
responsibilities, and enhanced oversight over routine and non-routine transactions.

GT
did not advise us that they believed internal controls necessary to develop reliable
financial statements did not exist. Our audit committee discussed the reportable
conditions with GT and we have authorized GT to respond fully to the inquiries of BPM
concerning the reportable conditions.

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.

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, 2005 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
will implement certain enhancements to its internal controls and procedures, which it
believes address 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 Accounting firm. 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, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act

The
information required by Item 9 regarding directors of the Company is incorporated herein
by reference to the sections entitled Election of Directors, Board
Committees and Meetings, and Code of Ethics included in the definitive
proxy statement for the Companys 2006 Annual Meeting of Stockholders (the 2006
Annual Meeting Proxy Statement). Information regarding executive officers is
included in Part I under the heading Executive Officers.

The
Company has adopted a Code of Ethics that applies to the Companys principal
executive officer, principal financial officer, controller, other officers and managers.
The Company will provide a copy of the Companys Code of Ethics free of charge upon
requesting party.

Item 10. Executive
Compensation

The
information required by Item 10 is incorporated herein by reference to the section
entitled Executive Compensation and Other Matters and Proposal 1:
Election of Directors  Directors Compensation included in the 2006 Annual
Meeting Proxy Statement.

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

The
information required by Item 11 is incorporated herein by reference to the section
entitled Security Ownership included in the 2006 Annual Meeting Proxy
Statement.

Item 12. Certain
Relationships and Related Transactions

The
information required by Item 12 is incorporated herein by reference to the section
entitled Certain Relationships and Other Transactions included in the 2006
Annual Meeting Proxy Statement.

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

---



|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)                                                                                          
|           |  |                                                                                                           
|4.2        |  | Warrant Agreement between
Teknowledge and Bridge Bank, N.A., dated March 28, 2002 (6)                     
|           |  |                                                                                                           
|4.3        |  | Warrant Agreement between
Teknowledge and Bridge Bank, N.A., dated March 28, 2003 (7)                     
|           |  |                                                                                                           
|4.4        |  | Warrant Agreement between
Teknowledge and Bridge Bank, N.A., dated September 1, 2004 (8)                  
|           |  |                                                                                                           
|4.5        |  | Warrant Agreement between
Teknowledge and Bridge Bank, N.A., dated March 28, 2005                         
|           |  |                                                                                                           
|4.6        |  | Warrant Agreement between
Teknowledge and Bridge Bank, N.A., dated June 21, 2005                          
|           |  |                                                                                                           
|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)  
|           |  |                                                                                                           
|16.1       |  | 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 firm                        
|           |  |                                                                                                           
|31.1       |  | Certification of Principal Executive
Officer pursuant to Section 302 of the Sarbanes-Oxley Act Of 2002    
|           |  |                                                                                                           
|31.2       |  | Certification of Principal Financial
Officer pursuant to Section 302 of the Sarbanes-Oxley Act Of 2002    
|           |  |                                                                                                           
|32.1       |  | Certification of Principal Executive
Officer pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002    
|           |  |                                                                                                           
|32.2       |  | 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
| | - | ---------------------------------------------------------------------------

---



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.
| | --- | ---------------------------------------------------------------------------------------------------------------

| | (9) | Filed as
an Exhibit to the Companys Quarterly Report on Form 10-QSB, for the quarter ended March 31, 2005.
| | --- | -----------------------------------------------------------------------------------------------------------

| | (10) | Filed
as an Exhibit to the Companys Quarterly Report on Form 10-QSB, for the quarter ended June 30, 2005.
| | ---- | ----------------------------------------------------------------------------------------------------------

| | (11) | Filed as an
Exhibit to the Companys Quarterly Report on Form 10-QSB, for the quarter ended September 30, 2005.
| | ---- | ---------------------------------------------------------------------------------------------------------------

| | (12) | 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.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------

(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.

Item 14. Principal
Accountant Fees and Services

The
information required by Item 14 is incorporated herein by reference to the section
entitled Ratification of Selection of Independent Registered Public
Accountants included in the 2005 Annual Meeting Proxy Statement.



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.

|                     | 
|-------------------- | 
|                     | 
|                     | 
|Date: April 14, 2006 | 
|                     | 
|                     | 
|                     | 

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                                    
|                       |  |                                             
|/s/ Neil Jacobstein    |  | Chairman of the Board of Directors          
|Neil Jacobstein        |  | and Chief Executive Officer                 
|                       |  | (Principal Executive Officer)               
|                       |  |                                             
|/s/ Dennis A. Bugbee   |  | Vice President Finance,                     
|Dennis A. Bugbee       |  | Chief Financial Officer                     
|                       |  | (Principal Financial and Accounting Officer)
|                       |  |                                             
|/s/ Benedict O'Mahoney |  | Director, Vice President,                   
|Benedict O'Mahoney     |  | Administration and Legal Affairs            
|                       |  |                                             
|/s/ Lawrence Druffel   |  | Director                                    
|Lawrence Druffel       |  |                                             
|                       |  |                                             
|/s/ Irwin Roth         |  | Director                                    
|Irwin Roth             |  |                                             
|                       |  |                                             

---



TEKNOWLEDGE CORPORATION

FORM 10-KSB  ITEM 13(a)(1)
and (2)

LIST OF CONSOLIDATED
FINANCIAL STATEMENTS

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

|                                                                                                  |         
|------------------------------------------------------------------------------------------------- | --------
|                                                                                                  | Page    
|                                                                                                  |         
|Reports of Independent Registered Public Accounting Firm                                          | 34      
|                                                                                                  |         
|Consolidated Balance Sheet - December 31, 2005                                                    | 35      
|                                                                                                  |         
|Consolidated Statements of Operations and Comprehensive Income (Loss)-                            | 36      
|Years ended December 31, 2005 and 2004                                                            |         
|                                                                                                  |         
|Consolidated Statement of Stockholders' Equity (Deficit) - Years Ended December 31, 2005 and 2004 | 37      
|                                                                                                  |         
|Consolidated Statements of Cash Flows - Years Ended December 31, 2005 and 2004                    | 38      
|                                                                                                  |         
|Notes to Consolidated Financial Statements                                                        | 39 -  51

---



Report of Independent
Registered Public Accounting Firm

To the Board of Directors and
Shareholders of Teknowledge Corporation:

We
have audited the accompanying consolidated balance sheet of Teknowledge Corporation and
subsidiary (the Company) as of December 31, 2005, and the related consolidated
statements of operations and comprehensive loss, stockholders equity (deficiency)
and cash flows for the each of the two years in the period ended December 31, 2005. 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. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes assessing
the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In
our opinion, the consolidated financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Teknowledge Corporation and
subsidiary as of December 31, 2005 and the results of their operations and their cash
flows for the each of the two years in the period ended December 31, 2005, 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

Palo Alto, California
March 23, 2006

---



TEKNOWLEDGE CORPORATION  CONSOLIDATED BALANCE
SHEET  AS OF DECEMBER 31, 2005

|                                                                         | 
|------------------------------------------------------------------------ | 
|ASSETS                                                                   | 
|Current assets:                                                          | 
|Cash and cash equivalents                                                | 
|Receivables:                                                             | 
|Billed, net of allowance of $51,856                                      | 
|Unbilled and other receivables                                           | 
|                                                                         | 
|Total receivables                                                        | 
|Prepaid and other current assets                                         | 
|                                                                         | 
|Total current assets                                                     | 
|                                                                         | 
|Long term government unbilled receivables                                | 
|Fixed assets at cost:                                                    | 
|Computer and other equipment                                             | 
|Software                                                                 | 
|Furniture and fixtures                                                   | 
|Leasehold improvements                                                   | 
|                                                                         | 
|Total fixed assets at cost                                               | 
|Less: Accumulated depreciation and amortization                          | 
|                                                                         | 
|Fixed assets, net                                                        | 
|                                                                         | 
|Total assets                                                             | 
|                                                                         | 
|LIABILITIES AND STOCKHOLDERS' EQUITY                                     | 
|Current liabilities:                                                     | 
|Accounts payable                                                         | 
|Payroll and related liabilities                                          | 
|Government rate reserve                                                  | 
|Other accrued liabilities                                                | 
|                                                                         | 
|Total current liabilities                                                | 
|Commitments and contingencies (Notes 4 and 10)                           | 
|Stockholders' equity                                                     | 
|Preferred stock, $0.01 par value, authorized 2,500,000 shares, including | 
|Series A Convertible Preferred Stock, none issued                        | 
|Common stock, $0.01 par value, authorized 25,000,000 shares,             | 
|5,735,754 shares issued and outstanding                                  | 
|Additional paid-in capital                                               | 
|Accumulated deficit since January 1, 1993                                | 
|(following quasi-reorganization)                                         | 
|                                                                         | 
|Total stockholders' equity                                               | 
|                                                                         | 
|Total liabilities and stockholders' equity                               | 
|                                                                         | 

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

---



TEKNOWLEDGE CORPORATION  CONSOLIDATED STATEMENTS
OF OPERATIONSAND COMPREHENSIVE INCOME (LOSS)

|                                                    | Years Ended December 31, | 
|--------------------------------------------------- | ------------------------ | 
|                                                    |                          | 
|                                                    |                          | 
|Revenues:                                           |                          | 
|Software services and licenses                      |                          | 
|Patent licenses                                     |                          | 
|                                                    |                          | 
|Total revenues                                      |                          | 
|                                                    |                          | 
|Cost of revenues:                                   |                          | 
|Software                                            |                          | 
|Patent licenses                                     |                          | 
|Write down of capitalized software costs            |                          | 
|                                                    |                          | 
|Total cost of revenues                              |                          | 
|                                                    |                          | 
|Gross profit (loss)                                 |                          | 
|                                                    |                          | 
|Operating expenses (income):                        |                          | 
|General and administrative                          |                          | 
|Sales and marketing                                 |                          | 
|Research and development                            |                          | 
|Gain on sale of assets                              |                          | 
|                                                    |                          | 
|Total operating expenses (income):                  |                          | 
|                                                    |                          | 
|Income (loss) from operations                       |                          | 
|Interest and other income (expense), net            |                          | 
|                                                    |                          | 
|Income (loss) before provision for income taxes     |                          | 
|Provision for income taxes                          |                          | 
|                                                    |                          | 
|Net income (loss) and comprehensive income (loss)   |                          | 
|                                                    |                          | 
|                                                    |                          | 
|Earnings (loss) per share:                          |                          | 
|Basic                                               |                          | 
|Diluted                                             |                          | 
|                                                    |                          | 
|Shares used in computing earnings (loss) per share: |                          | 
|                                                    |                          | 
|Basic                                               |                          | 
|Diluted                                             |                          | 

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

---



TEKNOWLEDGE CORPORATION CONSOLIDATED STATEMENT
OF STOCKHOLDERS EQUITY (DEFICIT)

|                           |  |  |  |           |       |  
|-------------------------- |  |  |  | --------- | ----- | -
|                           |  |  |  | Common    | Stock |  
|                           |  |  |  | Shares    |       |  
|                           |  |  |  | Issued    |       |  
|                           |  |  |  |           |       |  
|Balance, January 1, 2004   |  |  |  | 5,735,254 |       | $
|                           |  |  |  |           |       |  
|Exercise of stock options  |  |  |  | 500       |       |  
|                           |  |  |  |           |       |  
|Issuance of warrants       |  |  |  | -         |       |  
|                           |  |  |  |           |      
|                           |  |  |  |           |       |  
|Net loss                   |  |  |  | -         |       |  
|                           |  |  |  |           |       |  
|                           |  |  |  |           |       |  
|Balance, December 31, 2004 |  |  |  | 5,735,754 |       |  
|                           |  |  |  |           |       |  
|Issuance of warrants       |  |  |  | -         |       |  
|                           |  |  |  |           |       |  
|Net income                 |  |  |  | -         |       |  
|                           |  |  |  |           |       |  
|Balance, December 31, 2005 |  |  |  | 5,735,754 |       | $
|                           |  |  |  |           |       |  

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

---



TEKNOWLEDGE CORPORATION CONSOLIDATED STATEMENTS
OF CASH FLOWS

|                                                       | Years Ended December 31, | 
|------------------------------------------------------ | ------------------------ | 
|                                                       |                          | 
|                                                       |                          | 
|Cash flows from operating activities:                  |                          | 
|Net income (loss)                                      |                          | 
|Adjustments to
reconcile net income (loss) to net cash |                          | 
|provided by (used in) operating
activities:            |                          | 
|Depreciation and amortization                          |                          | 
|Deferred tax assets                                    |                          | 
|Amortization of warrants                               |                          | 
|Gain on sale of assets                                 |                          | 
|Write down of capitalized software costs               |                          | 
|Provision (benefit) for doubtful accounts receivable   |                          | 
|Changes in assets and liabilities:                     |                          | 
|Receivables                                            |                          | 
|Prepaids and other current assets                      |                          | 
|Accounts payable                                       |                          | 
|Other accrued liabilities                              |                          | 
|                                                       |                          | 
|                                                       |                          | 
|Net cash (used in) provided by operating activities    |                          | 
|                                                       |                          | 
|                                                       |                          | 
|Cash flow from investing activities:                   |                          | 
|Proceeds from sale of asset                            |                          | 
|Capitalization of software development costs           |                          | 
|Purchase of fixed assets                               |                          | 
|                                                       |                          | 
|                                                       |                          | 
|Net cash provided by (used in) investing activities    |                          | 
|                                                       |                          | 
|                                                       |                          | 
|Cash flow from financing activities:                   |                          | 
|Proceeds from the issuance of common stock             |                          | 
|Net repayments against line of credit                  |                          | 
|                                                       |                          | 
|                                                       |                          | 
|Net cash used in financing activities                  |                          | 
|                                                       |                          | 
|Net increase (decrease) in cash and cash equivalents   |                          | 
|Cash and cash
equivalents at the beginning of period   |                          | 
|                                                       |                          | 
|                                                       |                          | 
|Cash and cash
equivalents at the end of period         |                          | 
|                                                       |                          | 
|                                                       |                          | 
|Supplemental disclosure of
cash flow information:      |                          | 
|Cash paid for interest                                 |                          | 

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

---



TEKNOWLEDGE CORPORATION

NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS

DECEMBER 31, 2005

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.

As
Teknowledge continues to develop new products and services, the Company is subject to
risks inherent to companies at a similar stage of development. These include successful
introduction and market acceptance of the software products and related services,
sufficient resources to develop enhancements to the existing products and introduction of
follow-on products, competition from larger companies, the ability to retain and attract
employees, and sufficient working capital and cash flows to support the growth of the
business.

At
December 31, 2005, there was substantial doubt as to our ability to continue as a going
concern.  The Company has a working capital deficiency for the year ended December
31, 2005 and had an accumulated deficit of $1,788,188 at December 31, 2005. On August 22,
2005, the Company consummated a sale of its TekPortal software assets to Intuit Inc.,
receiving a $5,950,000 cash infusion that it used to pay off most of its debts and improve
its cash reserves. The Company currently believes that its continued negative cash flows
from operations coupled with the on-going quarterly obligations would require that it
obtain additional bank financing facilities. The Company is pursuing intellectual property
settlements with several parties. The Company believes that working capital at December
31, 2005 may be insufficient to meet the business objectives as currently structured and
without a cash infusion. Teknowledges cash reserves could be exhausted in nine
months after the filing of this 10-KSB. As a result of the foregoing factors, individually
or in the aggregate, the Company has an on going need for additional financing.

If
the Company is not able to obtain financing or win significant patent settlements, it
would most likely have insufficient cash to pay its obligations, and be unable to meet its
ongoing operating obligations as they come due in the ordinary course of business. As a
result, it may be required to seek protection under applicable bankruptcy laws. These
factors among others raise substantial doubt about the Companys ability to continue
as a going concern. The consolidated financial statements do not include any adjustments
that might result from this uncertainty.

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, 2005, the Companys funds were
invested in three banks.

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, 2005 and 2004, non-cash charges for issuance of warrants of
$13,458 and $42,662, were excluded from the statements of cash flows.

During
the year ended December 31, 2005, non-cash charges netted between the government rate
reserve and unbilled receivables resulted in the elimination of $90,023 from the
government rate reserve and was excluded from the statements of cash flows.

Receivables

Receivables
as of December 31, 2005 consist of the following:

|                                                | 
|----------------------------------------------- | 
|Commercial customers:                           | 
|Billed receivables                              | 
|Unbilled receivables                            | 
|                                                | 
|                                                | 
|U.S. Government:                                | 
|Billed receivables                              | 
|Unbilled receivables  long-term                | 
|                                                | 
|                                                | 
|                                                | 
|Gross receivables                               | 
|Allowance for doubtful accounts                 | 
|                                                | 
|Total receivables, net                          | 
|Less current receivables, net                   | 
|                                                | 
|Total long term government unbilled receivables | 
|                                                | 
|                                                | 

Approximately
$266,000 of unbilled government retained fees are not expected to be billed in 2006.

---



Concentration
of Credit and Customer Risk

In
2005 and 2004, approximately 39% and 50% 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 2005, 29% of total revenues were from the Department of
the Air Force. In 2004, 37% of total revenues were from the Department of the Air Force.
In 2005, 50% of total revenue was attributed to the Financial Solutions segment and 11% to
Patent licenses. Metavante Corporation provided 11% of the total Companys revenue
and was the only financial institution in 2005 to account for more than 10% of total
revenues. In 2005, Metavante Corporation accounted for 22%, Fiserv 16%, Bank of Bermuda
15%, and Pacific Capital Bank 11% of Financial Solutions revenue. At December 31, 2005,
29% of Financial Solutions accounts receivable were attributable to Metavante Corporation.

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 due
within 30 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, receivables, accounts
payable, line of credit and accrued liabilities approximate the fair value due to their
short maturities. Currently the Company has $1,860,000 in excess of Federal Deposit
Insurance Corporation (FDIC) limits of $100,000.

Capitalized
Software Development Costs

Teknowledge
capitalizes software development costs once technological feasibility is reached and
continuing until general availability of the product. During 2005 and 2004, software
development costs of $452,000 and $1,560,000 were capitalized respectively. Amortization
costs were $181,000 in 2005, and $2,213,000 in 2004. Amortization decreased in 2005 due to
the sale of TekPortal to Intuit. 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.

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 $32,000 in 2005 and $76,000 in 2004. 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.

---



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 2005. Accordingly, the Company has recorded a rate
adjustment reserve of $2,245,000 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 record 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.

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.

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, 2005
and 2004 is as follows:

|                                                                |  | 
|--------------------------------------------------------------- |  | 
|                                                                |  | 
|(in thousands, except
per share amounts)                       
|Net income after taxes (loss)
available to common shareholders: |  | 
|Numerator: Net income (loss)                                    |  | 
|                                                                |  | 
|Denominator for basic net
income (loss) per share:              |  | 
|Weighted average common shares outstanding                      |  | 
|                                                                |  | 
|Shares used in basic per share calculation                      |  | 
|                                                                |  | 
|Effect of dilutive securities:                                  |  | 
|Warrants                                                        |  | 
|Employee stock options                                          |  | 
|                                                                |  | 
|Diluted weighted average common shares                          |  | 
|                                                                |  | 
|Basic net income (loss) per share                               |  | 
|                                                                |  | 
|Diluted net income (loss) per share                             |  | 
|                                                                |  | 

In
2005, 373,471 options and warrants to purchase 56,750 shares of common stock were excluded
from the computation of diluted loss per share because the options exercise price
was greater than the average market price of the common shares. In 2004, 1,000,095 options
and 45,000 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 do to a net
loss.

Accounting
for Stock-Based Compensation

The
Company accounts for stock based compensation arrangements in accordance with Accounting
Principles Board (APB) Opinion No. 25. The Company has adopted the disclosure
provisions of Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-Based Compensation, as amended by SFAS 148. The Company
continues to apply APB Opinion No. 25 and related interpretations in accounting for the
options granted to employees and directors. The Companys option grants provide that
option exercise prices will not be less than fair market value per share on the date the
option is granted.

---



Had compensation cost been determined
under the fair value recognition provisions of SFAS Statement No. 123, as amended by SFAS
148, the Companys net income (loss) and earnings (loss) per share would have been
the following pro forma amounts.

|                                                | Year Ended December 31, | 
|----------------------------------------------- | ----------------------- | 
|                                                |                         | 
|                                                |                         | 
|Net income after taxes (loss), as reported      |                         | 
|Add: Stock-based employee compensation          |                         | 
|expense included in reported net income (loss), |                         | 
|net of related tax effects                      |                         | 
|Deduct: Total stock-based employee              |                         | 
|compensation expense determined under fair      |                         | 
|value based method for awards granted,          |                         | 
|modified or settled, net of related tax effects |                         | 
|                                                |                         | 
|                                                |                         | 
|Pro forma net income (loss)                     |                         | 
|                                                |                         | 
|                                                |                         | 
|                                                |                         | 
|Earnings (loss) per share:                      |                         | 
|Basic - as reported                             |                         | 
|Basic - pro forma                               |                         | 
|                                                |                         | 
|Diluted - as reported                           |                         | 
|Diluted - pro forma                             |                         | 

The
fair value of each option grant is estimated on the date of grant using the Black-Scholes
option pricing model with the following weighted-average assumptions used for grants in
2005 and 2004, respectively, risk-free interest rates of 4.0% and 3.8%; expected lives of
1 year with vesting immediately or by December 31, 2005 for 2005 and 5 years for 2004;
expected volatility of 200% and 90%, respectively; and expected dividend yield of 0% for
both periods.

Recently
Issued Accounting

In
December 2004, the Statement of Financial Accounting Standards Board (FASB)
issued SFAS No. 123 (Revised 2005) Share-Based Payment (SFAS No.
123R) that prescribes the accounting for share-based payment transactions in which a
company receives employee services in exchange for (a) equity instruments of the company
or (b) liabilities that are based on the fair value of the companys equity
instruments or that may be settled by the issuance of such equity instruments. SFAS No.
123R addresses all forms of share-based payment awards, including shares issued under
employee stock purchase plans, stock options, restricted stock and stock appreciation
rights. SFAS No. 123R eliminates the ability to account for share-based compensation
transactions using APB Opinion No. 25, Accounting for Stock Issued to
Employees, that was previously allowed under SFAS No. 123 as originally issued.
Under SFAS No. 123R, companies are required to record compensation expense for all share
based payment award transactions measured at fair value. In April 2005, the SEC delayed
the effective date of SFAS No. 123R. Accordingly, SFAS No. 123R is effective for the
Company beginning January 1, 2006. In March 2005, to further discuss the affects of SFAS
No. 123R the SEC released Staff Accounting Bulletin No. 107 (SAB 107) to highlight
the compliance issues for organizations that provide non-employee share-base payment
transactions and making the transition from a non-public company to reporting by Generally
Accepted Accounting Principles (GAAP.) The Company has adopted SFAS No. 123
and APB Opinion No. 25; see Accounting for Stock-Based-Compensations under Note 2. We have
not yet determined the final impact, if any, that the adoption of SFAS No. 123R 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
December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, (SFAS
153) an amendment of Accounting Principles Board Opinion No. 29. SFAS 153 replaces
the exception from fair value measurement for similar productive assets with that for
exchanges of nonmonetary assets that do not have commercial substance. The statement is
effective for the fiscal period beginning July 4, 2005 and we do not believe that the
adoption of SFAS 153 will have a significant effect on our financial statements

---



In
May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
CorrectionsA Replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS
No. 154 requires retrospective application to prior periods financial statements for
changes in accounting principal, unless it is impracticable to determine either the
period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires
that retrospective application of a change in accounting principle be limited to the
direct effects of the change. Indirect effects of a change in accounting principle, such
as a change in non-discretionary profit-sharing payments resulting from an accounting
change, should be recognized in the period of the accounting change. SFAS No. 154 also
requires that a change in depreciation, amortization, or depletion method for long-lived
non-financial assets be accounted for as a change in accounting estimate affected by a
change in accounting principle. SFAS No. 154 is effective for accounting changes and
corrections of errors made in fiscal years beginning after December 15, 2005. The
provisions of this statement are effective for us beginning January 1, 2006. We do not
anticipate that the adoption of SFAS No. 154 will have a material impact on our financial
position, results of operations or cash flows.

In
November 2005, FASB Staff Position (FSP) issued the FASB Statement of
Financial Accounting Standards (FAS) No. FAS 115-1 and 124-1 to address
determination of whether a financial asset is considered other than temporally impaired
(FAS 115-1), guidance for not-for-profit organization financial assets and the measurement
of loss, and also amends APB Opinion No. 18 regarding the Equity Method Calculations for
common stocks. FAS No. 115-1 and 124-1 goes into effects after December 15, 2005. We have
not yet determined the final impact, if any, that the adoption of FAS No. 115-1 and 124-1
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.

3.
      Other Accrued Liabilities

Other
accrued liabilities as of December 31, 2005 consist of the following:

|                         | 
|------------------------ | 
|Deferred revenue         | 
|Other                    | 
|Provision for income tax | 
|                         | 
|                         | 
|                         | 

4.      Lease
Commitments

The
Company leases facilities and equipment under non-cancelable operating leases. As of
December 31, 2005, the Company had facility leases with durations of more than one year in
the following locations:

|                           |                 
|-------------------------- | ----------------
|Location                   | Expires         
|                           |                 
|Palo Alto, California      | October 31, 2007
|Marina Del Rey, California | May 5, 2008     

The
remaining obligations under these leases are as follows:

|             |                 
|------------ | ----------------
|Year Ending  |                 
|December 31, |                 
|             |                 
|2006         | $        307,768
|2007         | 300,761         
|2008         | 34,121          
|             |                 
|             |                 
|             | $        642,650
|             |                 

Rent
expense for the years ended December 31, 2005 and 2004 totaled approximately $314,000 and
$589,000, respectively.

---



5.      Line
of Credit

Effective
March 28, 2004, the Company renewed its line of credit. The new agreement extended the
term of the line from one year to two years ending March 28, 2006 and increased the credit
limit from $3,000,000 to $4,000,000. The line operates as a revolving line of credit and
the intent is to repay borrowings, as funds are available. Under the arrangement, the
Company may borrow a maximum of the lesser of $3,000,000 or 80 percent of eligible
receivables at an initial rate of 1.0 percent over the Wall Street Journal prime interest
rate (currently 4.00%) with a floor of 4.25%. The line includes select financial covenants
tied principally to net income projections for the years ended December 31, 2004 and 2005.
The financing provided by the Bank is collateralized with the assets of the Company. In
conjunction with the credit line, the Company requested and received a $1,000,000 term
loan sub-facility. The term loan is for a two-year term at an initial interest rate of 3.0
percent over the Wall Street Journal prime rate with a floor of 4.25%. The Company
borrowed $1,000,000 against the term loan facility in the first quarter of 2004 and paid
off in October 2004.

Effective
September 1, 2004, the financial agreement between Teknowledge and the bank was modified
to include the following changes: 1) the interest rate on the receivables facility was
increased from 2.0 to 3.0 percent over the Wall Street Journal Prime rate
(WSJP), 2) the cash support level in the bank required to maintain the term
loan was raised from 75 to 100 percent, and 3) to supplement its existing cash reserves,
the Company was obligated to secure a cash infusion of at least $1,000,000 by December 31,
2005. Subsequent to the effective date of the new agreement, Teknowledge concluded two
Intellectual property licensing activities totaling $1,000,000. In addition to periodic
reporting requirements, Teknowledge provided to the bank a near term quarterly income
forecast that it is required to achieve with no greater than 20% variance to the plan.

On
June 30, 2005, the Company entered into a new agreement with Bridge Bank, N.A.(the
Bank) for a non-formula based loan facility (bridge advance) of
$700,000 that expired on August 31, 2005. The Company requested this facility while it
pursued various options to supplement the Companys cash reserves. During the loan
period the Company incurred a monthly processing fee of $40,000 for June, $50,000 for
July, and $60,000 for August. The Company also reduced the total amount of its facility
with the bank to $2,000,000 to save annual administrative fees. As a further condition of
this agreement, the Company granted the bank warrants to purchase 30,000 shares of stock
at $0.52 per share that are exercisable one year from the date of the agreement.

In
connection with the credit facilities dated March 28, 2003 and 2004 and the amended
facilities of September 1, 2004, March 28, 2005 and June 30, 2005, the Company granted
five warrants totaling 86,750 shares. The Company granted to the lender three increments
of 15,000 shares of Common Stock each one increment on March 28, 2005 of 11,750 shares and
the June 21, 2005 grant of 30,000 shares, at exercise prices of $3.00, $7.00, $2.50,
$1.50, and $0.52 per share, respectively. 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.

As
a condition a software asset sale agreement concluded August 22, 2005, Teknowledge paid
off its secured debt with the Bank of $675,000 and all outstanding fees, and terminated
its line of credit and current financing arrangements with the Bank.

6.      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:

|                                          
|------------------------------------------
|                                          
|Provision (benefit) at U.S. statutory rate
|Change in valuation allowance             
|Other                                     
|                                          
|Effective tax rate                        
|                                          

The components of the deferred income
tax asset as of December 31, 2005 are as follows:

---



|                                 | 
|-------------------------------- | 
|Net operating loss carryforwards | 
|Tax credit carryforwards         | 
|Cumulative temporary differences | 
|                                 | 
|Deferred tax asset               | 
|Valuation allowance              | 
|                                 | 
|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.  At December 31, 2005, the valuation allowance
was $10,355,997. 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.

At
December 31, 2005, the Company had Federal net operating loss carryforwards of
approximately $23.0 million available to offset future Federal taxable income. These loss
carryforwards expire at various dates through the year 2023 as follows:

|            |  
|----------- | -
|            |  
|2006        | $
|2007        |  
|2008        |  
|2009 - 2023 |  
|            |  
|            | $
|            |  

In
2005, $10 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.

7.      
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 2005, the
Company matched 5% of contributions on eligible wages. The Company matching contribution
vests at 20% per year over a five-year period. The Company contributed approximately
$153,000 and $154,000 to the plan during 2005 and 2004, respectively.

8.      
Stockholders Equity (Deficit)

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.

Stock-Based Compensation Plans

The
Company has two stock option plans accounted for under the recognition and measurement
principles of APB Opinion No. 25. The stock option plan for employees is called the
Teknowledge Corporation 1998 Stock Option Plan (the 1998 Plan) and the stock
option plan for Directors 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 1,166,838 shares were available for future grant as of December 31, 2005.
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 2005 vest immediately or by December 31, 2005. 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 129,386 shares were available for future grant as of December
31, 2005. 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, 2005, the following number of shares of common stock have been reserved
for future issuance under both Plans:

|                                                  | 
|------------------------------------------------- | 
|Teknowledge Corporation 1998 Stock Option Plan    | 
|2002 Stock Option Plan for Non-Employee Directors | 
|                                                  | 
|                                                  | 
|                                                  | 
|                                                  | 

|                                 | 2005 |  | 2004 |          
|-------------------------------- | ---- |  | ---- | ---------
|                                 |      |  |      |          
|                                 |      |  |      |          
|                                 |      |  |      |          
|                                 |      |  |      | Options  
|                                 |      |  |      |          
|Outstanding at beginning of year |      |  |      | 1,000,095
|Granted                          |      |  |      | 1,141,596
|Exercised                        |      |  |      | -        
|Forfeited                        |      |  |      | (929,564 
|                                 |      |  |      |          
|Outstanding at end of year       |      |  |      | 1,212,127
|                                 |      |  |      |          
|Exercisable at end of year       |      |  |      | 1,194,570

---



The
following table summarizes information about stock options outstanding at December 31,
2005:

|              |  |           | 
|------------- |  | --------- | 
|              |  |           | 
|Range of      |  |           | 
|Exercise      |  |           | 
|Prices        |  |           | 
|($'s)         |  | Options   | 
|              |  |           | 
|0.05  -  1.00 |  | 844,338   | 
|1.01  -  2.00 |  | 31,882    | 
|2.01  -  3.00 |  | 114,017   | 
|3.01  -  4.00 |  | 64,940    | 
|4.01  -  5.00 |  | 148,000   | 
|5.01  - 12.00 |  | 9,000     | 
|              |  |           | 
|              | 
|0.05  - 8.15  |  | 1,212,127 | 
|              | 

9.        Interest
and Other Income (Expense), net

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

|                 |  | 
|---------------- |  | 
|                 |  | 
|                 |  | 
|Interest income  |  | 
|Interest expense |  | 
|Other            |  | 
|                 |  | 
|                 |  | 
|                 |  | 
|                 |  | 

10.      Contingencies

Legal
Proceedings

Teknowledge
has an active patent licensing program, which includes the necessity of legal enforcement
of its patent rights in the marketplace. On August 19, 2002, Teknowledge entered into a
Contingency Fee Agreement and Power of Attorney in Damage Suit (the Fee
Agreement) with Goldstein & Faucett, L.L.P. (the Attorneys) for the
enforcement of its intellectual property rights, specifically U.S. Patent No. 6,029,175
entitled Automatic Retrieval of Changed Files by a Network Software Agent
(the 175 patent). Under the terms of the Fee Agreement, the Attorneys
agreed to pursue damages, compensation, and relief to which Teknowledge may be entitled
related to any infringement of the 175 patent, and Teknowledge will pay the
Attorneys fees and direct expenses out of any money collected from such efforts.

Pursuant
to the Fee Agreement, the Attorneys filed a Complaint in the United States District Court
for the District of Delaware on August 29, 2002 and named Akamai Technologies, Inc.,
Inktomi Corporation, and Cable & Wireless Internet Services, Inc. as defendants. On
November 22, 2002, the case was transferred to the United States District Court for the
District of Northern California. The Complaint stated a claim for patent infringement of
the 175 patent and sought reasonable royalties. The claims asserted in this
complaint concern the network cache technology features of the 175 patent, which can
be utilized to reduce latency and communication costs for members of a group with
interests in similar objects on a network.

---



The
Attorneys subsequently filed a Complaint on July 16, 2003 in the United States District
Court for the District of Northern California and named Yahoo! Inc., Microsoft Corporation
and AOL Timer Warner, Inc. as defendants. The Complaint stated a claim for patent
infringement of the 175 patent and sought reasonable royalties. The claims asserted
in this complaint concern the alert and notification features of the 175 patent,
which can be utilized to deliver alerts to users concerning changes to data items of
interest on a web page or availability of software updates.

On
December 12, 2003, the District Court for the Northern District of California ruled that
the two cases be consolidated into a single action. Microsoft Corporation filed a
counterclaim on February 3, 2004, claiming that Teknowledge infringed on two of its
patents, one for electronic bill payments, and the other for information aggregation.
Teknowledge has settled with all of the defendants and counterclaimants on terms that
included payments to Teknowledge. These settlements have been disclosed in the previous
SEC Form 8-K filed October 4, 2004, SEC Form 8-K/A filed October 12, 2004, SEC Form 8-K
filed November 3, 2004, SEC Form 8-K filed February 22, 2005, and SEC Form 8-K filed
August 12, 2005.

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

11.      
Segment Reporting

The
Company operates three reporting segments, Financial Solutions, Government Contract
R&D, and Patents and Technology Licensing. In 2005, 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):

|                              | FinancialSolutions | GovernmentContractR&D | Patent &Technologylicensing | Total
|----------------------------- | ------------------ | --------------------- | --------------------------- | -----
|Year ended December 31, 2005: |                    |                       |                             |      
|Revenues                      |                    |                       | $                           | 2,010
|Cost of revenues              |                    |                       |                             | 2,170
|                              |                    |                      
|Gross profit (loss)           |                    |                       | $                           | (160 
|                              |                    |                      

|                                    |  |  |   |       
|----------------------------------- |  |  | - | ------
|Year ended December 31, 2004:       |  |  |   |       
|Revenues                            |  |  | $ | 3,120 
|                                    |  | 
|Cost of revenues before adjustments |  |  |   | 3,691 
|Government rate reserve adjustment  |  |  |   | -     
|Capitalized software adjustment     |  |  |   | 1,753 
|                                    |  | 
|Adjusted cost of revenues           |  |  |   | 5,444 
|                                    |  | 
|Gross profit (loss)                 |  |  | $ | (2,324
|                                    |  | 

|(1) | The Patent and Technology revenues are the result of two patent and technology
          licensing agreements in 2005 arising from legal settlements
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The Patent and Technology revenues are the result of two patent and technology licensing
          agreements in 2004 arising from legal settlements
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------

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Revenue
for customers in the United States of America represented approximately 91% and 95% in
2005 and 2004, respectively. Substantially all of the Companys long-lived assets are
in the United States.

12.      
Disposal of Capitalized Software Asset

Financial
Solutions.  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 will be held in escrow as a reserve for
indemnification claims for a period of eighteen months, at which time it will be remitted
to Teknowledge, net of eligible claims.   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.

13.      Unaudited Quarterly
Financial Data (in thousands, except per share amounts):

|                                     |  | Quarterly Results Summary
(In thousands, except per share date) |   |       |  
|------------------------------------ |  | --------------------------------------------------------------- | - | ----- | -
|                                     |  |                                                                 |   | First |  
|Year ended December 31, 2005:        |  |                                                                 |   |       |  
|                                     |  |                                                                 |   |       |  
|Revenues                             |  |                                                                 | $ | 1,631 |  
|Gross profit (loss)                  |  |                                                                 |   | 399   |  
|Basic net income (loss)              |  |                                                                 |   | (136  | )
|Basic net income (loss) per share    |  |                                                                 |   | (0.02 | )
|Diluted net income (loss) per share  |  |                                                                 |   | (0.02 | )
|                                     |  |                                                                 |   |       |  
|Year ended December 31, 2004:        |  |                                                                 |   |       |  
|                                     |  |                                                                 |   |       |  
|Revenues                             |  |                                                                 | $ | 2,159 |  
|Gross profit (loss)                  |  |                                                                 |   | 251   |  
|Net loss                             |  |                                                                 |   | (514  | )
|Basic and diluted net loss per share |  |                                                                 |   | (0.09 | )

(1)Q3 2005 includes $3,764,000 gain
on sale of the TekPortal product to Intuit (see note #12)
(2)Q4 2004 includes $1,753,000 due to the write down of capital software development assets, and a $1,500,000 increase in the government rate reserve
(3)Q4 2004 includes $768,000 write off of deferred tax asset

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