<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION & RESULTS OF
OPERATIONS RESULTS OF OPERATIONS

The table below summarizes changes in selected operating indicators, showing
certain income, cost and expense items as a percentage of total revenue from
continuing operations for each of the past two years. Inflation has not been a
significant factor in Datakey's operations to date.

<TABLE>
<CAPTION>
                                        Percentage of Total
                                              Revenue
                                       -----------------------
Year Ended December 31,                  2001        2000
                                       -----------------------
<S>                                    <C>        <C>
REVENUE............................        100%       100%

COST AND EXPENSES
Cost of goods sold.................         43         53
Research and development,                   30         56
engineering and technical support..
Marketing and sales................         44         61
General and administrative.........         10         16
   Total cost and expenses.........        127        186
                                       -----------------------
Operating loss                             (27)       (86)
                                       -----------------------
Interest income....................          1          4
Loss before income taxes...........        (26)       (82)
Income taxes.......................         --         --
                                       -----------------------
Net loss from continuing operations        (26)%      (82)%
                                       =======================
</TABLE>

COMPARISON OF 2001 WITH 2000

                              CONTINUING OPERATIONS

TOTAL REVENUE: Total revenue was $7,815,000 in 2001 compared to $3,608,000 in
2000. The substantial increase in revenue is due to increasing acceptance and
demand for our information security solutions' products. This increasing
acceptance is created, in part, by banks, government agencies and enterprises
placing more emphasis on information security in general, and also because
Datakey's product offering has certain technology advantages compared to other
product offerings of its competitors. Because of the sale of the Electronic
Products (EP) operation in 2001, total revenue includes only revenue of
Information Security Solutions (ISS) products.

GROSS MARGINS: The gross profit margin increased to 57 percent in 2001 from 47
percent primarily due to a significant reduction in the costs of materials used
in cards and readers without a corresponding reduction in the selling price.

RESEARCH AND DEVELOPMENT, ENGINEERING AND TECHNICAL SUPPORT (RDETS): Research
and development, engineering and technical support expense increased by 16
percent to $2,325,000 in 2001 from $2,003,000 in 2000. Such expenses represented
30 and 56 percent of sales in 2001 and 2000, respectively. RDETS expense
increased during 2001 as the Company continues the development and support
activities of its information security products.

MARKETING AND SALES, GENERAL AND ADMINISTRATIVE: Marketing and sales expense
increased 56 percent to $3,461,000 in 2001 from $2,216,000 in 2000. As a
percentage of revenue these expenses decreased from 61 to 44 percent. The
increase in 2001 marketing and sales expense resulted from additions to the
sales staff, increased commissions due to higher revenue and continuing
promotional activities to promote the Company's information security products.
         General and administrative expenses increased 28 percent to $744,000 in
2001 from $582,000 in 2000 primarily as a result of increases in legal, audit,
insurance and employment related expenses.

INTEREST INCOME: Interest income, net of interest expense, decreased to $79,000
in 2001 from $145,000 in 2000, primarily due to a significant reduction in the
market rate of interest on interest bearing accounts.

INCOME TAX EXPENSE: As a result of the cumulative net operating loss carryovers
of approximately $17,936,000 at December 31, 2001, and $13,514,000 at December
31, 2000, the Company recorded no income tax expense in either year.

NET LOSS. Net loss in 2001 was $2,006,000 compared to $2,953,000 in 2000,
primarily due to the substantial increase in revenue and gross margin which more
than offset the increase in expenses.

                             DISCONTINUED OPERATIONS

The Company announced in February 2001 that it planned to phase down or divest
its EP business segment. Subsequently, the operations were sold in August 2001.
As a result, the losses of $487,000 in 2001 and $1,846,000 in 2000 are reflected
as losses from discontinued operations. Since the Company retained certain
contracts that are not yet complete, this business segment will continue to be
shown as discontinued operations until these contracts are finalized in 2002.


COMPARISON OF 2000 WITH 1999

                              CONTINUING OPERATIONS

TOTAL REVENUE: Total revenue was $3,608,000 in 2000 compared to $1,316,000 in
1999. The increase in revenue was due to increasing acceptance of the Company's
information security products and technology.

GROSS MARGINS: The gross profit margin decreased to 47 percent in 2000 from 48
percent in 1999, primarily because the Company began amortizing a prepaid
license fee, equal to 6 percent of sales, in 2000.

RESEARCH AND DEVELOPMENT, ENGINEERING AND TECHNICAL SUPPORT (RDETS): Research
and development, engineering and technical support expense increased by 23
percent to $2,003,000 in 2000 from $1,632,000 in 1999. RDETS expense increased
during 2000 as the Company continues the development and support activities of
its information security products.

MARKETING AND SALES, GENERAL AND ADMINISTRATIVE: Marketing and sales expense
increased 56 percent to $2,216,000 in 2000 from $1,418,000 in 1999. The increase
in 2000 expense resulted from increases in commission on the higher level of
sales, additions to staff, including a new European office, and continuing
promotion activities.
         General and administrative expenses increased 23 percent to $582,000 in
2000 from $472,000 in 1999 primarily as a result of increases in legal, audit
and employment related expenses.

INTEREST INCOME: Interest income, net of interest expense, increased to $145,000
in 2000 from $3,000 in 1999 as the Company invested a portion of the proceeds
from a $4 million private placement, completed in February 2000, in an interest
bearing account.

INCOME TAX EXPENSE: As a result of the cumulative net operating loss carryovers
of approximately $13,514,000 at December 31, 2000, the Company recorded no
income tax expense in 2000.

NET LOSS. Net loss in 2000 was $2,953,000 compared to $2,891,000 in 1999
primarily due to the significant 2000 increase in research and development,
engineering and technical support expenditures in the ISS business segment that
slightly exceeded the contribution from additional revenue.



<PAGE>

DISCONTINUED OPERATIONS

Loss in the EP business segment, now reflected as discontinued operations, was
$1,846,000 in 2000 compared to income of $18,000 in 1999. The loss in 2000 was
primarily due to a reduction in revenue to $3,799,000 in 2000 from $4,550,000 in
1999, and a charge of $1,281,000, in 2000, to reflect the estimated loss upon
disposal of the segment.

LIQUIDITY AND CAPITAL RESOURCES

Cash as of December 31, 2001, was $4,112,000 as compared to $1,533,000 as of
December 31, 2000. The Company had an increase of $2,579,000 in cash during 2001
compared to an increase of $1,188,000 in cash in 2000. The 2001 increase is due
to proceeds from the sale of common stock during the year of $4,752,000, offset
by the net loss of $2,493,000. The net loss was due, in part, to significant
expenditures totaling $5,786,000 in research, development, engineering,
technical support, and sales and marketing which were related to the Company's
information security products, and an additional charge of $487,000 relating to
discontinued operations. The Company invested $307,000 in equipment, licenses
and patents in 2001 compared to $630,000 in 2000.

Datakey's balance sheet reflected $5,887,000 in working capital and a current
assets to current liabilities ratio of 5.0 to 1 as of December 31, 2001.

CONTRACTUAL CASH OBLIGATIONS
The Company presently has no long-term debt outstanding and its only contractual
cash obligations are those from operating lease obligations. These lease
obligations total $631,000 over the next three years as shown on Note 8 to the
financial statements.

We also have a commercial commitment of $1,000,000 for a line of credit
agreement through April 2002. There were no advances outstanding on the line of
credit agreement at December 31, 2001.

We believe that our cash balance, availability under our line of credit, if
needed, and anticipated cash flows from operations will be adequate to fund our
cash requirements for fiscal 2002.

CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are summarized in the notes to our financial
statements. Some of the most critical policies are also discussed below.

Revenue Recognition and Deferred Revenue: The revenue from products and systems
sold by the information security business segment is recognized upon shipment to
the customer as we have no future obligation for support, upgrades or other
services. If the customer purchases an extended maintenance contract, revenue
from the contract is deferred and recognized over the term of the contract.

The revenue from products sold by the electronic products business segment,
which has been discontinued, is recognized upon shipment, FOB shipping point.

Shipping and handling charges to customers are included in net sales. Shipping
and handling costs incurred by us are included in cost of goods sold.

Software Development Costs: Our policy on software development costs is to
charge to expense those costs of software development incurred until the point
of technical feasibility is attained, at which time such costs are capitalized.

Technical feasibility for our current products was attained several years ago,
before we were able to ascertain the market acceptance of the products. As a
result, we charged these costs to operations, as the net realizable value was
not determinable at that time. Costs in recent years have been comprised
primarily of maintenance and customer support, which have been charged to
operations. New product development and/or significant product enhancements in
the future may result in an increased level of capitalized software costs.

Reserves and Review for Impairment: As a matter of policy, we review our major
assets for impairment. Our major operating assets are accounts receivable,
inventory, license agreements and property and equipment. We have not
experienced significant bad debts expense and our reserve for doubtful accounts
of $28,000 should be adequate for any exposure to loss in our December 31, 2001
accounts receivable. We have also established reserves for slow moving and
obsolete inventories and believe the reserve of $185,000 is adequate.

We depreciate our property and equipment and license agreements over their
estimated useful lives, and we have not identified any items that are impaired
except for one license agreement in 2001 for which we wrote off $45,000.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In July 2001, FAS 141, Business Combinations, and FAS 142, Goodwill and Other
Intangible Assets, were issued. These pronouncements provide that all business
combinations initiated after June 30, 2001 be accounted for using the purchase
method and that goodwill be reviewed for impairment rather than amortized,
beginning on January 1, 2002. The Company does not believe that the adoption of
these pronouncements will have a material effect on its financial statements.
Any business combination transactions in the future would be accounted for under
this new guidance.

In September 2001, the FASB issued Statement 143, Asset Retirement Obligations.
This Statement addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. The Statement will be effective for the Company's fiscal
year ending December 2003. The Company does not believe that the adoption of
this pronouncement will have a material effect on its financial statements.

In August 2001, the FASB issued Statement 144, Accounting for Impairment or
Disposal of Long-Lived Assets. This Statement addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. The Statement
will be effective for the Company's fiscal year ending December 2002. The
Company does not believe that the adoption of this pronouncement will have a
material effect on its financial statements.

In 2002, the Company plans to increase expenditures for product development,
marketing activities and inventory levels to support anticipated revenue growth.
The Company's current plan estimates annual revenue in 2002 in the range of $13
to $15 million. The Company believes its working capital together with its bank
line of credit, which the Company plans to extend for another year, will be
sufficient to fund its planned operations and product development and
promotional activities in 2002. In the event that the revenues for the Company's
products are significantly less than projected, the Company's ability to extend
its current bank credit line may be jeopardized and the Company's ability to
maintain its current business operations would be adversely affected.

OUTLOOK & RISKS

Certain statements in this Annual Report are forward looking, are based upon
current expectations and actual results may differ

<PAGE>




materially due to certain risks and uncertainties, including those set forth
below.

REVENUE: Revenue is expected to reach between $13 and $15 million in 2002 as
more pilot programs move into a deployment phase and additional pilot programs
are commenced. Revenue increases depend on customer acceptance and demand, the
effectiveness of the Company's marketing and sales organization, as well as
general business, economic and competitive conditions.

If a well-established company with much greater resources develops or begins to
aggressively market a competitive product, if new technology emerges that
surpasses that of the Company, or if similar technology is offered at a
significantly lower price, the Company could face significant competition
obstacles that would negatively impact the Company's ability to meet its revenue
goals. There is no assurance that the Company will achieve its revenue plan.

GROSS MARGINS: A gradual improvement in gross profit margins during 2002 is
expected through effective material purchasing and additional contribution from
software applications being developed. Such an increase in gross margin depends
on achievement of the expected purchasing prices, realization of the revenue
increases, a continuation of improvement in manufacturing processes and general
market conditions.

Contributing to a reduction in gross profit margin, however, will be revenue
from resale of certain products rather than acting as a principal supplier. A
third factor is the contribution to revenue, if any, from technology licensing
fees that carry a very high margin. Less than 5 percent of revenue in 2001 was
technology licensing fees as compared to about 30 percent in 2000.

On balance, therefore, the gross profit margin in 2002 may increase or decrease
depending on how significant revenue from resale of products becomes in relation
to technology licensing fees, and the extent to which we are successful in
achieving additional reductions in material costs.

RESEARCH AND DEVELOPMENT, ENGINEERING AND TECHNICAL SUPPORT: The Company intends
to increase funding for product development and support activities in 2002 by
about 7 percent compared to 2001. The ability to increase such funding depends
in significant part on the Company's ability to meet its 2002 revenue plan.

MARKETING AND SALES, GENERAL AND ADMINISTRATIVE: Marketing and sales expenses
are expected to increase about 14 percent in 2002 to support new product
introductions, increase the number of sales and marketing personnel dedicated to
the Company's information security products and to support the expected increase
in revenue. General and administrative expenses in 2002 are expected to increase
about 11 percent from the 2001 level to support the growth in the level of
activity.

Given the level of expected increases in expenses, the Company's ability to
attain profitability for the 2002 year will depend on the Company's reaching
revenue of at least $12 million in 2002.

EXPECTED PROFIT: The Company's goal is to reach quarterly profitability in the
second half of 2002 and to report a small profit for the year. The Company's
ability to attain profitability in the second half of 2002 and thereafter will
depend primarily on its ability to significantly increase the revenue from its
information security products. Based upon the level of information security
products sales to date, there has not been sufficient market acceptance to be
assured that revenue will increase significantly or that the Company will attain
profitability.

<PAGE>
                          INDEPENDENT AUDITOR'S REPORT

To the Stockholders
Datakey, Inc.
Burnsville, Minnesota

We have audited the accompanying balance sheets of Datakey, Inc., as of December
31, 2001 and 2000, and the related statements of operations, stockholders'
equity, and cash flows for the years then ended. 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 auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Datakey, Inc., as of December
31, 2001 and 2000, and the results of its operations and its cash flows for the
years then ended, in conformity with accounting principles generally accepted in
the United States of America.

                                              /s/ McGladrey & Pullen, LLP

Minneapolis, Minnesota
February 5, 2002




                                       1
<PAGE>
DATAKEY, INC.

BALANCE SHEETS
DECEMBER 31, 2001 AND 2000

<TABLE>
<CAPTION>

ASSETS (NOTE 3)                                                            2001         2000
-----------------------------------------------------------------------------------------------
<S>                                                                     <C>          <C>
Current Assets
   Cash and cash equivalents                                            $4,112,264   $1,532,558
   Trade receivables, less allowance for doubtful accounts of $28,000
     in 2001 and $26,000 in 2000 (Note 7)                                2,154,723      989,020
   Inventories (Note 2)                                                    926,028      513,846
   Prepaid expenses and other                                               84,433      113,176
   Net assets of discontinued operations (Note 10)                          82,077    1,561,999
                                                                        -----------------------
         TOTAL CURRENT ASSETS                                            7,359,525    4,710,599
                                                                        -----------------------

Other Assets
   Licenses and patents, less accumulated amortization of $832,374
     in 2001 and $698,517 in 2000 (Note 8)                                 191,839      498,961
                                                                        -----------------------

Equipment and Leasehold Improvements, at cost
   Production tooling                                                      209,752    1,162,750
   Equipment                                                               671,221    2,690,894
   Furniture and fixtures                                                  166,520      322,095
   Leasehold improvements                                                  146,812      278,371
                                                                        -----------------------
                                                                         1,194,305    4,454,110

   Less accumulated depreciation                                           803,548    4,227,882
                                                                        -----------------------
                                                                           390,757      226,228
                                                                        -----------------------
                                                                        $7,942,121   $5,435,788
                                                                        =======================
</TABLE>


See Notes to Financial Statements.



                                       2


<PAGE>


<TABLE>
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY                                              2001            2000
---------------------------------------------------------------------------------------------------------
<S>                                                                          <C>             <C>
Current Liabilities
   Accounts payable                                                          $    566,345    $    386,613
   Accrued expenses:
      Compensation                                                                313,098         226,803
      Other                                                                       118,119          74,031
   Deferred revenue                                                               474,897          63,797
   Net liabilities from discontinued operations (Note 10)                              --         480,875
                                                                             ----------------------------
         TOTAL CURRENT LIABILITIES                                              1,472,459       1,232,119
                                                                             ----------------------------

Commitments and Contingencies (Notes 3, 5, 8, and 10)

Stockholders' Equity (Notes 5, 6, and 11)
   Convertible preferred stock, voting, liquidation value $2.50 per share;
      authorized 400,000 shares; issued and outstanding
      150,000 shares                                                              375,000         375,000
   Common stock, par value $0.05 per share; authorized 20,000,000
      shares; issued and outstanding 9,974,012 shares in 2001 and
      8,269,173 shares in 2000                                                    498,701         413,459
   Additional paid-in capital                                                  18,580,288      13,906,744
   Accumulated deficit                                                        (12,984,327)    (10,491,534)
                                                                             ----------------------------
                                                                                6,469,662       4,203,669
                                                                             ----------------------------
                                                                             $  7,942,121    $  5,435,788
                                                                             ============================
</TABLE>





                                       3

<PAGE>
DATAKEY, INC.

STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2001 AND 2000


<TABLE>
<CAPTION>

                                                                      2001           2000
--------------------------------------------------------------------------------------------
<S>                                                               <C>            <C>
Net sales (Note 7)                                                $ 7,814,850    $ 3,608,480
                                                                  --------------------------

Costs and expenses:
   Cost of goods sold                                               3,369,483      1,904,221
   Research and development, engineering, and technical support     2,325,037      2,003,455
   Marketing and sales                                              3,460,675      2,216,282
   General and administrative                                         744,335        582,238
                                                                  --------------------------
         TOTAL COSTS AND EXPENSES                                   9,899,530      6,706,196
                                                                  --------------------------
         OPERATING LOSS                                            (2,084,680)    (3,097,716)

Interest income                                                       109,028        169,909
Interest expense                                                      (30,096)       (25,000)
                                                                  --------------------------
         LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES       (2,005,748)    (2,952,807)

Income tax expense (Note 4)                                                --             --
                                                                  --------------------------
         NET LOSS FROM CONTINUING OPERATIONS                       (2,005,748)    (2,952,807)
                                                                  --------------------------

Discontinued operations (Note 10):
   Loss from operations of discontinued segment                            --       (565,066)
   Loss on disposal of discontinued segment                          (487,045)    (1,281,000)
                                                                  --------------------------
         LOSS FROM DISCONTINUED OPERATIONS                           (487,045)    (1,846,066)
                                                                  --------------------------
         NET LOSS                                                 $(2,492,793)   $(4,798,873)
                                                                  ==========================
Loss per share:
   Basic and diluted loss from continuing operations              $     (0.21)   $     (0.37)
   Basic and diluted loss from discontinued operations                  (0.05)         (0.23)
                                                                  --------------------------
         BASIC AND DILUTED LOSS PER COMMON SHARE                  $     (0.26)   $     (0.60)
                                                                  ==========================

Weighted-average common shares:
   Basic and diluted                                                9,714,002      7,977,281
                                                                  ==========================

</TABLE>

See Notes to Financial Statements.





                                       4
<PAGE>
DATAKEY, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2001 AND 2000


<TABLE>
<CAPTION>
                                                                         Convertible Preferred Stock
                                                                         ---------------------------
                                                                            Shares          Amount
----------------------------------------------------------------------------------------------------
<S>                                                                       <C>            <C>
Balance, December 31, 1999                                                 150,000        $375,000
   Issuance of common stock (net of offering expenses of $409,745)              --              --
   Issuance of common stock in accordance with employee stock
      purchase plan (Note 6)                                                    --              --
   Compensation expense from stock options                                      --              --
   Net loss                                                                     --              --
                                                                         ----------------------------
Balance, December 31, 2000                                                 150,000         375,000
   Issuance of common stock (net of offering expenses of $297,066)              --              --
   Issuance of common stock in accordance with employee stock
      purchase plan (Note 6)                                                    --              --
   Compensation expense from stock options                                      --              --
   Net loss                                                                     --              --
                                                                         ----------------------------
Balance, December 31, 2001                                                 150,000        $375,000
                                                                         ============================

</TABLE>


See Notes to Financial Statements.





                                       5
<PAGE>

<TABLE>
<CAPTION>

                                                                    Common Stock         Additional            Accumulated
                                                             ------------------------      Paid-In     ----------------------------
                                                              Shares         Amount        Capital        Deficit         Total
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                          <C>         <C>            <C>            <C>             <C>
Balance, December 31, 1999                                   6,322,285   $    316,114   $  8,501,543   $ (5,692,661)   $  3,499,996
   Issuance of common stock (net of offering expenses
       of $409,745)                                          1,940,178         97,009      5,324,454             --       5,421,463
   Issuance of common stock in accordance with employee
      stock purchase plan (Note 6)                               6,710            336         16,775             --          17,111
   Compensation expense from stock options                          --             --         63,972             --          63,972
   Net loss                                                         --             --             --     (4,798,873)     (4,798,873)
                                                             -----------------------------------------------------------------------
Balance, December 31, 2000                                   8,269,173        413,459     13,906,744    (10,491,534)      4,203,669
   Issuance of common stock (net of offering expenses
       of $297,066)                                          1,689,473         84,474      4,625,421             --       4,709,895
   Issuance of common stock in accordance with employee
      stock purchase plan (Note 6)                              15,366            768         40,874             --          41,642
   Compensation expense from stock options                          --             --          7,249             --           7,249
   Net loss                                                         --             --             --     (2,492,793)     (2,492,793)
                                                             -----------------------------------------------------------------------
Balance, December 31, 2001                                   9,974,012   $    498,701   $ 18,580,288   $(12,984,327)   $  6,469,662
                                                             =======================================================================
</TABLE>

                                       6
<PAGE>
DATAKEY, INC.

STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2001 AND 2000

<TABLE>
<CAPTION>
                                                                      2001           2000
---------------------------------------------------------------------------------------------
<S>                                                               <C>            <C>
Cash Flows From Operating Activities
   Net loss                                                       $(2,492,793)   $(4,798,873)
   Adjustments to reconcile net loss to net cash used in
      operating activities:
      Depreciation                                                    233,403        353,881
      Amortization                                                    415,934        543,580
      Reserve for loss on disposal of discontinued segment                 --      1,281,000
      Utilization of reserve for loss of discontinued segment      (1,281,000)            --
      Loss on disposal of equipment                                   144,146         10,051
      Noncash compensation from stock options                           7,249         63,972
      Changes in assets and liabilities:
         Trade receivables                                           (749,499)       (12,821)
         Inventories                                                1,035,306     (1,112,343)
         Prepaid expenses                                              28,743             --
         Accounts payable                                            (177,808)       (59,734)
         Deferred revenue                                             411,100         36,819
         Other                                                          7,048         73,473
                                                                  ---------------------------
            NET CASH USED IN OPERATING ACTIVITIES                  (2,418,171)    (3,620,995)
                                                                  ---------------------------

Cash Flows From Investing Activities
   Purchases of equipment                                            (271,390)      (182,626)
   Proceeds on sale of segment                                        550,000             --
   Proceeds on sale of equipment                                        3,730             --
   License and patent costs                                           (36,000)      (447,317)
                                                                  ---------------------------
            NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES       246,340       (629,943)
                                                                  ---------------------------

Cash Flows From Financing Activities
   Net proceeds from issuance of common stock                       4,751,537      5,438,574
                                                                  ---------------------------

            INCREASE IN CASH AND CASH EQUIVALENTS                   2,579,706      1,187,636

Cash and Cash Equivalents
   Beginning                                                        1,532,558        344,922
                                                                  ---------------------------
   Ending                                                         $ 4,112,264    $ 1,532,558
                                                                  ===========================
Supplemental Disclosures of Noncash Items
   Cash paid for interest                                         $    30,096    $    25,000
                                                                  ===========================
</TABLE>

See Notes to Financial Statements.




                                       7
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 1.  NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

NATURE OF BUSINESS: Datakey, Inc., provides products and systems directed to the
information security market, which enables user identification and
authentication, secure data exchange, and information validation. The Company is
discontinuing a segment (Note 10) which provides electronic products, consisting
of proprietary memory keys, cards, and other custom-shaped tokens, that serve as
a convenient way to carry electronic information and are packaged to survive in
portable environments. The Company has a wholly owned subsidiary which is
inactive.

A summary of significant accounting policies follows:

USE OF ESTIMATES: 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 those estimates.

CASH AND CASH EQUIVALENTS: For purposes of reporting in the statements of cash
flows, the Company includes all cash accounts and all highly liquid debt
instruments purchased with an original maturity of three months or less as cash
and cash equivalents on the accompanying balance sheets.

The Company maintains its cash in bank deposit accounts, which, at times, may
exceed federally insured limits. The Company has not experienced any losses in
such accounts.

INVENTORIES: Inventories are stated at the lower of cost (first-in, first-out
method) or market.

LICENSES AND PATENTS: Licenses and patents are stated at cost. Patents are being
amortized using the straight-line method over their economic useful lives, which
have been estimated to be five years. The costs of the license agreements are
amortized to cost of goods sold as the products incorporating the licensed units
are sold or over the life of the agreement.

ACCOUNTING FOR LONG-LIVED ASSETS: The Company periodically reviews the
utilization of its licenses, patents, equipment, and leasehold improvements for
impairment. In 2000, management had determined that no impairment in the value
of these assets had occurred. In 2001, the Company recognized an impairment
expense on one of its license agreements of $45,000.


DEPRECIATION: Depreciation of equipment and leasehold improvements is computed
on the straight-line and accelerated methods over the following estimated useful
lives:

<TABLE>
<CAPTION>
                                                                   Years
-------------------------------------------------------------------------
<S>                                                                  <C>
Production tooling                                                   2-5
Equipment                                                            3-7
Furniture and fixtures                                                 7
Leasehold improvements                                     Life of lease
</TABLE>

                                       8
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

WARRANTY COSTS: The Company provides for estimated normal warranty costs at the
time of product sales to customers and for other costs associated with specific
warranty issues at the time their existence and amounts are determinable.

INCOME TAXES: Deferred taxes are provided on an asset and liability method
whereby deferred tax assets are recognized for deductible temporary differences
and operating loss or tax credit carryforwards, and deferred tax liabilities are
recognized for taxable temporary differences. Temporary differences are the
differences between the amounts of assets and liabilities recorded for income
tax and financial reporting purposes. Deferred tax assets are reduced by a
valuation allowance when management determines that it is more likely than not
that some portion or all of the deferred tax assets will not be realized.
Deferred tax assets and liabilities are adjusted for the effects of changes in
tax laws and rates on the date of enactment.

REVENUE RECOGNITION AND DEFERRED REVENUE: The revenue from products and systems
sold by the information security business segment is recognized upon shipment to
the customer, as the Company has no future obligation for support, upgrades, or
other services. If the customer purchases an extended maintenance contract,
revenue from the contract is deferred and recognized over the term of the
contract.

The revenue from products sold by the electronic products business segment is
recognized upon shipment, FOB shipping point.

Shipping and handling charges to customers are included in net sales. Shipping
and handling costs incurred by the Company are included in cost of goods sold.

SOFTWARE DEVELOPMENT COSTS: The Company's policy is to charge to expense those
costs of software development incurred until the point of technical feasibility
is attained, at which time such costs are capitalized.

Technical feasibility for the Company's current products was attained several
years ago, before the Company was able to ascertain the market acceptance of the
products. As a result, the Company charged these costs to operations, as the net
realizable value was not determinable at that time. Costs in recent years have
been comprised primarily of maintenance and customer support, which have been
charged to operations. Company plans for new product development and/or
significant product enhancements in the future may result in an increased level
of capitalized software costs.

RESEARCH AND DEVELOPMENT, ENGINEERING, AND TECHNICAL SUPPORT: Research and
development costs, engineering, and technical support are charged to expense as
incurred and consist primarily of engineering expenses related to product
development. Engineering and technical support consist primarily of maintenance
of the Company's products and systems. Research and development costs were
approximately $1,972,000 and $1,609,000 during 2001 and 2000, respectively.

ADVERTISING: Expenditures for advertising costs are expensed as incurred.
Advertising and product promotion expense was approximately $83,000 and $213,000
during 2001 and 2000, respectively.

FAIR VALUE OF FINANCIAL INSTRUMENTS: The Company's financial instruments consist
of cash and cash equivalents and short-term trade receivables and payables for
which current carrying amounts approximate fair value.


                                       9
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

LOSS PER SHARE: The Company computes basic and diluted net loss per share based
upon the weighted- average number of common shares outstanding during each year.
Potential common shares, such as options and warrants, were not included in the
computation of diluted loss per common share since their effect would be
anti-dilutive. Due to the losses in 2001 and 2000, basic and diluted loss per
share were the same for both years.

EMERGING ACCOUNTING STANDARDS: The FASB has issued SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities, which the Company adopted in the
fiscal year ended December 31, 2001. Statement No. 133 establishes accounting
and reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. It requires
than an entity recognize all derivatives as either assets or liabilities in the
balance sheet and measure those instruments at fair value. SFAS No. 133 did not
have a significant effect on the Company's financial statements.

In July 2001, the Financial Accounting Standards Board issued two
statements--Statement No. 141, Business Combinations, and Statement No. 142,
Goodwill and Other Intangible Assets, which will potentially impact the
Company's accounting for its reported intangible assets. The standards generally
are required to be implemented by the Company in its 2002 financial statements.
The adoption of these standards is not expected to have a material impact on the
Company's financial statements.

In September 2001, the FASB issued Statement No. 143, Asset Retirement
Obligations. This statement addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. The statement will be effective for the
Company's fiscal year ending 2003. Management does not expect the adoption of
this standard to have a material impact on the Company's financial statements.

FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets, replaces Statement No. 121--an earlier pronouncement on this topic. The
new statement establishes a single accounting model for long-lived assets to be
disposed of by sale. Statement No. 144 will be effective for the Company's
fiscal year ending 2002. Management does not expect the adoption of this
standard to have a material impact on the Company's financial statements.

NOTE 2.  INVENTORIES

Inventories consist of the following components as of December 31, 2001 and
2000:


<TABLE>
<CAPTION>
                                    2001         2000
-------------------------------------------------------
<S>                              <C>          <C>
Raw materials                    $ 764,249    $ 459,729
Work in process                     19,193       71,314
Finished goods                     327,873      398,510
Inventory obsolescence reserve    (185,287)    (415,707)
                                 ----------------------
                                 $ 926,028    $ 513,846
                                 ======================
</TABLE>

                                       10
<PAGE>

DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 3.  FINANCING AGREEMENTS

The Company has available a $1,000,000 line of credit from a bank which bears
interest at the prime rate (4.75 percent at December 31, 2001) plus 1.25 percent
and is secured by substantially all assets of the Company. The line of credit
expires in April 2002 and is subject to annual renewal. There were no balances
outstanding as of December 31, 2001 or 2000.

Subsequent to year-end the Company entered into two standby letters of credit
with a bank up to a maximum $500,000 in favor of two of its vendors. In
connection with these letters of credit, the Company has assigned cash of
$500,000 held in an account at the bank. The letters expires on March 15, 2002,
and April 30, 2002.

NOTE 4.  INCOME TAXES

The income tax benefit is different from that which would be computed by
applying the U.S. federal income tax rate (35 percent) to pretax loss as
follows:

<TABLE>
<CAPTION>

                                                                     December 31
                                                             ---------------------------
                                                                 2001           2000
-----------------------------------------------------------------------------------------
<S>                                                          <C>            <C>
Computed "expected" federal tax benefit at statutory rates   $  (872,000)   $(1,680,000)
Effect of net operating loss with no current benefit             872,000      1,680,000
                                                             ----------------------------
Actual tax benefit                                           $        --    $        --
                                                             ----------------------------
</TABLE>

Deferred taxes consist of the following components as of December 31, 2001 and
2000:


<TABLE>
<CAPTION>
                                                                 2001           2000
-----------------------------------------------------------------------------------------
<S>                                                          <C>            <C>
Deferred tax assets:
   Net operating loss carryforwards                          $ 6,456,000    $ 5,279,000
   Research and development tax credit                           349,000        279,000
   Allowance for doubtful accounts                                10,000          9,000
   Inventory                                                      58,000        270,000
   Accrued expenses and deferred revenue                          59,000        506,000
   Contributions carryforward                                      7,000         15,000
   Depreciation                                                   20,000             --
                                                             ----------------------------
Total gross deferred tax assets                                6,959,000      6,358,000

Valuation allowance                                           (6,959,000)    (6,314,000)
                                                             ----------------------------
                                                                      --         44,000

Deferred tax liability:
   Depreciation                                                       --        (44,000)
                                                             ----------------------------
Net deferred taxes                                           $        --    $        --
                                                             ----------------------------
</TABLE>

Realization of deferred tax assets is dependent upon the generation of
sufficient future taxable income. Management has determined that significant
uncertainty exists regarding the realizability of the net deferred tax assets
and, accordingly, has provided a valuation allowance against them.


                                       11
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 4. INCOME TAXES (CONTINUED)

At December 31, 2001, the Company's net operating loss and tax credit
carryforwards expire as follows:

<TABLE>
<CAPTION>
                                             Research and
                                              Development
                  Operating Loss              Tax Credit
                   Carryforward              Carryforward
---------------------------------------------------------
<S>              <C>                       <C>
2011               $ 1,850,000               $        --
2012                 3,540,000                   113,000
2018                 2,560,000                    59,000
2019                 2,450,000                    67,000
2020                 3,114,000                    40,000
2021                 4,422,000                    70,000
                   --------------------------------------
                   $17,936,000               $   349,000
                   ======================================

</TABLE>


The use of the federal net operating losses will be limited to $5.5 million per
year under the provisions of the Internal Revenue Code, Section 382, which
relates to a 50 percent change in control over a three-year period. Further
changes of control may result in additional limitations of the remaining
carryforward. Utilization of the carryforwards is dependent upon the Company
attaining profitable operations in the future.

NOTE 6. STOCKHOLDERS' EQUITY

CONVERTIBLE PREFERRED STOCK: The preferred stock is convertible at the rate of
one share of common stock for each share of preferred stock, subject to certain
anti-dilution adjustments. Conversion is mandatory in the event of certain
future public offerings of corporate stock. The holders of the preferred stock
have certain piggyback and demand registration rights, voting rights, and a
liquidation preference of $2.50 per share, and share in dividends paid on common
stock.

SERIES B PREFERRED STOCK: The Board of Directors has designated 120,000 shares
of previously undesignated stock as Series B Preferred Stock. The shares have a
par value of $0.05 per share and a liquidation value equal to the greater of
$100 or 100 times the aggregate amount to be distributed per share to holders of
common stock. Shares of Series B Preferred Stock are not convertible into shares
of the Company's common stock. Each share of Series B Preferred Stock will be
entitled to a minimum preferential quarterly dividend payment of $1 per share
but will be entitled to an aggregate dividend of 100 times the dividend declared
per share of common stock. Each share of Series B Preferred Stock has 100 votes.
In the event of any merger, consolidation, or other transaction in which common
stock is exchanged, each share of Series B Preferred Stock will be entitled to
receive 100 times the amount received per share of common stock. There are no
shares of Series B Preferred Stock outstanding.



                                       12
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 5. STOCKHOLDERS' EQUITY (CONTINUED)

SHAREHOLDER RIGHTS PLAN: On October 19, 2001, the Company's Board of Directors
adopted a Shareholder Rights Plan which took effect on October 26, 2001. Under
the plan, rights were constructively distributed as a dividend at the rate of
one right for each share of common stock or convertible preferred stock of the
Company held by the shareholders of record as of the close of business on
November 9, 2001. The Board further authorized the issuance of one right
(subject to adjustment) with each share of common stock or convertible preferred
stock issued subsequent to November 9, 2001, but prior to the expiration date.
Each right entitles its holder to purchase one-hundredth of a share of Series B
Preferred Stock at an exercise price of $60, subject to adjustment. The rights
will only be exercisable if a person or group acquires, has the right to
acquire, or has commenced a tender offer for 15 percent or more of the
outstanding common stock. The rights are nonvoting, pay no dividends, expire on
November 9, 2011, and may be redeemed by the Company for $0.001 per right at any
time before the tenth day (subject to adjustment) after a 15 percent position is
acquired. The rights have no effect on earnings per share until they become
exercisable.

After the rights are exercisable, if the Company is acquired in a merger or
other business combination, or if 50 percent or more of the Company's assets are
sold, each right will entitle its holder (other than the acquiring person or
group) to purchase, at the then current exercise price, common stock of the
acquiring entity having a value of twice the exercise price.

UNDESIGNATED STOCK: The Company has 9,480,000 shares of undesignated capital
stock.

NOTE 6. STOCK OPTIONS AND WARRANTS

STOCK OPTIONS: The Company has reserved 1,400,000 common shares for issuance as
qualified and nonqualified stock options for its key employees and directors.
The Company has also reserved 100,000 common shares for issuance as nonqualified
options to various distributors, dealers, and consultants. Option prices are
generally at the fair market value of the stock at the time an option is
granted. Options become exercisable as determined at the date of grant by a
committee of the Board of Directors. Options expire 10 years after the date of
grant, unless an earlier expiration date is set at the time of grant.

The Company has adopted the disclosure-only provisions of Statement of Financial
Accounting Standards No. 123, Accounting for Stock-Based Compensation. In 2001
and 2000, compensation cost of $7,249 and $63,972, respectively, was recognized
for the stock options. Had compensation cost for the Company's stock options
been determined based on the fair value at the grant date for awards in 2001 and
2000, consistent with the provisions of SFAS No. 123, the Company's net loss
attributable to common stockholders and basic and diluted loss per share would
have changed to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                                                                   Years Ended December 31
                                                                        -------------------------------------------
                                                                              2001                         2000
-------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>                          <C>
Net loss attributable to common stockholders, as reported               $  (2,492,793)               $  (4,798,873)
Net loss attributable to common stockholders, pro forma                    (3,232,857)                  (5,268,742)
Basic and diluted loss per share, as reported                                   (0.26)                       (0.60)
Basic and diluted loss per share, pro forma                                     (0.33)                       (0.66)

</TABLE>


                                       13

<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 6. STOCK OPTIONS AND WARRANTS (CONTINUED)

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 2001 and 2000:


<TABLE>
<CAPTION>
                                                                                 Years Ended December 31
                                                                           -----------------------------------
                                                                               2001                    2000
--------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>                       <C>
Expected dividend yield                                                            --                      --
Expected stock price volatility                                                101.45%                 101.36%
Risk-free interest rate                                                          5.01%                   6.40%
Expected life of options                                                   4.50 years              4.88 years
Weighted-average fair value of options granted during the year               $   2.03                $   3.95
</TABLE>

Additional information relating to all outstanding options as of December 31,
2001 and 2000, is as follows:

<TABLE>
<CAPTION>

                                                           2001                           2000
                                                 --------------------------      -------------------------
                                                                  Weighted-                      Weighted-
                                                                   Average                        Average
                                                                  Exercise                       Exercise
                                                   Shares          Price           Shares          Price
----------------------------------------------------------------------------------------------------------
<S>                                            <C>               <C>           <C>               <C>
Options outstanding at beginning of year         1,059,423         $3.84         1,011,581         $3.24
   Options exercised                               (87,840)         2.31          (136,126)         3.42
   Options forfeited                              (178,266)         3.46          (128,666)         3.55
   Options granted                                 360,403          2.81           312,634          5.48
                                                 ----------------------------------------------------------
Options outstanding at end of year               1,153,720         $3.66         1,059,423         $3.84
                                                 ----------------------------------------------------------
</TABLE>

The following table summarizes information about stock options outstanding at
December 31, 2001:


<TABLE>
<CAPTION>
                                       Options Outstanding        Options Exercisable
                                      ----------------------  ----------------------------
                                       Weighted-
                                        Average
                        Number         Remaining   Weighted-      Number       Weighted-
                     Outstanding      Contractual   Average    Exercisable      Average
Range of            at December 31,       Life     Exercise   at December 31,   Exercise
Exercise Prices         2001             (Years)     Price         2001           Price
--------------------------------------------------------------------------------------------
<S>                <C>                <C>         <C>        <C>              <C>
$0.01                     7,354           8.84     $   0.01         6,483        $   0.01
$1.50 - $2.25           219,125           8.30         1.86       114,227            1.89
$2.50 - $3.625          540,165           7.00         3.11       196,510            3.24
$3.74 - $5.25           208,576           7.42         4.42       134,433            4.63
$5.38 - $7.56           113,500           6.21         5.98        64,500            5.93
$8.00 - $8.38            65,000           8.29         8.13        26,001            8.11
---------------------------------------------------------------------------------------------
$0.01 - $8.38         1,153,720           7.33     $   3.66       542,154        $   3.81
---------------------------------------------------------------------------------------------
</TABLE>

At December 31, 2000, there were 408,333 options exercisable at a
weighted-average exercise price of $3.62.


                                       14

<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 6. STOCK OPTIONS AND WARRANTS (CONTINUED)

EMPLOYEE STOCK PURCHASE PLAN: Under its 1998 employee stock purchase plan, which
became effective for the plan year beginning January 1, 1999, the Company is
authorized to issue up to 100,000 shares of common stock to its full-time
employees, nearly all of whom are eligible to participate. Employees can choose
each year to have up to 10 percent of their earnings withheld to purchase the
Company's stock at a price that is 85 percent of the lower of its
beginning-of-year or end-of-year fair market value. During 2001 and 2000, 15,366
and 6,710 shares, respectively, were issued under the plan.

WARRANTS: The Company has issued warrants to purchase shares of common stock at
prices between $1.25 and $6.60 per share. All warrants are currently
exercisable. The following tables summarize information about warrants
outstanding at December 31, 2001 and 2000:


<TABLE>
<CAPTION>
                                                             2001                           2000
                                                  --------------------------    ----------------------------
                                                                   Weighted-                       Weighted-
                                                                    Average                         Average
                                                                   Exercise                        Exercise
                                                   Shares            Price        Shares             Price
------------------------------------------------------------------------------------------------------------
<S>                                               <C>              <C>           <C>               <C>
Warrants outstanding at beginning of year         1,395,243        $   3.93      1,519,295         $   1.59
   Warrants exercised                                    --              --     (1,004,052)            1.34
   Warrants granted                               1,680,268            3.04        880,000             5.05
                                                  ----------------------------------------------------------
Warrants outstanding at end of year               3,075,511        $   3.44      1,395,243         $   3.93
                                                  ----------------------------------------------------------
</TABLE>


Warrants outstanding at December 31, 2001, expire as follows:


<TABLE>
<S>                                                                                           <C>
2003                                                                                                 97,353
2004                                                                                                 10,000
2005                                                                                                880,000
2006                                                                                              1,680,268
2008                                                                                                 37,890
2009                                                                                                370,000
                                                                                                  ---------
                                                                                                  3,075,511
                                                                                                  ---------

</TABLE>


NOTE 7. MAJOR CUSTOMERS AND INTERNATIONAL SALES

MAJOR CUSTOMERS: Direct and indirect sales to U.S. government agencies from
continuing operations were approximately $1,250,000 and $818,000 in 2001 and
2000, respectively. Accounts receivable from U.S. government agencies were
approximately $844,000 and $41,000 at December 31, 2001 and 2000, respectively.
In addition, sales to an agency of the Canadian government were approximately
$4,152,000, or 53 percent of net sales from continuing operations, during the
year ended December 31, 2001. Accounts receivable from this customer were
approximately $511,000 at December 31, 2001. Sales to another customer were
approximately $1,437,000, or 19 percent of total sales, during the year ended
December 31, 2000. Accounts receivable from this customer were approximately
$564,000 at December 31, 2000.



                                       15
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 7. MAJOR CUSTOMERS AND INTERNATIONAL SALES (CONTINUED)

INTERNATIONAL SALES: Export sales to international customers, including Canada,
from continuing operations, for 2001 and 2000 were approximately $5,206,000 and
$1,593,000, respectively. Accounts receivable from international customers were
approximately $982,000 and $277,000 at December 31, 2001 and 2000, respectively.
Sales to customers in Canada, including an agency of the Canadian government,
accounted for approximately 57 percent of sales in 2001. No other individual
countries accounted for more than 10 percent of sales in 2001. Sales to
customers in Great Britain accounted for approximately 12 percent of sales in
2000. No other individual countries accounted for more than 10 percent of sales
in 2000.

NOTE 9. COMMITMENTS AND CONTINGENCIES

LICENSE AGREEMENTS: The Company has entered into various license agreements to
allow the Company to bundle licensed products into certain of the Company's
products. Under the agreements, payments are based upon the number of units sold
and the nature of the item bundled. In these agreements, the Company agreed to
purchase a minimum quantity of software units over a specified period of time.
The value of the minimum purchase is included in the initial license payment
which has been made.

LEASES: The Company leases its office and warehouse facilities under a
noncancelable operating lease, which expires in June 2004. In addition, certain
items of equipment are leased under noncancelable operating leases through
December 2004.


Future lease commitments are as follows:

<TABLE>
<S>                                                     <C>
2002                                                    $ 266,000
2003                                                      251,000
2004                                                      114,000
                                                        ---------
                                                        $ 631,000
                                                        ---------
</TABLE>

Rent expense totaled approximately $233,000 and $240,000 in 2001 and 2000,
respectively.

In connection with the transaction described in Note 10, the Company is
subleasing a portion of its office space. The Company will receive monthly
rentals of $9,500 through June 2004. Sublease income during 2001 was
approximately $46,000.

EMPLOYEE BENEFITS: The Company maintains a voluntary 401(k) plan in effect for
its employees. The Company offers a match of 25 percent of the employees'
contributions, up to 6 percent. The Company's match was approximately $45,000
and $36,000 in 2001 and 2000, respectively. In addition, a discretionary
contribution can be authorized by the Board of Directors. There were no
discretionary contributions authorized in 2001 and 2000.


                                       16
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 9. OPERATING SEGMENTS

The Company had two reportable segments: ISS Information Security Solutions
(ISS) and Electronic Products (EP). The ISS Information Security Solutions
segment produces and markets products for the information security market, which
enable user identification and authentication, secure data exchange, and
information validation. EP produced proprietary memory keys, cards, and other
custom-shaped tokens that serve as a convenient way to carry electronic
information.

The accounting policies of the segments are the same as those described in the
summary of significant accounting policies. There are no inter-segment
transactions. The Company evaluates performance based on operating earnings of
the respective segments. The following tables present information by segment. As
further discussed in Note 10, the revenues and expenses of EP are reflected in
the statements of operations on a net basis as loss from operations of
discontinued segment.


<TABLE>
<CAPTION>
                                                                         2001
                                     ---------------------------------------------------------------------------
                                         ISS                    EP              Unallocated            Total
----------------------------------------------------------------------------------------------------------------
<S>                                  <C>                  <C>                  <C>                 <C>
Revenue                              $  7,815,000         $  2,425,000         $         --        $ 10,240,000
Depreciation and amortization             479,000              170,000                   --             649,000
Segment profit (loss)                  (2,085,000)            (487,000)              79,000          (2,493,000)

<CAPTION>
                                                                         2000
                                     ---------------------------------------------------------------------------
                                         ISS                    EP              Unallocated            Total
----------------------------------------------------------------------------------------------------------------
<S>                                  <C>                  <C>                  <C>                 <C>
Revenue                              $  3,608,000         $  3,799,000         $         --        $  7,407,000
Depreciation and amortization             583,000              314,000                   --             897,000
Segment profit (loss)                  (3,098,000)          (1,846,000)             145,000          (4,799,000)
</TABLE>


NOTE 10. DISCONTINUED OPERATIONS

In February 2001, the Company's Board of Directors approved management's plan to
discontinue the operations of the EP segment. The Company's plan anticipated the
phasedown of operations through December 31, 2001, and the 2000 financial
statements were prepared as if the operation would be phased down. In August
2001 certain assets of the EP segment were sold to an unrelated party for
$550,000. One customer contract was retained by the Company with deliveries
expected to take place in 2002.

The 2000 estimated loss of $1,281,000 on the phasedown of the EP segment
included the write-off of inventory, patents, and equipment anticipated to
remain at the date of closedown and expenses associated with the phasedown, net
of estimated operating income through closedown. The loss from disposal of the
discontinued segment in 2001 of $487,045 was the amount in excess of the loss
estimated at December 2000, net of sales proceeds of $550,000. The disposal of
the segment is being accounted for as discontinued operations and, accordingly,
its net assets have been segregated from continuing operations in the
accompanying balance sheets, and the results of its operations have been
excluded from continuing operations for all periods presented.


                                       17
<PAGE>
DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS
--------------------------------------------------------------------------------

NOTE 10. DISCONTINUED OPERATIONS (CONTINUED)

Net assets and liabilities of the discontinued EP segment at December 31, 2001
and 2000, are summarized as follows:


<TABLE>
<CAPTION>
                                                        Years Ended December 31
                                                    ------------------------------
                                                        2001               2000
----------------------------------------------------------------------------------
<S>                                                 <C>                <C>
Trade receivables                                   $    82,077        $   498,281
Inventories                                                  --          1,927,488
Equipment and leasehold improvements                         --            344,418
Patents                                                      --             72,812
Reserve for discontinued operations                          --         (1,281,000)
                                                    ------------------------------
Net assets from discontinued operations             $    82,077        $ 1,561,999
                                                    ==============================

Accounts payable                                    $        --        $   357,540
Accrued expenses:
   Compensation                                              --             90,165
   Other                                                     --             33,170
Reserve for discontinued operations                          --                 --
                                                    ------------------------------
Net liabilities from discontinued operations        $        --        $   480,875
                                                    ==============================
</TABLE>


The EP segment had total revenues of $2,425,299 and $3,798,687 in 2001 and 2000,
respectively.

                                       18