MANAGEMENT'S  DISCUSSION  AND  ANALYSIS OF  FINANCIAL  CONDITION  AND 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 for each
of the  past  three  years.  Inflation  has not  been a  significant  factor  in
Datakey's operations to date.

                                 Percentage of Total Revenue
Year Ended December 31,            1996     1995     1994
                                 --------- ------- ---------
Revenue........................    100%      100%     100%

Cost and Expenses
Cost of goods sold.............     65%       67%      70%
Research and development.......     35        10       13
Marketing and sales............     20        15       17
General and administrative.....     18         9       10
                                 --------- -------- --------
   Total cost and expenses.....    138       101      110
Interest income................      6         5        5
                                 --------- -------- --------
Income (loss) before income
taxes..........................    (32)        4       (5)
Income taxes (benefit).........     (6)        2       (2)
                                 --------- -------- --------
Net income (loss)..............    (26)        2       (3)
                                 ========= ======== ========


Comparison of 1996 with 1995

Total  Revenue:  Total  revenue was  $6,558,000 in 1996, a decrease of 9 percent
from  $7,219,000  in 1995.  Commercial  sales were  $5,669,000  or 86 percent of
revenue with government  sales  representing  $889,000 or 14 percent of revenue.
The revenue decrease is primarily due to customer requested delays in commercial
OEM product  shipments  during the second half of 1996  resulting from delays in
shipments to their customers.

Gross margins:  The gross profit margin  increased to 35 percent in 1996 from 33
percent in 1995 in spite of a reduction in revenue  which  normally  reduces the
margin percentage.  The improved margin percentage is primarily due to increases
in  product   selling  prices  in  excess  of  the  increases  in  material  and
manufacturing costs.

Research  and  development:  Research and  development  expenses  increased  221
percent  to  $2,263,000  in 1996  from  $704,000  in 1995  due to the  Company's
significant  increase  in  product  development   activities  for  new  end-user
products.

Marketing and sales, General and administrative:  Marketing and sales expense in
1996  increased  17  percent to  $1,312,000  from  $1,124,000  in 1995 due to an
increase in product  promotion  expense for newly  developed and  in-development
end-user products.  General and administrative  expenses increased 73 percent to
$1,156,000  in 1996  from  $670,000  in 1995  primarily  due to an  accrual  for
severance pay and benefits due the Company's former chief executive officer.

Interest  income:  Interest income decreased 6 percent to $361,000 in 1996 from
$381,000  in 1995 due to a  decline  in the  Company's  investment  in  interest
bearing investments.

Income  tax  expense  (benefit):  Income tax  benefit  for 1996 is  $388,000  as
compared to an income tax expense of $106,000 in 1995. The benefit is related to
the 1996 loss  before  taxes of  $2,094,000  for which the  Company  recorded  a
deferred  tax asset of  $325,000,  and 1995  expense is related to the  $282,000
income before taxes. 


<PAGE>

Comparison of 1995 with 1994

Total  Revenue:  Total revenue was $7,219,000 in 1995, an increase of 23 percent
from  $5,874,000  in 1994.  The increase was  principally  due to a  substantial
increase in  commercial  revenue  offset,  in part,  by a decline in  government
revenue.  Commercial  sales  increased  33  percent to  $6,205,000  in 1995 from
$4,669,000  in 1994.  Commercial  sales as a percentage  of total revenue was 86
percent in 1995 versus 79 percent in 1994. The increase in commercial  sales was
attributed  to  increased  business  with  existing  customers as well as sales,
generally small initially,  to several new customers.  The decline in government
revenue resulted from a discontinuation  of US Government  purchases of keys for
the secure telephone program.

Gross margins:  The gross profit margin on net sales  increased to 33 percent in
1995 from 29 percent in 1994.  This  increase  in gross  profit  percentage  was
achieved  primarily  by  improvements  in  manufacturing  productivity  and  the
increase in revenue over which the fixed factory overhead is absorbed.

Research and development:  Research and development expenses decreased 9 percent
to $704,000 from $771,000 in 1994 and also  decreased as a percentage of revenue
to 10  percent  in 1995  from 13  percent  in  1994.  The  decrease  in 1995 was
primarily related to a reduction in travel and project supplies expense.

Marketing  and sales,  General and  administrative:  Marketing and sales expense
increased  16 percent to  $1,124,000  in 1995 from  $971,000  in 1994.  The 1995
increase  was  principally  due to  commissions  payable on the higher  level of
revenue and an increase in travel and promotional expenses.  Marketing and sales
expense  declined  as a  percentage  of  revenue  to 15  percent in 1995 from 17
percent in 1994.  General and  administrative  expenses  increased 14 percent to
$670,000 in 1995 from  $590,000 in 1994.  This increase was related to increased
data  processing  support  costs for a more complex  computer  system as well as
general increases in a variety of administrative  costs necessary to support the
growth in the Company.  General and  administrative  expenses as a percentage of
revenue declined to 9 percent in 1995 from 10 percent in 1994.

Interest  income:  Interest income increased 34 percent to $381,000 in 1995 from
$285,000 in 1994. The increase was due to an increased  market interest rate for
the Company's interest bearing investments as well as an increase in the average
balance of these investments.

Liquidity and Capital Resources

The Company's  operating  activities  used $489,000 of cash in 1996 and provided
$938,000 of cash in 1995.  The  Company had a reduction  of $834,000 in cash and
held-to-maturity  marketable  debt securities in 1996 compared to an increase of
$601,000 in 1995. The 1996 reduction in cash and marketable  debt securities was
primarily the result of a significant increase, totaling $1,747,000, in research
and  development  and marketing  expenses which was  principally  related to the
Company's new product development  activities.  Trade receivables as of December
31, 1996,  were $635,000  compared to  $1,055,000  as of December 31, 1995.  The
reduction  in trade  receivables  is due to a lower  level of  shipments  in the
fourth  quarter of 1996 as  compared  to the fourth  quarter of 1995.  Inventory
decreased $94,000 to $1,129,000 as of December 31, 1996,  compared to $1,223,000
as of December 31, 1995. The lower 1996 inventory  level reflects a reduction in
the  expected  level of revenue  during  the  fourth  quarter of 1996 as well as
improvements in inventory management.  Accrued compensation expense increased by
$349,000  primarily  due to the accrual of  severance  pay and  benefits due the
Company's former chief executive  officer.  The Company invested $515,000 in the
purchase of equipment and  maintenance  of licenses and patents in 1996 compared
to $318,000 in 1995.  The 1996  increase is  primarily  attributable  to prepaid
license fees related to licensed client and server software that will be bundled
with the Company's  information  security systems.  Cash, cash equivalents,  and
investment in  held-to-maturity  marketable  debt  securities as of December 31,
1996, were $6,133,000 as compared to $6,967,000 as of December 31, 1995.

   Datakey's  balance  continues  to reflect a strong  financial  position  with
$6,737,000 in working capital and a current assets to current  liabilities ratio
of 6.6 to 1 as of December 31, 1996.


<PAGE>

Outlook

The  statements  in this outlook  section are based upon  current  expectations.
These  statements are forward  looking and actual results may differ  materially
due to the risks, issues and uncertainties set forth below.

Revenue: Customer requested shipment delays experienced in the fourth quarter of
1996 are, based upon customer communications to us, expected to continue through
the first one or two  quarters  of 1997 and will  result in a  reduction  in OEM
products  revenue for the year as compared to 1996. New end-user  products being
developed  for the  information  security  marketplace  are  planned  for  sales
introduction by mid-1997 and, based upon current  expectations,  are expected to
result in  material  revenue  during  the second  half of 1997.  As with any new
product line, revenue will depend on customer acceptance, the extent of which is
difficult to assess at this time. If this revenue  meets the  Company's  present
expectations the total revenue in 1997 will exceed the 1996 level.

Gross  margins:  A gradual  improvement  in gross profit  margins during 1997 is
expected through selective price increases,  effective  material  purchasing and
improvements in manufacturing efficiency.

Research  and  development:  The  Company  will  continue  to fund  new  product
development  activities  at a higher  level in 1997  than in 1996,  and may also
exceed the 1996  percentage of revenue unless revenue from these new products in
the second half of 1997 is substantial.

Marketing and sales,  General and  administrative:  Marketing and sales expenses
are  expected  to  increase  by 30 to 40 percent in 1997 to support  new product
introductions and the expected  increase in revenue,  but will be about the same
percent  of revenue as in 1996  provided  the  revenue  from new  product  sales
materializes  as  expected.  General  and  administrative  expenses  in 1997 are
expected  to  increase  only  slightly  from the 1996  level,  exclusive  of the
1996 severance pay accrual.

Interest  income:  Interest  income is  expected  to decline in 1997 as the pany
intends to use the proceeds from maturing investments to fund continuing product
development   and  marketing   activities  to  support  the  Company's   planned
introduction of advanced information security products.

Income tax  benefit:  The  Company  has  recorded  an income tax  benefit  and a
corresponding  deferred tax asset of $325,000 as of December 31, 1996 related to
the  estimated   future  tax  benefit  of  the  Company's  net  operating   loss
carryforward.  Management  believes  it is more likely than not that the Company
will realize  income in the future from its existing OEM products  business,  as
well as income from its new advanced information security products business that
will  allow  the  Company  to  utilize  a  portion  of the  net  operating  loss
carryforward  to reduce future  taxable  income.  However,  the net deferred tax
asset could be increased or reduced in the future if  management's  estimates of
taxable income during the carryforward period change.

Expected loss: For the reasons  explained  above the Company expects to report a
loss in  1997.  Although  the  Company  expects  to have new  end-user  products
available  for sale in the  second  half of  1997,  the  marketability  of these
products will not be known until at least late 1997. The extent of the Company's
loss will depend directly on product availability and market acceptance.

Liquidity  and  capital  resources:  The Company  plans to continue  new product
development and marketing activities during 1997 and expects to spend $4.5 to $5
million on these  activities.  Inventory levels are expected to increase in 1997
to  support  advanced  information  security  products  that are  planned  to be
available for sale in the second half of the year. 1997 investments in equipment
and  maintenance of licenses and patents in 1997 are expected to be about 2 to 3
times the 1996 level of $515,000  primarily  related to prepaid license fees for
client and server software to be bundled with the Company's information security
products.  This  spending  will  be  funded  by a  reduction  in  the  Company's
marketable debt  securities.  The Company's  working capital and investments are
sufficient  to  fund  its  planned  operations  and  continued  development  and
promotional activities in 1997.


<PAGE>

Issues and Uncertainties:

While  management is optimistic  about the companies  long-term  prospects,  the
following  issues and  uncertainties,  as well as those discussed in the outlook
section, should be considered in evaluating its growth outlook.

    Rapid technological change. Datakey's information security end-user products
such as SignaSURE EDMTM and SignaSURE ESSTM will integrate  hardware tokens with
software   that  provide  a  much  higher  level  of  security   than   software
implementations  alone. There is a possibility that software-only  solutions may
overcome this deficiency in the future.

    Customer Acceptance. While Datakey performs market research and beta testing
to determine  the  viability of its new products,  actual user  acceptance  will
ultimately  dictate  the  success  of the  marketing  and sales  efforts  of new
products such as SignaSURE EDM and ESS.  Although the company  believes that the
decision to fund these new products is correct, there are no assurances that the
investments already made and additional investments planned for 1997 will result
in a financial return.

    Product delivery schedules. Delays in the release of new products will cause
operational inefficiencies, increased development costs and reduced revenues.

    Price  competition.  While  Datakey  believes that its strategy of providing
token-based  product solutions at a price that is competitive with software-only
products is attainable,  there are no assurances that competitive pressures will
not force the company to accept reduced margins to compete in the future.  Large
companies have recognized the need for information security and could enter this
market as competitors with much greater  financial  resources.  A portion of the
new end-user products' cost is royalties and license fees which would need to be
re-negotiated in order to maintain acceptable profit margins.

    Integrated  information  security  products.   Although  the  Company's  new
products  will  operate  seamlessly  with  popular  application  programs,   new
application  programs  that  integrate  information  security into their product
could erode the future market for these Datakey products.

    Marketing  and sales.  The future  revenue  of Datakey  end-user  systems is
dependent  on the  success of a new and  untested  marketing  and  direct  sales
organization.

     Need  for  information  security.  Although  corporate  utilization  of the
Internet and internal intranets dictate a need for information  security,  there
are no assurances that other, more secure information transmission media may not
become  available  in the future  that would  preclude  the need for the type of
information security provided by the Company's products.

<PAGE>
                       INDEPENDENT AUDITOR'S REPORT


To the Stockholders
Datakey, Inc.

We have audited the accompanying  consolidated  balance sheets of Datakey,  Inc.
and  Subsidiary as of December 31, 1996 and 1995,  and the related  consolidated
statements of operations,  stockholders'  equity, and cash flows for each of the
three years in the period ended December 31, 1996. These consolidated  financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is to express an opinion on these financial  statements based on
our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable  assurance about whether the  consolidated  financial  statements are
free of material  misstatement.  An audit includes  examining,  on a test basis,
evidence  supporting the amounts and disclosures in the  consolidated  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 financial  position of Datakey,  Inc. and
Subsidiary as of December 31, 1996 and 1995, and the results of their operations
and their cash flows for each of the three  years in the period  ended  December
31, 1996, in conformity with generally accepted accounting principles.


                                               McGLADREY & PULLEN, LLP
                                               /s/ McGladrey & Pullen, LLP


Minneapolis, Minnesota
February 5, 1997
<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS
December 31, 1996 and 1995
<TABLE>
<S>                                                                            <C>                <C>    

ASSETS                                                                               1996               1995
--------------------------------------------------------------------------------------------------------------------
Current Assets
     Cash and cash equivalents                                                 $        140,030   $         713,230
     Investment in held-to-maturity securities (Note 2)                               5,993,228           6,253,984
     Trade receivables, less allowance for doubtful accounts of
         $45,000 in 1996 and $34,300 in 1995 (Note 7)                                   634,538           1,055,075
     Inventories (Note 3)                                                             1,128,907           1,222,938
     Deferred taxes (Note 4)                                                                  -             109,000
     Prepaid expenses and other                                                          46,962              52,177
     Refundable income taxes                                                                  -              46,642
                                                                               -------------------------------------
                   Total current assets                                               7,943,665           9,453,046
                                                                               -------------------------------------

Other Assets
     Deferred taxes (Note 4)                                                            325,000                   -
     Licenses and patents, less amortization--1996 $105,531;
         1995 $118,702 (Note 8)                                                         228,986             158,264
Noncompete agreement, less amortization--1995 $123,750                                        -              41,250
                                                                               -------------------------------------
                                                                                        553,986             199,514
                                                                               -------------------------------------

Equipment and Leasehold Improvements, at cost
     Production tooling                                                               1,179,021           1,109,524
     Equipment                                                                        2,561,659           2,358,938
     Furniture and fixtures                                                             267,482             211,822
     Leasehold improvements                                                             234,452             211,761
                                                                               -------------------------------------
                                                                                      4,242,614           3,892,045

     Less accumulated depreciation                                                    2,840,909           2,366,660
                                                                               -------------------------------------
                                                                                      1,401,705           1,525,385
                                                                               -------------------------------------
                                                                               $      9,899,356   $      11,177,945
                                                                               =====================================
</TABLE>

See Notes to Consolidated Financial Statements.

<PAGE>
<TABLE>
<S>                                                                            <C>                <C>  


LIABILITIES AND STOCKHOLDERS' EQUITY                                                 1996               1995
--------------------------------------------------------------------------------------------------------------------
Current Liabilities
     Accounts payable                                                          $        559,280   $         509,683
     Accrued expenses:
         Compensation (Note 9)                                                          538,664             189,980
         Other                                                                          108,885             108,692
                                                                               -------------------------------------
                   Total current liabilities                                          1,206,829             808,355
                                                                               -------------------------------------



Deferred Taxes (Note 4)                                                                       -             158,000
                                                                               -------------------------------------



Commitments (Notes 5 and 8)



Stockholders' Equity (Notes 5 and 6)
     Convertible preferred stock, voting, stated 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
         10,000,000 shares; issued and outstanding 2,882,069 shares
         in 1996 and 2,835,236 shares in 1995                                           144,103             141,762
     Additional paid-in capital                                                       4,070,815           3,885,887
     Retained earnings                                                                4,102,609           5,808,941
                                                                               -------------------------------------
                                                                                      8,692,527          10,211,590
                                                                               -------------------------------------
                                                                               $      9,899,356   $      11,177,945
                                                                               =====================================
</TABLE>


<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1996, 1995, and 1994
<TABLE>
<S>                                                        <C>                 <C>                <C> 

                                                                 1996                1995               1994
--------------------------------------------------------------------------------------------------------------------
Net sales (Note 7)                                         $       6,558,025   $      7,219,308   $       5,873,508
                                                           ---------------------------------------------------------

Costs and expenses:
     Cost of goods sold                                            4,282,062          4,821,516           4,111,131
     Research and development                                      2,262,920            703,816             771,230
     Marketing and sales                                           1,311,663          1,123,781             970,782
     General and administrative                                    1,156,270            669,954             590,078
                                                           ---------------------------------------------------------
                   Total costs and expenses                        9,012,915          7,319,067           6,443,221
                                                           ---------------------------------------------------------

                   Operating loss                                 (2,454,890)           (99,759)           (569,713)

Interest income                                                      360,558            381,385             284,693
                                                           ---------------------------------------------------------
                   Income (loss) before income taxes              (2,094,332)           281,626            (285,020)

Income tax expense (benefit) (Note 4)                               (388,000)           106,000            (112,000)
                                                           ---------------------------------------------------------
                   Net income (loss)                       $      (1,706,332)  $        175,626   $        (173,020)
                                                           =========================================================

Net income (loss) per common share                         $            (.60)  $            .06   $            (.06)

Weighted average number of common shares and
     common equivalent shares outstanding                          2,861,498          3,006,352           2,829,236
</TABLE>

See Notes to Consolidated Financial Statements.

<PAGE>

DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 1996, 1995, and 1994
<TABLE>
<CAPTION>

                                                                                                  
                                           Convertible Preferred Stock     Common Stock           
                                         ------------------------------------------------------
                                            Shares         Amount         Shares       Amount     
--------------------------------------------------------------------------------------------------
<S>                                         <C>           <C>            <C>         <C>          
Balance, December 31, 1993                    150,500     $   376,250    2,829,070   $  141,454   
     Conversion of preferred stock               (500)         (1,250)         500           25   
     Net loss                                       -               -            -            -   
                                         ----------------------------  ---------------------------
Balance, December 31, 1994                    150,000         375,000    2,829,570      141,479   
     Issuance of common stock under
           stock options (Note 6)                   -               -        5,666          283   
     Net income                                     -               -            -            -   
                                         ----------------------------  ---------------------------
Balance, December 31, 1995                    150,000         375,000    2,835,236      141,762   
     Issuance of common stock under 
           stock options (Note 6)                   -               -       46,833        2,341   
     Net loss                                       -               -            -            -   
                                         ----------------------------  ---------------------------
Balance, December 31, 1996                    150,000     $   375,000    2,882,069   $  144,103   
                                         ============================  ===========================
</TABLE>
See Notes to Consolidated Financial Statements.


CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (continued)
<TABLE>
<CAPTION>

                                          Additional
                                           Paid-In           Retained
                                           Capital           Earnings             Total
------------------------------------------------------------------------------------------
<S>                                      <C>             <C>                 <C>             
Balance, December 31, 1993               $3,864,406      $   5,806,335       $ 10,188,445
     Conversion of preferred stock            1,225                  -                  -
     Net loss                                     -           (173,020)          (173,020)
                                        --------------------------------------------------
Balance, December 31, 1994                3,865,631          5,633,315         10,015,425
     Issuance of common stock under
           stock options (Note 6)            20,256                  -             20,539
     Net income                                   -            175,626            175,626
                                        --------------------------------------------------
Balance, December 31, 1995                3,885,887          5,808,941         10,211,590
     Issuance of common stock under 
           stock options (Note 6)           184,928                  -            187,269
     Net loss                                     -         (1,706,332)        (1,706,332)
                                        --------------------------------------------------
Balance, December 31, 1996               $4,070,815      $   4,102,609       $  8,692,527
                                        ==================================================
</TABLE>


<PAGE>

DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 1996, 1995, and 1994

<TABLE>
<S>                                                        <C>                 <C>                <C>   

                                                                 1996                1995               1994
--------------------------------------------------------------------------------------------------------------------
Cash Flows From Operating Activities
     Net income (loss)                                     $      (1,706,332)  $        175,626   $        (173,020)
     Adjustments to reconcile net income (loss) to net
         cash provided by (used in) operating activities:
         Depreciation                                                475,475            461,378             402,394
         Amortization                                                134,041            133,253              82,549
         Change in accrued interest on investment
            securities                                                16,962            (44,399)            (96,689)
         Deferred taxes                                             (374,000)           114,000              18,500
         Changes in assets and liabilities:
            Trade receivables                                        420,537            135,818             133,964
            Inventories                                               94,031            126,047            (639,068)
            Accounts payable                                          49,597           (249,193)             63,488
            Other                                                    400,734             85,049            (107,972)
                                                           ---------------------------------------------------------
                   Net cash provided by (used in)
                       operating activities                         (488,955)           937,579            (315,854)
                                                           ---------------------------------------------------------

Cash Flows From Investing Activities
     Purchase of equipment                                          (351,795)          (262,892)           (574,752)
     Purchase of held-to-maturity securities                      (5,829,941)        (6,073,735)         (8,313,568)
     Proceeds from maturity of held-to-maturity
         securities                                                6,073,735          5,974,726           6,806,795
     License and patent costs                                       (163,513)           (55,526)            (92,882)
                                                           ---------------------------------------------------------
                   Net cash provided by (used in)
                       investing activities                         (271,514)          (417,427)         (2,174,407)
                                                           ---------------------------------------------------------

                                                    (Continued)
</TABLE>

<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Years Ended December 31, 1996, 1995, and 1994

<TABLE>
<S>                                                        <C>                 <C>                <C>

                                                                 1996                1995               1994
--------------------------------------------------------------------------------------------------------------------
Cash Flows From Financing Activities
     Net proceeds from issuance of common stock                      187,269             20,539                   -
     Payments on non-compete obligation                                    -            (82,500)            (82,500)
                                                           ---------------------------------------------------------
                   Net cash provided by (used in)
                       financing activities                          187,269            (61,961)            (82,500)
                                                           ---------------------------------------------------------

                   Increase (decrease) in cash and
                       cash equivalents                             (573,200)           458,191          (2,572,761)

Cash and Cash Equivalents
     Beginning                                                       713,230            255,039           2,827,800
                                                           ---------------------------------------------------------
     Ending                                                $         140,030   $        713,230   $         255,039
                                                           =========================================================

Supplemental Disclosures of Cash Flow Information
     Net cash refunds of income taxes                      $          75,112   $         63,038   $         136,603
                                                           =========================================================

Supplementary Schedule of Noncash Investing and
     Financing Activities
     Obligation recorded under non-compete
         agreement                                         $               -   $              -   $         165,000
                                                           =========================================================
</TABLE>

See Notes to Consolidated Financial Statements.







<PAGE>
DATAKEY, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.  Nature of Business and Significant Accounting Policies

Nature of business:  Datakey,  Inc. is an  international  supplier of electronic
products and services. The Company designs,  manufactures, and markets products,
subsystems,  and systems  solutions to record,  store,  and transmit  electronic
information.  The Company is  developing  products  and systems  directed to the
information   security  market  which  will  enable  user   identification   and
authentication,  secure data exchange, and information  validation.  The Company
also provides OEM 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's
practice is to grant credit on an unsecured  basis to customers who meet certain
financial criteria.

A summary of significant accounting policies follows:

Principles of consolidation:  The consolidated  financial statements include the
accounts of Datakey,  Inc.  and its  wholly-owned  subsidiary.  All  significant
intercompany accounts and transactions have been eliminated in consolidation.

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

Cash and cash  equivalents:  For purposes of reporting  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 consolidated 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.

Investment in debt  securities:  The Company has  investments in debt securities
consisting of obligations of the U. S.  government  with maturities of 12 months
or  less.  Since  the  Company  intends  to hold the  debt  securities  to their
maturities,   the  investment  in  debt   securities  has  been   classified  as
held-to-maturity and is recorded at amortized cost.

Fair value of financial instruments: The Company's financial instruments consist
of cash  and cash  equivalents,  marketable  securities,  and  short-term  trade
receivables and payables for which current  carrying  amounts  approximate  fair
market value.

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



<PAGE>


Note 1.  Nature of Business and Significant Accounting Policies (Continued)

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

                                                                  Years
-------------------------------------------------------------------------------
Production tooling                                                 2-5
Equipment                                                          5-7
Furniture and fixtures                                              7
Leasehold improvements                                          Life of lease


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

Income taxes: Deferred taxes are provided on a 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.

Licenses  and  patents:  Licenses  and  patents are stated at cost and are being
amortized using the straight-line  method over their economic useful lives which
has been estimated to be five years. The cost of the license agreement discussed
in Note 8 will be amortized to cost of goods sold as the products  incorporating
the licensed units are sold.

Noncompete agreement: During 1994, the Company's former president entered into a
noncompete  agreement  with the  Company  payable  over a one-year  period.  The
agreement  not to compete was for a period of two years and was  amortized  over
that term using the straight-line method.

Revenue  recognition:  The Company  records  sales  revenue upon shipment to the
customer.

Research and development:  Research and development costs are charged to expense
as incurred.

Net income  (loss) per common  share:  In 1995,  net income per common share and
common  equivalent  share  was  based on the  weighted-average  number of common
shares outstanding during the year, adjusted for the conversion of the preferred
shares into common  shares,  and the use of the treasury stock method to include
the effect of the exercise of all stock options having exercise prices less than
the average  market price of common  stock.  In 1996 and 1994,  the net loss per
common  share  was  based  on  the  weighted-average  number  of  common  shares
outstanding.

There was no material  difference  between  primary and fully diluted net income
per share in 1995.



<PAGE>


Note 2.  Investment in Held-to-Maturity Securities

The  following  is a summary of the  Company's  investment  in  held-to-maturity
securities as of December 31, 1996 and 1995:
<TABLE>
<CAPTION>

                                                               Gross           Gross
                                             Amortized       Unrealized      Unrealized         Fair
                                                Cost           Gains           Losses          Value
------------------------------------------ --------------- --------------- --------------- ---------------
<S>                                        <C>             <C>             <C>             <C>   
U. S. government securities:
1996                                       $5,993,228      $    465        $  6,445        $5,987,248
1995                                        6,253,984         8,713             743         6,261,954

</TABLE>

All  securities are due within one year and all  investment  earnings  represent
interest income on the above securities and previously held debt securities.

Note 3.  Inventories  

Inventories  consist of the  following  components  as of December  31, 1996 and
1995:

                                        1996            1995
--------------------------------- --------------   ------------------
Raw materials                     $      754,629   $    822,035
Work in process                           87,453        127,567
Finished goods                           286,825        273,336
                                    ------------   ------------
                                  $    1,128,907   $  1,222,938
                                    ============   ============


Note 4.  Income Taxes

The income tax expense (benefit), consists of the following:

                                           1996           1995          1994
------------------------------------- -------------   -----------   -----------
Currently payable (refundable):
Federal                               $    (15,000)   $    (9,000)  $(131,500)
State                                        1,000          1,000       1,000
Deferred                                  (374,000)       114,000      18,500
                                      -------------   -----------   -----------
                                      $   (388,000)   $   106,000   $(112,000)
                                      =============   ===========   ===========




<PAGE>


Note 4. Income Taxes (Continued)

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

                                                        1996           1995           1994
-------------------------------------------------    ----------     ----------    -----------
<S>                                                  <C>            <C>           <C>                                          
Computed "expected" federal tax expense
  (benefit) at statutory rates                       $ (733,000)    $   99,000    $  (100,000)
Effect of graduated tax rates                            21,000         (3,000)         3,000
Effect of net operating loss carryforward, with
  no current benefit                                    338,000            -               -
State income taxes, net of federal benefit                1,000          1,000          1,000
Nontaxable municipal bond interest income                    -             -          (11,000)
Other                                                   (15,000)         9,000         (5,000)
                                                     -----------    ----------    -----------
Actual tax expense (benefit)                         $ (388,000)    $  106,000    $  (112,000)
                                                     -----------    ----------    -----------
</TABLE>


Net deferred tax assets (liabilities)  consist of the following components as of
December 31, 1996 and 1995:

                                               1996         1995
                                             --------     --------    
Deferred tax assets:
Allowance for doubtful accounts             $  16,000    $  12,000
Inventory                                      86,000       59,000
Warranty reserve                               18,000       13,000
Compensation and benefits                     134,000       13,000
Net operating loss carryforward               698,000          -
Other                                             -         12,000
                                             --------     --------
Total gross deferred tax assets               952,000      109,000
Valuation allowance                          (455,000)         -
                                             --------     --------
Net deferred tax assets                       497,000      109,000

Deferred tax liability:
Depreciation                                 (172,000)    (158,000)
                                             --------     --------
Net deferred tax asset (liability)          $ 325,000    $ (49,000)
                                             ========     ========


Realization  of  deferred  tax assets  associated  with the net  operating  loss
carryforward  is dependent  upon the  generation  of sufficient  future  taxable
income  prior  to the  expiration  of the  loss  carryforwards.  Management  has
established a valuation allowance against a portion of the deferred tax asset in
recognition of the risk that part of the loss  carryforward may not be realized.
Although  realization  is not assured  for the  remaining  deferred  tax assets,
management  believes  it is more  likely  than not that  they  will be  realized
through  future  taxable  income.  However,  the net deferred tax asset could be
increased or reduced in the future if  management's  estimates of taxable income
during the carryforward period change.



<PAGE>


Note 4. Income Taxes (Continued)

At  December  31,  1996,  the  Company's  net  operating  loss is  approximately
$1,850,000 and expires in the year 2011.

Note 5.  Preferred Stock

The preferred  shares are  convertible  at the rate of one share of common stock
for each share of preferred stock, subject to certain antidilution  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,  have a liquidation  preference of $2.50 per share,
and share in dividends paid on common stock.

Note 6.  Stock Options

The Company has reserved  800,000 common shares for issuance under qualified and
nonqualified stock options for its key employees and directors.  The Company has
also reserved  50,000 common shares for issuance under  nonqualified  options to
various  distributors,  dealers,  and  consultants.  Option  prices are the fair
market  value of the stock at the time the option was  granted.  Options  become
exercisable  as  determined  at the date of grant by a committee of the Board of
Directors.  Options  expire ten 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.
Accordingly,  no  compensation  cost has been  recognized  for the stock  option
plans.  Had  compensation  cost  for  the  Company's  stock  option  plans  been
determined based on the fair value at the grant date for awards in 1996 and 1995
consistent  with the provisions of SFAS No. 123, the Company's net income (loss)
and net income  (loss) per share  would  have  changed to the pro forma  amounts
indicated below:

                                                    1996             1995
----------------------------------------------- -------------  ---------------
Net income (loss), as reported                  $ (1,706,332)  $    175,626
Net income (loss), pro forma                      (1,844,604)       112,348
Net income (loss), per share, as reported              (0.60)           .06
Net income (loss), per share, pro forma                (0.64)           .04


The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option-pricing   model  with  the   following   weighted-average
assumptions used for grants in 1996 and 1995:

                                                     1996            1995
----------------------------------------------- --------------  --------------
Expected dividend yield                                -               -
Expected stock price volatility                     48.39%             32.76%
Risk-free interest rate                              5.87%              6.71%
Expected life of options                           3 years            3 years



<PAGE>


Note 6. Stock Options (Continued)

The  pro  forma  effect  on net  loss or net  income  in  1996  and  1995 is not
representative  of the pro forma effect in future years because it does not take
into consideration pro forma  compensation  expense related to grants made prior
to 1995.

Additional  information  relating to all outstanding  options as of December 31,
1996, 1995, and 1994 is as follows:
<TABLE>
<CAPTION>

                                       1996                      1995               1994
                             ------------------------  -----------------------  -----------
                                            Weighted-                Weighted-
                                            Average                  Average
                                            Exercise                 Exercise
                                Shares       Price        Shares      Price        Shares
---------------------------- -----------  ----------  ------------- ----------  -----------
<S>                             <C>       <C>          <C>          <C>          <C>
Options outstanding at
  beginning of  year             452,334  $    4.16      179,000    $    5.17       304,000
Options exercised                (46,833)      4.00       (5,666)        3.63          -
Options expired                  (27,334)      3.73      (33,000)        4.66      (145,000)
Options granted                  139,000       4.80      312,000         3.62        20,000
                                --------  ---------    ---------    ---------   -----------
Options outstanding at end
  of year                        517,167  $    4.37      452,334    $    4.16       179,000
                                ========  =========    =========    =========   ===========

Weighted-average fair value
  of options, granted during
  the year                        $ 1.29                 $ 1.15 
</TABLE>


The following table summarizes  information  about stock options  outstanding at
December 31, 1996:
<TABLE>
<CAPTION>

                                                Options Outstanding          Options Exercisable
                                            ----------------------------  ---------------------------
                                              Weighted-
                                               Average
                                Number        Remaining     Weighted-        Number      Weighted-
  Range of                    Outstanding    Contractual     Average      Exercisable     Average
  Exercise                        at            Life         Exercise          at         Exercise
   Prices                    December 31,      (Years)        Price       December 31,     Price
                                 1996                                         1996
-------------- ------------- -------------- -------------- -------------  ------------- -------------
<C>                            <C>                <C>     <C>             <C>           <C>         
$3.00 - $4.44                    322,167           8.8     $    3.62         156,337    $    3.58
$5.00 - $5.75                    180,000           6.8          5.45          90,000         5.63
$7.25 - $8.00                     15,000          10.0          7.50          12,500         7.40
--------------                ----------  -------------    ------------     --------    ---------
$3.00 - $8.00                    517,167           8.2     $    4.37         258,837    $    4.48
--------------                ==========  =============    ============     ========    =========
</TABLE>



<PAGE>


Note 7.  Major Customers and International Sales

Major  customers:  Net sales  for  1996,  1995,  and 1994  include  sales to the
following major customers.
<TABLE>
<CAPTION>

                                          Amount of Net Sales          Trade Receivables Balance
                               -------------------------------------   ------------------------
                                  1996         1995        1994           1996        1995
------------------------------  ----------  -----------  -----------   ----------   ----------
<S>                            <C>         <C>          <C>           <C>          <C>         
U.S. government agencies       $  889,000  $   993,000  $ 1,146,000   $  103,000   $  192,000
Customer A                      1,161,000    2,158,000      781,000      104,000       94,000
Customer B                        376,000      563,000      627,000          -           -
Customer C                        471,000      530,000      603,000       14,000       98,000
                               ----------  -----------  -----------   ----------   ----------
                              $ 2,897,000  $ 4,244,000  $ 3,157,000   $  221,000   $  384,000
                               ==========  ===========  ===========   ==========   ==========
                              
</TABLE>


International sales: Export sales to international customers for 1996, 1995, and
1994 were $1,906,000, $1,907,000, and $1,716,000, respectively.

Note 8.  Commitments

Lease:  The  Company  leases  its  office  and  warehouse   facilities  under  a
noncancelable  operating  lease which expires June 1999.  Total rent expense for
1996,  1995, and 1994 was $97,000.  Minimum annual cash  commitments  under this
lease are  approximately  $124,000,  $131,000,  and $67,000 for 1997,  1998, and
1999, respectively.

License agreement: As of December 31, 1996, the Company had paid $110,000 as the
first payment for a license agreement for the use of certain products.  Upon the
successful  delivery of a beta version of the product by April 1997, the Company
will be required to make additional  nonrefundable  quarterly  payments totaling
$768,000 through October 1998.

Note 9.  Fourth Quarter 1996 Operating Results

The Company  recorded a pretax  loss of  $1,356,000  in the 1996 fourth  quarter
compared to pretax losses totaling $738,000 in the first three quarters of 1996.
The  fourth  quarter  1996 loss is due in part to lower than  expected  revenues
which were  primarily due to reduced sales to the Company's OEM  customers.  The
Company  also  continued  to increase  its level of  spending  on  research  and
development and marketing for its new information security products and systems.
Fourth quarter  expenditures for research and development and marketing  totaled
$1,213,000  compared  to  $2,361,000  for the first three  quarters of 1996.  In
addition,  the Company  accrued a $332,000  charge in the fourth quarter of 1996
relating to severance  costs to be paid to the  Company's  former  president and
chief executive officer who resigned in December 1996.