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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

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FORM 10-K

|(Mark One)                                                   |                                                                                                           
|------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------
|ý                                                            | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]       
|FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002                 
|OR                                                          
|o                                                            | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
|For the transition period
from                            to

COMMISSION FILE NUMBER 0-20191

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Intrusion Inc.(Exact name of registrant as specified in its charter)

|DELAWARE(State or other jurisdiction of
incorporation or organization)                                    |  | 75-1911917(I.R.S. Employer
Identification No.)
|--------------------------------------------------------------------------------------------------------- |  | ----------------------------------------------
|1101 EAST ARAPAHO ROAD
RICHARDSON, TEXAS(Address of principal executive offices)                          |  | 75081(Zip Code)                               
|Registrant's telephone number, including area code:(972) 234-6400                                        
|Securities registered pursuant to Section 12(b) of the Act:
None                                         
|Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value(Title of class)

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Indicate
by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past
90 days. Yes ý    No o

Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the
Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. ý

Indicate
by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act
Rule 12-b2): Yes o    No ý

State
the aggregate market value of the voting and non-voting equity held by non-affiliates computed by reference to the price at which the common equity was last
sold, or the average bid and asked price of such common equity, as of the last business day of the Registrants' most recently completed second fiscal quarter: $13,661,251. As of February 27,
2003, 20,648,425 shares of the Registrant's Common Stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's definitive Proxy Statement filed in connection with the Registrant's 2003 Annual Meeting of Stockholders are incorporated by
reference into Part III of this Form 10-K.

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INTRUSION INC.  INDEX



|           |  |                                                                                       |  | Page
|---------- |  | ------------------------------------------------------------------------------------- |  | ----
|PART I     |  |                                                                                       |  |     
|Item 1.    |  | Business                                                                              |  | 3   
|Item 2.    |  | Properties                                                                            |  | 16  
|Item 3.    |  | Legal Proceedings                                                                     |  | 16  
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                   |  | 16  
|PART II    |  |                                                                                       |  |     
|Item 5.    |  | Market for Registrant's Common Equity and Related Stockholder Matters                 |  | 17  
|Item 6.    |  | Selected Financial Data                                                               |  | 17  
|Item 7.    |  | Management's Discussion and Analysis of Financial Condition And Results of Operations |  | 19  
|Item 7A.   |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 29  
|Item 8.    |  | Financial Statements and Supplementary Data                                           |  | 29  
|Item 9.    |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  |  | 29  
|PART III   |  |                                                                                       |  |     
|Item 10.   |  | Directors and Executive Officers of the Registrant                                    |  | 30  
|Item 11.   |  | Executive Compensation                                                                |  | 30  
|Item 12.   |  | Security Ownership of Certain Beneficial Owners and Management                        |  | 30  
|Item 13.   |  | Certain Relationships and Related Transactions                                        |  | 30  
|Item 14.   |  | Controls and Procedures                                                               |  | 30  
|PART IV    |  |                                                                                       |  |     
|Item 15.   |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                      |  | 30  
|Signatures |  | 33                                                                                   

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PART I

Item 1. Business.

In addition to the historical information contained herein, the discussion in this Form 10-K contains certain forward-looking statements,
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, that involve risks and uncertainties, such as statements
concerning: growth and anticipated operating results, developments in Intrusion Inc.'s markets and strategic focus; new products and product enhancements; potential acquisitions and the
integration of acquired businesses, products and technologies; strategic relationships and future economic and business conditions. The cautionary statements made in this Form 10-K
should be read as being applicable to all related forward-looking statements whenever they appear in this Form 10-K. Intrusion Inc.'s actual results could differ materially
from the results discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed under the section captioned
"Factors That May Affect Future Results of Operations" in Item 1 of this Form 10-K as well as those cautionary statements and other factors set forth elsewhere herein.

General

We develop, market and support a family of network intrusion detection systems and security appliances that address vital issues facing organizations deploying
business applications over the Internet or internally via Intranets. We currently provide network security solutions including intrusion detection systems and virtual private network and firewall
appliances.

We
market and distribute our products through a direct sales force to end-users, distributors and by numerous domestic and international system integrators, managed service
providers and value-added resellers. Our end-user customers include high technology, manufacturing, telecommunications, retail, transportation, health care, insurance, entertainment,
utilities and energy companies, government agencies, financial institutions, and academic institutions.

Our
company was organized in Texas in September 1983 and reincorporated in Delaware in October 1995. For more than 15 years, we provided local area networking
equipment and were known as Optical Data Systems or ODS Networks. On April 17, 2000, we announced plans to sell, or otherwise dispose of, our networking divisions, which included our Essential
Communications division ("Essential") and our local area networking assets. In accordance with these plans, we have accounted for these businesses as discontinued operations. On June 1, 2000,
we changed our name from ODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ ticker symbol from ODSI to INTZ to reflect our focus on intrusion detection solutions. On
November 1, 2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.

Our
principal executive offices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and our telephone number is (972) 234-6400. References to "we", "us",
"our" or "Intrusion Inc." refer to Intrusion Inc. and its subsidiaries.

Recent Developments

The economic and industry environment continued to be extremely challenging during 2002. As a result, our revenues continued to decline. We took measures to
reduce operating costs throughout the year and even into the first quarter of 2003. Restructuring charges for the year totaled $0.2 million and were paid prior to December 31, 2002.
Further restructuring charges of $0.1 million were taken in January 2003 as a result of further reductions in force made in January 2003 in an effort to reduce operating costs to
a level consistent with revenue.

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We
sold Essential Communications ("Essential") during the first quarter of 2002 and recognized a gain on sale of $0.4 million. During the fourth quarter of 2002, we successfully
negotiated an early termination of the lease related to our discontinued operations, Essential. In addition, we wrote off all accounts receivable amounts related to Essential. The net impact of these
transactions resulted in a $0.1 million gain on discontinued operations related to Essential for the fourth quarter and $0.5 million gain for the year.

In
conjunction with our annual review of all intangible assets, we determined that the goodwill and other intangible assets relating to the original acquisition of Mimestar were
impaired. The impairment was determined to be the full value of the assets, as such, the remaining balances of the intangible assets were written off during December 2002. The amortization for
the year on these assets totaled $0.8 million. The impairment charge during December 2002 to write off all intangible assets related to Mimestar was $3.0 million.

During
the fourth quarter of 2002 we performed a slow-moving and obsolete review of our inventory. During our review, we determined that inventory related to the SecureCom
line of business should be completely reserved as it is an older generation product that is not being actively marketed. As a result, we recorded a $1.0 million charge to write down the value
of the SecureCom inventory during December of 2002 to record the inventory at the lower of cost or market.

Industry Background

In the last decade, network security has changed from being a technology deployed only by the government and the most sophisticated or most paranoid of companies,
to a technology that is a core component of even the smallest networks. This change has come about with the permeation of the Internet as a business enabler. Today, email, WWW access, web sites,
web-based applications and e-commerce are the core components of communications and operations for business and government.

Although
the Internet has many business advantages, its openness and accessibility makes it a potential threat to the networks and systems that are attached to it. Computer hackers,
curious or disgruntled employees, contractors and competitors may compromise or destroy information assets or disrupt the normal operations and brand equity of the enterprise.

Enterprises
are therefore adopting a variety of security solutions to meet the challenge posed by malicious intruders, curious hackers and disgruntled employees. To be effective, an
organization requires an enterprise-wide information risk management process that can be managed centrally and implemented on a distributed basis. Organizations seek systems with the
optimum combination of best-of-breed capabilities and total cost of ownership. To secure the enterprise network requires two key elements:



Intrusion Inc.
focuses on these two areas of network security, network intrusion detection systems and VPN/firewall security appliances.

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Network Intrusion Detection Systems

NIDS analyze network traffic for attacks. They examine individual packets within the data stream to identify threats from authorized users, back-door
attacks and hackers who have thwarted the firewall to exploit network connections, cause system outages and access information assets. NIDS add a level of visibility into the nature and character of
the network. They provide information about the use and usage of the network that can be used to:



Security Appliances

VPN/Firewall technology has become mainstream. Every size of business, from Small-Office, Home-Office (SOHO) to the distributed enterprise with a
large Remote-Office, Branch-Office (ROBO) contingent, is using a firewall and connects mobile users and home user with VPNs. With these broadly deployed systems and mature technology, the primary
value drivers have changed from best-of-breed technology to simplified management and reduced total cost of ownership.

Security
appliances simplify the deployment of security systems with preinstalled and preconfigured operating systems and application software and appliance management systems that
simplify management and reduce or eliminate the learning curve for the system. Available in desktop or rack-mountable versions, these integrated appliances extend the reach of security
administrators to remote and branch offices.



Intrusion Inc. Solution and Products

Intrusion Inc. addresses the challenges of network security by developing, marketing and supporting a family of network intrusion detection systems and
security appliances for deployment by enterprises, to include remote and branch offices, and for managed security service providers. We seek to protect information assets from attack and misuse and to
safeguard data integrity. We believe implementing adequate perimeter defenses and monitoring network traffic to "trust-but-verify" are critical elements for the protection of
information assets and integrity.

Intrusion SecureNet Network IDS Products

Intrusion SecureNet network IDS provides industry leading protocol decode detection technology in a user customizable hybrid system. While Intrusion SecureNet
Sensors are in the top-tier of the market for detection and throughput technology, the real benefits of the System are in the Total Cost of Ownership category.

With
the SecureNet system, Intrusion has simplified deployment, management and monitoring to reduce the total cost of ownership for an easy to set up and manage enterprise IDS. The
Intrusion SecureNet system provides more customization and event flow options for the high-end deployments.

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The Intrusion SecureNet system is a "plug-and-protect" network IDS and can tap into networks without interfering with the network operations.

The
SecureNet system provides intuitive and powerful data mining and configuration. Intrusion SecureNet Provider is the three-tier enterprise management and monitoring
system. SecureNet Provider is for enterprise deployments with no license limitations placed on architecture. SecureNet Provider follows the workflow of the security analyst with a highly productive
environment for intrusion research, resolution and decision support. Intrusion SecureNet WBI, the web browser interface for the sensor, provides for effortless Sensor configuration with SecureNet
Provider. SecureNet WBI also delivers complete, stand-alone IDS for the small and medium business. Each Intrusion Sensor comes with SecureNet WBI for local management and monitoring. No other software
or equipment is requireduse any web browser to access a full power, full-features network IDS.

The
Intrusion SecureNet System has two primary components, Management and Sensors.

Sensors
are the components that are connected to the network and monitor the traffic for matches to signatures. Signatures are patterns, anomalies and traffic flows that match known
attacks or indicate suspicious activities. When the Sensor matches traffic to a signature it will send an event to the Manager.

The
Intrusion SecureNet Sensor is available as an appliance with performance and pricing appropriate for networks ranging from 3Mb/s to Gigabit with a Common Criteria EAL2 certified
Gigabit appliance. 95% of Intrusion SecureNet sales are appliance-based Sensors. Intrusion SecureNet Pro software Sensors are also available. Sensors include the following.



Management
varies by the number of Sensors it can support and the features for analyzing data. Management breaks into the following categories.



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The
Intrusion SecureNet Provider suite is a three-tier management system that is tuned for the needs of the distributed enterprise and managed service provider. SecureNet
Provider follows the workflow of the intrusion detection security analyst and provides the most productive environment for intrusion issue resolution. The SecureNet Provider suite includes
applications for event monitoring, policy creation and tuning and centralized software deploymentmaking up the complete suite of tools required to manage and monitor IDS architecture from
five sensors to 100, and more.

The
Intrusion SecureNet WBI is a one-tier management system that is perfectly suited for initial IDS deployments and the small business wanting to deploy network IDS. The WBI
provides a complete user experience from event monitoring, to signature tuning, to Sensor configuration.

In
addition to the standalone benefits of SecureNet WBI, it is also used with SecureNet Provider for its easy Sensor configuration capabilities.

PDS Family of Security Appliances

Effective deployment of a security strategy involves installation, configuration, validation, and implementation of all systems. We believe the optimal solution
is a combined software and appliance solution that enables increased performance, effectively leverages personnel and reduces the total cost of ownership to the enterprise.

As
organizations expand their operations to include remote offices, regional divisions, branch locations and telecommuters, securing the enterprise becomes more complex. We offer
cost-effective integrated security software and appliance solutions that enable centralized management and allow businesses to more easily secure their networks by enabling a variety of
complementary security technologies.

The
PDS Series of security appliances are Linux-based platforms with open Intel architecture that enable the deployment of market leading Check Point Software Technologies
VPN-1®/FireWall-1® and Small Office software. PDS appliances deliver security software solutions for managed service providers, large enterprises, small
businesses and remote offices.

While
many security platforms can be difficult or costly to manage, a PDS appliance delivers Web-based setup and administration with centralized policy management. The PDS
family of security appliance products includes the following.



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Third-Party Products

We believe that it is beneficial to work with third parties with complementary technologies to provide integrated solutions to our customers. As there is fast
movement and many mergers and acquisitions in the security space, there can be no assurance that we will have access to all of the third-party products that may be desirable or for the term desirable
to offer fully integrated solutions to our customers.

Customer Services

In addition to offering our network security products, we also offer a wide range of services, including design and configuration, project planning, training,
installation and maintenance.

Product Development

The network security industry is characterized by rapidly changing technology, standards, economy and customer demands. We believe that our future success depends
in large part upon the timely enhancement of existing products as well as the development of technologically advanced new products that meet industry standards, perform successfully and simplify the
user's tasks so that they can do more with less resources, all to achieve market acceptance. We are currently marketing next-generation network IDS products and are developing products to
meet emerging market requirements and are continuously engaged in testing to ensure that our products interoperate with other manufacturers' products, which comply with industry standards.

During
2002, 2001 and 2000, our research and development expenditures were $6.1 million $12.5 million, and $13.1 million, respectively. All of our expenditures for
hardware and software research and development costs have been expensed as incurred. At December 31, 2002, we had 24 employees engaged in research and product development.

Manufacturing and Supplies

Our operational strategy relies on the outsourcing of manufacturing components, assembly and certain other operations to reduce fixed costs and to provide
flexibility in meeting market demand.

Our
internal manufacturing operations consist primarily of replication of software on CDs, packaging, testing and quality control of finished units. Materials used in our manufacturing
processes include semiconductors such as microprocessors, memory chips and application specific integrated circuits ("ASICs"), printed circuit boards, power supplies and enclosures.

Our
external manufacturing operations consists primarily of hardware assembly and configuration and the loading of the appropriate software.

Intellectual Property and Licenses

Our success and our ability to compete is dependent, in part, upon our proprietary technology. While we have applied for certain patents, we currently rely on a
combination of contractual rights, trade secrets and copyright laws to establish and protect our proprietary rights in our products. We have also entered into non-disclosure agreements
with our suppliers, resellers and certain customers to limit access to and disclosure of proprietary information. There can be no assurance that the steps taken by us to protect our intellectual
property will be adequate to prevent misappropriation of our

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technology or that our competitors will not independently develop technologies that are substantially equivalent or superior to our technology.

We
have entered into software and product license agreements. These license agreements provide us with additional software and hardware components that add value to our security
products. These license agreements do not provide proprietary rights that are unique or exclusive to us and are generally available to other parties on the same or similar terms and conditions,
subject to payment of applicable license fees and royalties.

Sales, Marketing and Customers

Field Sales Force.Our direct sales organization focuses on major account sales, channel partners
including distributors, Value Added Resellers ("VARs") and integrators; promotes our products to current and potential customers; and monitors evolving customer requirements. The field sales and
technical support force provides training and technical support to our resellers and end users and assists our customers to design secure data networking solutions.

We
currently conduct sales and marketing efforts from our principal office in Richardson (Dallas), Texas; Washington, D.C.; and through foreign sales offices located in the following
countries: England, France and Germany. In addition, we have sales personnel, sales engineers and sales representatives located in Los Angeles, Chicago, Canada, Spain, Eastern Europe, Israel,
Malaysia, Taiwan, Japan, South Korea and Australia.

Distributors.We have signed distribution agreements with distributors in the United States, Europe
and Asia. In general, these relationships are non-exclusive. Distributors typically maintain an inventory of our products. Under these agreements, we provide certain protection to the
distributors for their inventory of our products for price reductions as well as products that are slow moving or have been discontinued. Recognition of sales to distributors and related gross profits
are deferred until the distributors resell the merchandise. However, since we have legally sold the inventory to the distributor and we no longer have care, custody or control over the inventory, we
recognize the trade accounts receivable and reduce inventory related to the sale at the time of shipment to the distributor.

Resellers.Domestic and international system integrators and VARs (collectively, "resellers") sell
our products as stand-alone solutions to end users and integrate our products with products sold by other vendors into network security systems that are sold to end users. Our field sales force and
technical support organization provide support to these resellers. Our agreements with resellers are non-exclusive, and our resellers generally sell other products that may compete with
our products. Resellers may place higher priority on products of other suppliers who are larger than and have more name recognition than us, and there can be no assurance that resellers will continue
to sell and support our products.

Foreign Sales.We believe that rapidly evolving international markets are important sources of future
net sales. Our export sales are currently being made through a direct sales force supplemented by international resellers in Europe, Asia, Latin America and Canada. Export sales accounted for
approximately 33.4%, 36.4% and 19.2% of net sales in 2002, 2001 and 2000, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in this
report for a geographic breakdown of our product revenue in 2002, 2001 and 2000. Sales to foreign customers and resellers generally have been made in United States dollars.

Marketing.We have implemented several methods to market our products, including public relations and
placed articles, regular participation in and presenting during trade shows and seminars, advertisement in trade journals, telemarketing, distribution of sales literature and product specifications
and ongoing communication with our resellers and installed base of end-user customers.

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Customers.Our end-user customers include manufacturing, high technology,
telecommunications, retail, transportation, health care, insurance, entertainment, utilities and energy companies, government agencies, financial institutions and academic institutions. Sales to
certain customers and groups of
customers can be impacted by seasonal capital expenditure approval cycles, and sales to customers within certain geographic regions can be subject to seasonal fluctuations in demand.

Although
we sell our products to many customers, direct sales to two resellers and end-user customers, iGov.com and TRW Systems & Information Technology ("TRW") have
each accounted for 10% or more of our net sales in at least one of the past three fiscal years as indicated in the following schedule.

|         |  | Percentage of Net Sales |  
|-------- |  | ----------------------- | -
|
|
|iGov.com |  | 3.1                     | %
|TRW      |  | 0.0                     |  

In
2002, 19.9% of our revenue was derived from the sales to the U.S. government through system integrators and resellers. The loss of sales to the various U.S. government agencies could
have a material adverse effect on our business and operating results if not replaced. No other customer accounted for 10% or more of our net sales in 2002, 2001 or 2000, respectively.

Backlog.We believe that only a small portion of our order backlog is non-cancelable and
that the dollar amount associated with the non-cancelable portion is immaterial. We purchase inventory based upon our forecast of customer demand and maintain inventories of
sub-assemblies and finished products in advance of receiving firm orders from customers. Orders are generally fulfilled within two days to eight weeks following receipt of an order. Due to
the generally short cycle between order and shipment and occasional customer-initiated changes in delivery schedules or cancellation of orders that are made without significant penalty, we do not
believe that our backlog as of any particular date is indicative of future net sales.

Customer Support, Service and Warranty.We service, repair and provide technical support for our
products. Our field sales and technical support force work closely with resellers and end-user customers
on-site and by telephone to assist with pre- and post-sales support services such as network security design, system installation and technical consulting. By
working closely with our customers, our employees increase their understanding of end-user requirements and provide input to the product development process.

We
warrant all of our products against defects in materials and workmanship for periods ranging from 90 days to 12 months. Before and after expiration of the product
warranty period, we offer both on-site and factory-based support, parts replacement and repair services. Extended warranty services are separately invoiced on a time and materials basis or
under an annual maintenance contract.

Competition

The market for network security solutions is intensely competitive and subject to frequent product introductions with new technologies, improved price and
performance characteristics. Industry suppliers compete in areas such as conformity to existing and emerging industry standards, interoperability with networking and other security products,
management and security capabilities, performance, price, ease of use, scalability, reliability, flexibility, product features and technical support. We believe that our approach focusing on the
network perimeters with market leading VPN/firewall control technology and network intrusion detection visibility technology that reduce the total cost of ownership compared to the competition
provides us with an advantage with large organizations with complex security requirements.

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There
are numerous companies competing in various segments of the data security markets. Our principle competitors in the network intrusion detection market include Internet Security
Systems, Inc., Cisco Systems, Inc., Enterasys Networks, Inc. and NFR Security, Inc. Our principle competitors in the Check Point Software Technologies Ltd.
VPN/firewall appliance market include Nokia Corporation, Celestix Networks, Inc., International Business Machines Corp. and Hewlett Packard Company. Several of our competitors have
substantially greater financial, technical, sales and marketing resources, better name recognition and a larger customer base than we do. In addition, many of our competitors may provide a more
comprehensive networking and security solution than we currently offer. Even if we do introduce advanced products, which meet evolving customer requirements in a timely manner, there can be no
assurance that our new products will gain market acceptance.

Certain
companies in the network security industry have expanded their product lines or technologies in recent years as a result of acquisitions. Further, more companies have developed
products which conform to existing and emerging industry standards and have sought to compete on the basis of price. We anticipate increased competition from large networking equipment vendors, which
are expanding their capabilities in the network security market. In addition, we anticipate increased competition from private "start-up" companies that have developed or are developing
advanced security products. Increased competition in the security industry could result in significant price competition, reduced
profit margins or loss of market share, any of which could have a material adverse effect on our business, operating results and financial condition. There can be no assurance that we will be able to
compete successfully in the future with current or new competitors.

Employees

As of December 31, 2002, we employed a total of 78 persons, including 40 in sales, marketing and technical support, 5 in manufacturing and operations, 24
in research and product development and 9 in administration and finance.

None
of our employees are represented by a labor organization, and we are not a party to any collective bargaining agreement. We have not experienced any work stoppages and consider our
relations with our employees to be good.

Competition
in the recruiting of personnel in the networking and data security industry is intense. We believe that our future success will depend in part on our continued ability to
hire, motivate and retain qualified management, sales and marketing, and technical personnel. To date, we have not experienced significant difficulties in attracting or retaining qualified employees.

Factors That May Affect Future Results of Operations

In addition to the other information in this Form 10-K, the following factors should be considered in evaluating Intrusion Inc. and our
business.

Technological Changes.The market for our products is characterized by frequent product
introductions, rapidly changing technology and continued evolution of new industry standards. The market for security products requires our products to be compatible and interoperable with products
and architectures offered by various vendors, including other security products, networking products, workstation and personal computer architectures and computer and network operating systems. Our
success will depend to a substantial degree upon our ability to develop and introduce in a timely manner new products and enhancements to our existing products that meet changing customer requirements
and evolving industry standards. The development of technologically advanced products is a complex and uncertain process requiring high levels of innovation as well as the accurate anticipation of
technological and market trends. There can be no assurance that we will be able to identify, develop, manufacture, market and support new or enhanced products successfully in a timely manner. Further,
we or our competitors may introduce new products or product enhancements that shorten the life cycle

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of or obsolete our existing product lines, any of which could have a material adverse effect on our business, operating results and financial condition.

Market Acceptance.We are pursuing a strategy to increase the percentage of our revenue generated
through indirect sales channels including distributors, value added resellers, system integrators, original equipment manufacturers and managed service providers. There can be no assurance that our
products will gain market acceptance in these indirect sales channels. Further, competition among security companies to sell products through these indirect sales channels could result in significant
price competition and reduced profit margins.

We
are also pursuing a strategy to further differentiate our product line by introducing complementary security products and incorporating new technologies into our existing product
line. There can be no assurance that we will successfully introduce these products or that such products will gain market acceptance. We anticipate competition from networking companies, network
security companies and others in each of our product lines. We anticipate that profit margins will vary among our product lines and that product mix fluctuations could have an adverse effect on our
overall profit margins.

Acquisitions.Some of our competitors have acquired several security companies with complementary
technologies, and we anticipate that such acquisitions will continue in the future. These acquisitions may permit such competitors to accelerate the development and commercialization of broader
product lines and more comprehensive solutions than we currently offer. In the past, we have relied upon a combination of internal product development and partnerships with other security vendors to
provide competitive solutions to customers. Certain of the recent and future acquisitions by our competitors may have the effect of limiting our access to commercially significant technologies.
Further, the business combinations and acquisitions in the security industry are creating companies with larger market shares, customer bases, sales forces, product offerings and technology and
marketing expertise. There can be no assurance that we will be able to compete successfully in such an environment.

We
have made acquisitions in the past, and we may, in the future, acquire or invest in additional companies, business units, product lines, or technologies to accelerate the development
of products and sales channels complementary to our existing products and sales channels. Acquisitions involve numerous risks, including: difficulties in assimilation of operations, technologies, and
products of the acquired companies; risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions; the potential
loss of key employees of the acquired company; and the diversion of our attention from normal daily operation of our business. There can be no assurance that any other acquisition or investment will
be consummated or that such acquisition or investment will be realized.

Product Transitions.Once current security products have been in the market place for a period of
time and begin to be replaced by higher performance products (whether of our design or a competitor's design), we expect the net sales of such products to decrease. In order to achieve revenue growth
in the future, we will be required to design, develop and successfully commercialize higher performance products in a timely manner. There can be no assurance that we will be able to introduce new
products and gain market acceptance quickly enough to avoid adverse revenue transition patterns during current
or future product transitions. Nor can there be any assurance that we will be able to respond effectively to technological changes or new product announcements by competitors, which could render
portions of our inventory obsolete.

Manufacturing and Suppliers.Our operational strategy relies on outsourcing of product assembly and
certain other operations. There can be no assurance that we will effectively manage our third-party contractors or that these contractors will meet our future requirements for timely delivery of
products

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of sufficient quality and quantity. Further, we intend to introduce a number of new products and product enhancements in 2003 that will require that we rapidly achieve volume production of those new
products by coordinating our efforts with those of our suppliers and contractors. The inability of the third-party contractors to provide us with adequate supplies of high-quality products
could cause a delay in our ability to fulfill orders and could have an adverse effect on our business, operating results and financial condition.

All
of the materials used in our products are purchased under contracts or purchase orders with third parties. While we believe that many of the materials used in the production of our
products are generally readily available from a variety of sources, certain components such as microprocessors and motherboards are available from one or a limited number of suppliers. The lead times
for delivery of components vary significantly and can exceed twelve weeks for certain components. If we should fail to forecast our requirements accurately for components, we may experience excess
inventory or shortages of certain components that could have an adverse effect on our business and operating results. Further, any interruption in the supply of any of these components, or the
inability to procure these components from alternative sources at acceptable prices within a reasonable time, could have an adverse effect on our business and operating results.

Intellectual Property and Licenses.There are many patents held by companies, which relate to the
design and manufacture of network security systems. The holders of those patents could assert potential claims of infringement. We could incur substantial costs in defending our company and our
customers against any such claim regardless of the merits of such claims. In the event of a successful claim of infringement, we may be required to obtain one or more licenses from third parties.
There can be no assurance that we could obtain the necessary licenses on reasonable terms.

Sufficiency of Cash Flow.As of December 31, 2002, we had cash, cash equivalents and
investments in the amount of approximately $10.7 million, down from approximately $20.4 million as of December 31, 2001. Although we believe we have sufficient cash resources to
finance our operations and expected capital expenditures for the next twelve months, the sufficiency of our cash resources may depend to a certain extent on general economic, financial, competitive or
other factors beyond our control. Moreover, despite actions to reduce our costs and improve our profitability, we expect our operating losses and net operating cash outflows to continue during 2003.
As a result, we may not be able to achieve the revenue and gross margin objectives necessary to achieve positive cash flow or profitability without obtaining additional financing. We do not currently
have any arrangements for financing as we believe that our cash flows are sufficient for the next twelve months, and we may not be able to secure
additional debt or equity financing on terms acceptable to us, or at all, at the time when we need such funding. If our business does not generate sufficient cash flow from operations and sufficient
future financings are not available, we may not be able to operate or grow our business, pay our expenses when due or fund our other liquidity needs.

Dependence on Check Point Technologies.Our PDS family of security appliances, which are integrated
with Check Point Software Technologies' market-leading VPN-1®/FireWall-1® software, represents 29.1% of our 2002 sales. Although we are a certified
appliance partner of Check Point and our PDS products have received certification from Check Point, we have no long-term agreement or exclusive relationship with Check Point. As a result,
the loss or significant change in our relationship with Check Point, the failure of future PDS products to receive Check Point certification, the business failure of Check Point or its acquisition by
or of one of our competitors, and the loss of market share of Check Point or market acceptance of its products could each have a material adverse effect on our business, financial condition and
results of operations.

Third-Party Products.We believe that it is beneficial to work with third parties with complementary
technologies to broaden the appeal of our security products. These alliances allow us to provide integrated solutions to our customers by combining our developed technology with third-party

13

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products. As there is fast movement and many mergers and acquisitions in the security space, there can be no assurance that we will have access to all of the third-party products that may be
desirable or for the term desirable to offer fully integrated solutions to our customers.

Dependence on Key Customers.In the past, a relatively small number of customers have accounted for a
significant portion of our revenue. We expect to continue to derive a substantial portion of our net revenue from sales to U.S. government agencies, large system integrators and managed service
providers. We continuously face competition from Internet Security Systems, Cisco, Enterasys, NFR, Nokia, Celestix, IBM, Hewlett Packard and others for U.S. government security projects and corporate
security installations. Any reduction or delay in sales of our products to these customers could have a material adverse effect on our operating results.

International Operations.Our international operations may be affected by changes in demand resulting
from fluctuations in currency exchange rates and local purchasing practices, including seasonal fluctuations in demand, as well as by risks such as increases in duty rates, difficulties in
distribution, regulatory approvals and other constraints upon international trade. Our sales to foreign customers are subject to export regulations. In particular, certain sales of our data security
products require clearance and export licenses from the U.S. Department of Commerce under these regulations. Any inability to obtain such clearances or any required foreign regulatory approvals on a
timely basis could have a material adverse effect on our operating results.

Impact of Government Customers.In 2002, 19.9% of our revenue was derived from sales to the U.S.
government, either directly by us or through system integrators and other resellers. Sales to the
government present risks in addition to those involved in sales to commercial customers, including potential disruption due to appropriation and spending patterns and the government's reservation of
the right to cancel contracts and purchase order for its convenience.

Discontinued Operations.In the second quarter of 2000, we discontinued our networking operations and
accordingly have shown the networking operations as discontinued in the accompanying financial statements.

During
the first quarter of 2001, we closed the sale of our legacy local area networking division generating a gain of $2.1 million, which was used to reduce the estimated net
realizable value of the net assets of the remaining discontinued operations of Essential. During the second quarter of 2001, in response to unfavorable market conditions and efforts to sell Essential,
we recorded additional charges to write down the net assets of Essential to reflect an estimated net realizable value of $0.8 million. The $5.0 million second quarter charge included
$0.8 million for operating losses expected to be incurred between July and the end of the first quarter of 2002 by which time we expected to have exited, disposed of or otherwise transitioned a
majority of our ownership in Essential.

In
March 2002 we sold Essential for $1 million generating a gain on sale of $0.5 million. Terms of the sale included transferring $0.7 million in net
property, plant and equipment, $0.1 million in current liabilities and product maintenance obligations for which $0.4 million was recorded in deferred revenue.

A
condition of the sale was to give Essential personnel 60 days to exit Essential's leased facility, the obligation for which we retained as part of the sale. Included in the gain
on the sale of Essential was management's estimate of $0.3 million to terminate this lease agreement, which was equivalent to 2 years' lease and maintenance of the facility. The
contractual term of the lease ran through February 2009. Successful termination of the lease during the fourth quarter of 2002 for less than $0.3 million resulted in additional gain on
sale of $0.1 million.

Effects of Military Actions.United States military actions or other events occurring in response or
in connection to them, including future terrorist attacks against United States targets, actual conflicts involving the United States or it allies or military or trade disruptions could impact our
operations, including by:

14

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Should
such events occur, our business, operating results and financial condition could be materially and adversely affected.

Restructuring and Cost Reductions.We implemented a restructuring plan in 2002, which resulted in
$0.2 million charge. The objective of our restructuring plan was to reduce our cost structure to a sustainable level that is consistent with the current macroeconomic environment. We also
implemented other strategic initiatives designed to strengthen our operations. These plans involved, among other things, reductions in our workforce and facilities, aligning our organization around
our business objectives, realignment of our research and development team, our sales force and changes in our sales management. Further workforce reductions were made in the first quarter of 2003,
which resulted in additional restructuring charges. Any further workforce reductions could result in temporary reduced productivity of our remaining employees. Additionally, our customers and
prospects may delay or forgo purchasing our products due to a perceived uncertainty caused by the restructuring and other changes. Failure to achieve the desired results of our initiatives could
seriously harm our business, results of operations and financial condition.

Potential Nasdaq Delisting.The Nasdaq Stock Market maintains certain minimum requirements to
maintain the listing for our common stock. These requirements include a minimum bid price for our common stock of $1.00. The trading price of our common stock has not been at least $1.00 since
June 27, 2002, and we received a notice of noncompliance from Nasdaq on August 12, 2002. In order to take advantage of additional grace periods for compliance, we transferred the listing
of our common stock from the Nasdaq National Market to the Nasdaq SmallCap Market, effective December 4, 2002. Although we expect to continue to have the opportunity to regain compliance for
listing on the Nasdaq National Market, if the minimum bid price of our common stock is not at least $1.00 for at least 10 consecutive trading days on or prior to August 7, 2003, Nasdaq may seek
to delist our common stock from the Nasdaq SmallCap Market. We cannot assure you that we will be able to meet the minimum bid price requirement prior to the deadline in order to maintain our listing
on the Nasdaq SmallCap Market or that we will be able to maintain compliance with Nasdaq's other continued listing requirements.

If
we are unable to regain compliance with the minimum bid price requirement or fail to comply with other Nasdaq continued listing requirements, our common stock likely would trade in a
less efficient market, such as the OTC Bulletin Board or in the "pink sheets" maintained by the National Quotation Bureau, Inc. Because these alternatives generally are considered to be less
efficient markets, our stock price, the liquidity of our common stock and our general business reputation may be adversely impacted.

General.Sales of our products fluctuate, from time to time, based on numerous factors, including
customers' capital spending levels and general economic conditions. While certain industry analysts believe that there is a significant market for network security products, there can be no assurance
as to
the rate or extent of the growth of such market or the potential adoption of alternative technologies. Future declines in network security product sales as a result of general economic conditions;
adoption of alternative technologies or any other reason could have a material adverse effect on our business, operating results and financial condition.

Due
to the factors noted above and in "Management's Discussion and Analysis of Financial Condition and Results of Operations", our future earnings and common stock price may be subject
to significant volatility, particularly on a quarterly basis. Past financial performance should not be considered a reliable indicator of future performance and investors should not use historical
trends to anticipate results or trends in future periods. Any shortfall in revenue and earnings from the levels

15

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anticipated by securities analysts could have an immediate and significant effect on the trading price of our common stock in any given period. Also, we participate in a highly dynamic industry,
which often results in volatility of our common stock price.

Item 2. Properties.

Our headquarters are located in a two-story building in Richardson, Texas, with an aggregate of approximately 95,000 square feet of floor space. This
facility includes our corporate administration, operations, marketing, research and development, sales and technical support personnel. We occupy this facility under a lease, the base term of which
expires in February 2005, with two seven-year options to extend the lease term, subject to compliance with certain conditions.

Personnel
of Essential were located in a 15,120 square foot leased property in Albuquerque, New Mexico. The lease was scheduled to expire in February 2009. In March 2002,
we sold the assets of Essential (see Discontinued Operations). A condition of the sale was to give Essential personnel 60 days to exit the facility. Included in the total $0.4 million
gain on the sale of Essential in March 2002 was a $0.3 million reserve to terminate the lease, which is the equivalent of 2 years' lease and maintenance of the facility.
Successful termination of the Essential lease for less than $0.3 million resulted in a $0.1 million gain on disposition during the fourth quarter of 2002, for a total gain on
Discontinued Operations for 2002 of $0.5 million.

Much
of our security software research and development staff is located in a 6,464 square foot leased property in San Diego, California. This lease was renewed in August 2002 and
will expire in August of 2004. Research and development personnel occupy this facility.

In
addition, we lease small amounts of office space for sales and technical support personnel domestically and internationally in Washington D.C., England, France and Germany. We believe
that the existing facilities at December 31, 2002 will be adequate to meet our requirements through 2003.
See Note 5 of Notes to Consolidated Financial Statements for additional information regarding our obligations under leases.

Item 3. Legal Proceedings.

We are subject to legal proceedings and claims that arise in the ordinary course of business. We do not believe that the outcome of those matters will have a
material adverse affect on our consolidated financial position, operating results or cash flows. However, there can be no assurance such legal proceedings will not have a material impact.

On
March 22, 2002, Morgan Newton Company, L.P. ("Morgan Newton") filed suit against us in Dallas County District Court, Case No. DV02-02339-C, alleging
claims for breach of contract, promissory estoppel, and fraud. The claims arise out of an alleged oral representation to Morgan Newton concerning a request for quotation for the purchase of a large
amount of Morgan Newton's products. Morgan Newton has not specified the amount of damages it is seeking in the lawsuit, but it is possible that Morgan Newton may be seeking damages in excess of
$2.0 million. In addition to actual damages, Morgan Newton is also seeking attorney's fees and punitive damages. We believe Morgan Newton's claims are without merit and intend to vigorously
defend this lawsuit, generally denying all claims and asserting certain affirmative defenses. As of this time, discovery is substantially underway, and trial has been scheduled for
October 2003.

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

There were no matters submitted to a vote of our security holders during the fourth quarter of 2002.

16

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PART II

Item 5. Market for Intrusion's Common Equity and Related Stockholder Matters.

Prior to December 4, 2002, our common stock traded on The Nasdaq National Market. Since December 4, 2002, our common stock trades on the Nasdaq
SmallCap Market under the symbol "INTZ". As of February 27, 2003 there were approximately 212 registered holders of record of the common stock. The following table sets forth, for the periods
indicated, the high and low per share intra-day sales prices for the common stock, as reported by The Nasdaq Stock Market.

2002

2001High

Low

High

LowFirst Quarter

$
2.15

$
1.20

$
8.50

$
3.25Second Quarter


1.85


0.76


4.90


2.75Third Quarter


1.12


0.01


4.14


0.90Fourth Quarter


0.69


0.24


2.15


0.62


We
have not declared or paid cash dividends on our capital stock in our two most recent fiscal years. We currently retain any earnings for use in our business and do not anticipate
paying any cash dividends in the foreseeable future. Future dividends, if any, will be determined by our Board of Directors.

All
stock option plans under which our Common Stock is reserved for issuance have previously been approved by our shareholders. The following table provides summary information as of
December 31, 2002 for all of our stock option plans (in thousands, except per share data). See Note 10 to our consolidated financial statements for additional discussion.

|                                                           |  | Number of Shares of Common Stock to be Issued upon Exercise of Outstanding Options |     | Weighted Average Exercise Price of Outstanding Options, Excludes Warrants Rights |  | No. of Shares of Common Stock Remaining Available for Future Issuance |    
|---------------------------------------------------------- |  | ---------------------------------------------------------------------------------- | --- | -------------------------------------------------------------------------------- |  | --------------------------------------------------------------------- | ---
|Equity compensation plans approved by security holders     |  | 1,685                                                                              | (1) | 4.89                                                                             |  | 1,680                                                                 | (2)
|Equity compensation plans not approved by security holders |  |                                                                                   |     |                                                                                 |  |                                                                      |    
|Total                                                      |  | 1,685                                                                              |     | 4.89                                                                             |  | 1,680                                                                 |    

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Item 6. Selected Financial Data.

The following selected consolidated financial data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of
Operations" in Item 7 of this Form 10-K and the consolidated financial statements and notes thereto included in Item 15 of this Form 10-K. Continuing operations
consisted of our information security business, which began operations in 1998. Discontinued operations are composed of our local area networking divisions, which were discontinued in
April 2000 and Essential, which was discontinued in March 2001.

17

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Statement of Operations Data:(In thousands, except per share data)

|                                                           |                                     | Year Ended December 31, |        
|---------------------------------------------------------- | ----------------------------------- | ----------------------- | -------
|
|Revenue                                                    |                                     | $                       | 7,834  
|Cost of sales                                              |                                     |                         | 6,147  
|                                                           |                                     |                         |        
|Gross profit                                               |                                     |                         | 1,687  
|Operating expenses:                                        |                                     |                         |        
|                                                           | Sales and marketing                 |                         |        
|                                                           | Research and development            |                         |        
|                                                           | In-process research and development |                         |        
|                                                           | General and administrative          |                         |        
|                                                           | Amortization of intangibles         |                         |        
|                                                           | Impairment of intangibles           |                         |        
|                                                           | Restructuring costs                 |                         |        
|                                                           |                                     |                         |        
|Operating loss                                             |                                     |                         | (22,773
|Interest income, net                                       |                                     |                         | 351    
|Other income (expense)                                     |                                     |                         | (7     
|                                                           |                                     |                         |        
|Income (loss) from continuing operations before income tax |                                     |                         | (22,429
|Income tax provision (benefit)                             |                                     |                         | (608   
|                                                           |                                     |                         |        
|Income (loss) from continuing operations                   |                                     |                         | (21,821
|Income (loss) from discontinued operations, net of tax     |                                     |                         | 544(4  
|                                                           |                                     |                         |        
|Net income (loss)                                          |                                     |                         | (21,277
|                                                           |                                     |                         |        
|Basic earnings (loss) per share, continuing operations     |                                     |                         | (1.06  
|                                                           |                                     |                         |        
|Diluted earnings (loss) per share, continuing operations   |                                     |                         | (1.06  
|                                                           |                                     |                         |        
|Basic earnings (loss) per share                            |                                     |                         | (1.03  
|                                                           |                                     |                         |        
|Dilutive earnings (loss) per share                         |                                     |                         | (1.03  
|                                                           |                                     |                         |        
|Weighted average shares outstanding                        |                                     |                         |        
|                                                           |  Basic                             |                         |        
|                                                           |                                     |                         |        
|                                                           |  Diluted                           |                         |        
|                                                           |                                     |                         |        

Balance Sheet Data:

|                           |  | 2002 |        | 2001 |   | 2000   |  | 1999 |        | 1998
|-------------------------- |  | ---- | ------ | ---- | - | ------ |  | ---- | ------ | ----
|Working capital            |  | $    | 10,701 |      | $ | 25,240 |  | $    | 52,514 |     
|Total assets               |  |      | 16,939 |      |   | 42,295 |  |      | 92,414 |     
|Total liabilities          |  |      | 4,555  |      |   | 8,797  |  |      | 13,627 |     
|Total stockholders' equity |  |      | 12,384 |      |   | 33,498 |  |      | 78,787 |     

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18

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See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Notes to the Consolidated Financial
Statements.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

"Safe Harbor" Statement under the Private Litigation Reform Act of 1995

This Annual Report, other than historical information, may include forward-looking statements, including statements with respect to financial results, product
introductions, market demand, sales channels, industry trends, sufficiency of cash resources and certain other matters. These statements are made under the "safe harbor" provisions of the Private
Securities Litigation Reform Act of 1995 and involve risks and uncertainties which could cause actual results to differ materially from those in the forward-looking statements, including those
discussed in the section entitled "Factors That May Affect Future Results of Operations" in Item 1 and elsewhere in this Annual Report on Form 10-K and other filings with the
Securities and Exchange Commission.

Overview

We develop, market and support a family of network intrusion detection software and appliances that address vital security issues facing organizations deploying
business applications over the Internet or internally via Intranets. We currently provide network security solutions including intrusion detection systems and VPN/firewall appliances. On
June 1, 2000, we changed our name from ODS Networks, Inc. to Intrusion.com Inc. and our NASDAQ ticker symbol from ODSI to INTZ to reflect our focus on
intrusion detection solutions. On November 1, 2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc. During the second quarter of 2000, we announced our plan to
sell, or otherwise dispose of, our networking divisions, which includes our Essential Communications division and our local area networking assets, and began accounting for these networking divisions
as discontinued operations.

Critical Accounting Policies and Estimates

Management's discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the
reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including
those related to product returns, bad debts, inventories, intangible assets, income taxes, warranty obligations, restructuring, maintenance contracts and contingencies. We base our estimates on
historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of
assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We
believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

19

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Goodwill and Other Intangible Assets

Effective January 1, 2002, we adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 142 "Goodwill and Other Intangible
Assets" ("SFAS 142"), which requires companies to cease amortizing goodwill and certain intangible assets with indefinite useful lives. Instead, SFAS 142 requires that goodwill and
intangible assets deemed to have indefinite useful lives be reviewed for impairment upon adoption of SFAS 142, annually thereafter, and upon the occurrence of any event that indicates potential
impairments.

In
accordance with SFAS 142, we discontinued recording goodwill amortization effective January 1, 2002.

SFAS 142
prescribes a two-phase process for impairment testing of goodwill. The first phase screens for potential impairment, while the second phase (if necessary)
measures the impairment. Goodwill is potentially impaired if the net book value of a reporting unit exceeds its estimated fair value. We have
determined that we have one reporting unit. This methodology differs from the Company's previous policy, as permitted under accounting standards existing at that time, of using undiscounted cash flows
on an enterprise-wide basis to determine if goodwill is recoverable.

The
Company elected to perform its annual impairment review during the fourth quarter of each year, commencing in the fourth quarter of 2002. In connection with our annual impairment
review, we determined that the value of goodwill was impaired. At the time of our impairment review, the remaining goodwill of $0.4 million was associated with the MimeStar purchase
transaction. Based on the decline in the market value of the Company as indicated by the decline in its stock price over the last year, it was determined that the goodwill carrying value should be
zero at December 31, 2002. Therefore, an impairment charge of $0.4 million was recorded and is included in impairment of intangibles in the accompanying consolidated statement of
operations.

Long-Lived Assets

Effective January 1, 2002, we adopted the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("SFAS 144"), which supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," ("SFAS 121")
and accounting and reporting provisions of Accounting Principles Bulletin Opinion 30, "Reporting the Results of Operations," for a disposal of a segment. The primary objective of SFAS 144 is to
develop one accounting model based on the framework established in SFAS 121 for long-lived assets to be disposed of and significantly changes the criteria that would have to be met
to classify an asset as held for sale. SFAS 144 also requires expected future operating losses from discontinued operations to be displayed in the period(s) in which the losses are incurred,
rather than as of the measurement date. Our adoption of SFAS 144 had no effect on the Company's financial position or results of operations.

We
review long-lived assets, other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. Conditions that would necessitate an impairment assessment include material adverse changes in operations, significant adverse differences in actual results in comparison with initial
valuation forecasts prepared at the time of acquisition, a decision to abandon acquired products, services or technologies, or other significant adverse changes that would indicate the carrying amount
of the recorded asset might not be recoverable. Recoverability of assets held and used is measured by a comparison of the carrying amount of an asset to undiscounted pre tax future net cash flows
expected to be generated by that asset. An impairment loss is recognized for the amount by which the carrying amount of the assets exceeds the fair value of the assets. Long-lived assets
held for sale are reported at the lower of cost or fair value less costs to sell.

20

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As
a result of the write-off of goodwill during the fourth quarter of 2002, we determined that a triggering event indicating potential impairment of the associated
intangibles had occurred. At
December 31, 2002, the remaining intangibles of $2.6 million principally included purchased software associated with the MimeStar purchase transaction. We determined that the
undiscounted pre tax cash flows associated with this software was not likely to exceed the remaining carrying values. Due to technological changes that had taken place with respect to the core
software code acquired, it was determined that the carrying value should be zero at December 31, 2002. Therefore, an impairment charge of $2.6 million was recorded and is included in
impairment of intangibles in the accompanying consolidated statement of operations.

Revenue Recognition

We generally recognize product revenue upon shipment of product. We accrue for estimated warranty costs, sales returns and other allowances at the time of
shipment based on our experience. Revenue from maintenance contracts is deferred and recognized over the contractual period the services are performed. To date, warranty costs and sales returns have
not been material. There is a risk that technical issues on new products could result in unexpected warranty costs and returns.

We
recognize software revenue from the licensing of our software products in accordance with Statement of Position ("SOP") No. 97-2 "Software Revenue Recognition" and
SOP 98-9 "Modification of 97-2, Software Revenue Recognition, with respect to certain transactions" whereby revenue from the licensing of our products is not recognized until
all four of the following have been met: i) execution of a written purchase order, license agreement or contract; ii) shipment of the product has occurred; iii) the license fee is
fixed and determinable; and iv) collectibility is probable. The Company defers and recognizes maintenance and support revenue over the term of the contract period, which is generally one year.

We
have signed distribution agreements with distributors in the United States, Europe and Asia. In general, these relationships are non-exclusive. Distributors typically
maintain an inventory of our products. Under these agreements, we provide certain protection to the distributors for their inventory of our products for price reductions as well as products that are
slow moving or have been discontinued by us. Recognition of sales to distributors and related gross profits are deferred until the distributors resell the merchandise. However, since we have legally
sold the inventory to the distributor and we no longer have care, custody or control over the inventory, we recognize the trade accounts receivable and reduce inventory related to the sale at the time
of shipment to the distributor. Revenue, offset by deferred cost of sales, is included in deferred revenue in the accompanying financial statements.

Allowance for Doubtful Accounts and Returns

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial
condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventory

We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market
value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be
required.

21

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Discontinued Operations

In the second quarter of 2000, we discontinued our networking operations and accordingly have shown the networking operations as discontinued in the accompanying
financial statements.

During
the first quarter of 2001, we closed the sale of our legacy local area networking division generating a gain of $2.1 million, which was used to reduce the estimated net
realizable value of the net assets of the remaining discontinued operations of Essential. During the second quarter of 2001, in response to unfavorable market conditions and efforts to sell Essential,
we recorded additional charges to write down the net assets of Essential to reflect an estimated net realizable value of $0.8 million. The $5.0 million second quarter charge included
$0.8 million for operating losses expected to be incurred between July and the end of the first quarter of 2002 by which time we expected to have exited, disposed of or otherwise transitioned a
majority of our ownership in Essential.

In
March 2002 we sold Essential for $1 million generating a gain on sale of $0.5 million. Terms of the sale included transferring $0.7 million in net
property, plant and equipment, $0.1 million in current liabilities and product maintenance obligations for which $0.4 million was recorded in deferred revenue.

A
condition of the sale was to give Essential personnel 60 days to exit Essential's leased facility, the obligation for which we retained as part of the sale. Included in the gain
on the sale of Essential was management's estimate of $0.3 million to terminate this lease agreement, which was equivalent to 2 years' lease and maintenance of the facility. The
contractual term of the lease ran through February 2009. Successful termination of the lease during the fourth quarter of 2002 for less than $0.3 million resulted in additional gain on
sale of $0.1 million.

22

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Results of Operations

The following tables set forth, for the periods indicated, certain financial data as a percentage of net sales.

|                                                           |                             | Year Ended December 31, |      
|---------------------------------------------------------- | --------------------------- | ----------------------- | -----
|
|Net sales                                                  |                             | 100.0                   | %    
|Cost of sales                                              |                             | 78.5                    |      
|                                                           |                             |                         |      
|Gross profit                                               |                             | 21.5                    |      
|Operating expenses:                                        |                             |                         |      
|                                                           | Sales and marketing         |                         | 150.5
|                                                           | Research and development    |                         | 77.7 
|                                                           | General and administrative  |                         | 32.9 
|                                                           | Amortization of intangibles |                         | 10.2 
|                                                           | Impairment of intangibles   |                         | 38.4 
|                                                           | Restructuring costs         |                         | 2.6  
|                                                           |                             |                         |      
|Operating loss                                             |                             | (290.7                  | )    
|Interest income, net                                       |                             | 4.5                     |      
|Other income (expense)                                     |                             | (0.1                    | )    
|                                                           |                             |                         |      
|Income (loss) from continuing operations before income tax |                             | (286.3                  | )    
|Income tax provision (benefit)                             |                             | (7.8                    | )    
|                                                           |                             |                         |      
|Income (loss) from continuing operations                   |                             | (278.5                  | )    
|Income (loss) from discontinued operations, net of tax     |                             | 6.9                     |      
|                                                           |                             |                         |      
|Net income (loss)                                          |                             | (271.6                  | )    
|                                                           |                             |                         |      

|                 |               | 2002  |      | 2001  |      | 2000  |    
|---------------- | ------------- | ----- | ---- | ----- | ---- | ----- | ---
|Domestic sales   |               | 66.6  | %    | 63.6  | %    | 80.8  | %  
|Export sales to: |               |       |      |       |      |       |    
|                 | Europe        |       | 14.5 |       | 25.4 |       | 7.6
|                 | Canada        |       | 4.0  |       | 4.0  |       | 2.7
|                 | Asia          |       | 14.6 |       | 6.3  |       | 7.4
|                 | Latin America |       | 0.3  |       | 0.7  |       | 1.5
|                 |               |       |      |       |      |       |    
|Net sales        |               | 100.0 | %    | 100.0 | %    | 100.0 | %  
|                 |               |       |      |       |      |       |    

2002 compared with 2001

Net Sales

Net sales decreased 53.0% to $7.8 million in 2002 from $16.7 million in 2001. The decrease in net sales is primarily due to the decline in sales of
SecureCom and other products, which are approaching end-of-life, coupled with a longer sales cycle related to our newer products. In addition, the severe worldwide economic
conditions in 2002 negatively impacted our sales of SecureNet network intrusion detection products and PDS security appliance products.

Export
sales in 2002 decreased to $2.6 million, or 33.4% of net sales, compared to $6.1 million, or 36.4% of net sales in 2001 primarily due to a continued economic decline
and decrease in technology spending.

23

---

Gross Profit

Gross profit decreased 47.2% to $1.7 million in 2002 from $3.2 million in 2001. As a percentage of net sales, gross profit increased to 21.5% for
2002 from 19.1% in 2001. This increase is primarily associated with a more profitable product mix in 2002.

Cost
of sales in 2002 includes a $1.0 million fourth quarter write-off of SecureCom inventory as demand has shifted to our new intrusion detection and security
appliance product lines. Absent of this write-off, gross profit would have been $2.7 million or 33.8% as a percentage of net sales.

Gross
profit as a percentage of net sales is impacted by several factors, including shifts in product mix, changes in channels of distribution, sales volume, fluctuations in
manufacturing costs, pricing strategies, and fluctuations in sales of integrated third-party products.

Sales and Marketing

Sales and marketing expenses decreased 50.0% to $11.8 million in 2002 from $23.6 million in 2001 as we restructured our sales force, including
headcount reductions, to respond to the decline in sales. As a percentage of net sales, sales and marketing expenses increased to 150.5% in 2002 from 141.1% in 2001. We expect sales and marketing
expenses to decrease in 2003 compared to 2002 as we recognize the full benefit from restructuring actions taken throughout 2002 and early 2003. We also expect sales and marketing expenses, as a
percentage of net sales, to decrease in 2003 compared to 2002.

Research and Development

Research and development expenses decreased 51.5% to $6.1 million, or 77.7% of net sales, in 2002 compared to $12.5 million, or 75.2% of net sales,
in 2001 as we reduced headcount in our engineering department to respond to the decline in sales and eliminated engineering efforts with regards to our SecureCom product family. Our research and
development costs are expensed in the period in which they are incurred. We expect research and development expenses to decrease in 2003 compared to 2002 as we recognize the full benefit from
restructuring actions taken throughout 2002 and early in 2003. In addition, the lease agreement for the R&D facility in San Diego, California was renewed in September 2002 at a lower monthly
rate for fewer square feet to accommodate the reduction in the R&D workforce. We expect research and development, as a percentage of net sales, to decrease in 2003 compared to 2002.

General and Administrative

General and administrative expenses, excluding amortization expenses, decreased 42.5% to $2.6 million in 2002 from $4.5 million in 2001 as we
reduced headcount in our support functions to reduce costs. As a percentage of net sales, general and administrative expenses increased to 32.9% in 2002 from 26.9% in 2001. We expect general and
administration expenses to decrease in 2003 compared to 2002 as we recognize the full benefit of restructuring actions taken throughout 2002 and early in 2003. In addition to the restructuring impact,
amortization expense of $0.8 million incurred in 2002 related to the intangible assets that were written off in December 2002 will not be incurred in 2003.

Amortization and Impairment of Intangibles

Amortization of intangibles decreased 35.3% to $0.8 million in 2002 from approximately $1.2 million in 2001, due to the adoption of SFAS
No. 142 whereby goodwill was not amortized throughout the year. We took an impairment charge during December 2002 to write all intangible assets related to the Mimestar acquisition down
to zero as a result of our annual SFAS 142 goodwill impairment test and other impairment reviews conducted during the fourth quarter. The total charge

24

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for the write-down was $3.0 million. Total amortization and charges for impairment was $3.8 million for 2002.

Restructuring Costs

Demand continued to shift to our new intrusion detection and security appliance product lines during 2002, and as such, we streamlined operations and activities
that are not aligned with these core markets and strategies. We recorded restructuring charges of $0.2 million for severance as a result of reductions in force. All severance obligations
related to the 2002 restructuring charge were paid prior to December 31, 2002 and we were not receiving any benefits from those severed individuals after December 31, 2002.

Pursuant
to the restructuring action discussed above and those taken in 2001, we reduced operating expenses, excluding restructuring charges and amortization, 37.3% from
$6.5 million in the first quarter of 2002 to $4.1 million in the fourth quarter of 2002. Comparing first quarter 2002 to fourth quarter 2002 operating expense categories, sales and
marketing reduced 44.1% from $3.9 million to $2.2 million, research and development reduced 29.4% from $1.9 million to $1.3 million and general and administrative reduced
21.0% from $0.7 million to $0.6 million, respectively.

Interest Income, Net

Net interest income decreased 79.2% to $0.4 million in 2002 from $1.7 million in 2001 primarily due to a decrease in average cash and
interest-bearing investment balances and lower interest rates. We expect net interest income to decrease in 2003 compared to 2002 as we expect our average cash and interest-bearing investment balances
to decline for 2003 when compared to 2002. In addition, we expect interest rates to remain low, resulting in a lower return on investment. Net interest income will vary in the future based on our cash
flow and rate of return on investments.

Income Taxes

Our effective income tax rate was a benefit of 2.9% in 2002 compared to an income tax benefit of 4.8% in 2001. We have fully utilized our net operating loss
carryback.

2001 compared with 2000

Net Sales

Net sales decreased 28.1% to $16.7 million in 2001 from $23.2 million in 2000. The decrease in net sales is primarily due to the fact that the
decline in our maturing SecureCom product line was greater than the growth in our more recently introduced product lines, SecureNet Pro and our PDS appliances. In addition, the economic decline in
technology spending for large enterprise and federal customers during 2001 contributed to the decrease in our net sales for the period.

Export
sales in 2001 increased to $6.1 million, or 36.4% of net sales, compared to $4.5 million, or 19.2% of net sales in 2000 primarily due to greater international
acceptance of our security products.

Sales
to iGov.com in 2001 and 2000 were 5.4% and 14.2%, respectively of net sales. Sales to TRW in 2001 and 2000 were 7.9% and 24.1%, respectively of net sales. In addition, a portion of
our sales to iGov.com, TRW and other corporations were resold by those organizations to various agencies of the U.S. government.

Gross Profit

Gross profit decreased 23.9% to $3.2 million in 2001 from $4.2 million in 2000. As a percentage of net sales, gross profit increased to 19.1% for
2001 from 18.1% in 2000. This increase is primarily

25

---

associated to a decrease in our operations infrastructure spending, which includes operations management, supply chain management, purchasing, quality, order entry, planning and other related
functions.

Cost
of Sales in 2001 includes a $1.3 million second quarter write-off of SecureCom inventory as demand has shifted to our new intrusion detection and security
appliance product lines. Absent this write-off, gross profit would have been $4.5 million or 27.2% as a percentage of net sales.

Gross
profit as a percentage of net sales is impacted by several factors, including shifts in product mix, changes in channels of distribution, sales volume, fluctuations in
manufacturing costs, pricing strategies, and fluctuations in sales of integrated third-party products.

Sales and Marketing

Sales and marketing expenses decreased 15.1% to $23.6 million in 2001 from $27.7 million in 2000 as we restructured our sales force, including
headcount reductions, to accommodate the decline in information technology spending. As a percentage of net sales, sales and marketing expenses increased to 141.1% in 2001 from 119.5% in 2000. We
expect sales and marketing expenses to decrease in 2002 compared to 2001 as we recognize the full benefit from restructuring actions taken throughout 2001. We also expect sales and marketing expenses,
as a percentage of net sales, to decrease in 2002 compared to 2001.

Research and Development

Research and development expenses decreased 4.0% to $12.5 million, or 75.2% of net sales, in 2001 compared to $13.1 million, or 56.3% of net sales,
in 2000 as we reduced headcount in our engineering department to accommodate the decline in information technology spending and eliminated engineering efforts with regards to our SecureCom product
family. Our research and development costs are expensed in the period in which they are incurred. We expect research and development expenses to decrease in 2002 compared to 2001 as we recognize the
full benefit from restructuring actions taken throughout 2001. The Company expects research and development, as a percentage of net sales, to decrease in 2002 compared to 2001.

General and Administrative

General and administrative expenses, excluding amortization expenses, decreased 23.6% to $4.5 million in 2001 from $5.9 million in 2000 as we
reduced headcount in our support functions to reduce costs. As a percentage of net sales, general and administrative expenses increased to 26.9% in 2001 from 25.3% in 2000. We expect general and
administration expenses to decrease in 2002 compared to 2001 as we recognize the full benefit of restructuring actions taken throughout 2001.

Amortization of Intangibles

Amortization of intangibles increased 26.5% to $1.2 million in 2001 from approximately $1.0 million in 2000, due to the acquisition of MimeStar in
June 2000. Amortization expense in 2001 reflects a full year amortization of MimeStar intangibles. Absent any acquisitions or impairment of MimeStar intangibles, we expect amortization of
intangibles to be $0.8 million in 2002.

Restructuring Costs

Demand continued to shift to our new intrusion detection and security appliance product lines during 2001, and as such, we streamlined operations and activities
that are not aligned with these core markets and strategies. This shift in demand resulted in a charge of $3.1 million to recognize the impairment of intangible assets (primarily developed
technology) related to our SecurityAnalyst and

26

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SecureEnterprise product lines. We also recorded restructuring charges of $1.3 million for severance as a result of reductions in force affecting 150 employees and $0.2 million for
early termination of excess lease space. Substantially all severance obligations and the lease termination payment were paid prior to December 31, 2001.

Pursuant
to these restructuring actions, we reduced operating expenses, excluding restructuring charges and amortization, 48.4% from $14.1 million in the first quarter of 2001 to
$7.3 million in the fourth quarter of 2001. Comparing first quarter 2001 to fourth quarter 2001 operating expense categories, sales and marketing reduced 44.7% from $8.0 million to
$4.4 million, research and development reduced 51.5% from $4.3 million to $2.1 million and general and administrative reduced 57% from $1.8 million to $0.8 million,
respectively. We expect operating expenses, excluding amortization and any additional restructuring charges, to be less than $7.0 million in the first quarter of 2002.

Interest Income, Net

Net interest income decreased 48.9% to $1.7 million in 2001 from $3.3 million in 2000 primarily due to a decrease in average cash and
interest-bearing investment balances. As a percentage of net sales, net interest income was 10.1% and 14.2% in 2001 and 2000, respectively. We expect net interest income to decrease in 2002 compared
to 2001 as we expect our average cash and interest-bearing investment balances to decline for 2002 when compared to 2001. Net interest income will vary in the future based on our cash flow and rate of
return on investments.

Other Income

Other income decreased 99.8% to $0.1 million in 2001 from $66.3 million in 2000 primarily due to the sale of Alteon stock in the first quarter of
2000, resulting in gross proceeds of $67.1 million.

Income Taxes

Our effective income tax rate was a benefit of 4.8% in 2001 compared to an income tax rate of 7.6% in 2000. We were able to carry back our 2001 net operating loss
to 2000 and expect to recover $2.8 million of income taxes, which we expect to receive by June 30, 2002. We also incurred a $475 thousand foreign tax expense related to the sale
of the LAN business. These two items were the primary contributors to a $1.8 million tax benefit for 2001. See Note 9 of the Notes to Consolidated Financial Statements.

Liquidity and Capital Resources

Our principal sources of liquidity at December 31, 2002 were $2.9 million of cash and cash equivalents and $7.8 million of
short-term investments. As of December 31, 2002, we do not hold investments with a stated maturity beyond one year. Working capital at December 31, 2002 was
$10.7 million compared to $25.2 million as of December 31, 2001.

Net
cash used in continuing operations in 2002 was $9.9 million, primarily due to an operating loss for the year, a decrease in accounts payable and accrued expenses, offset by
depreciation and amortization (including the impairment charge on intangibles), a decrease in accounts receivable and inventories (including the obsolescence charge). Future fluctuations in accounts
receivable, inventory balances and accounts payable will be dependent upon several factors, including but not limited to quarterly sales, timely collection of accounts receivable, and the accuracy of
our forecasts of product demand and component requirements.

During
2002, our cash, cash equivalents and investments declined $9.7 million from $20.4 million on December 31, 2001 to $10.7 million on December 31,
2002. During 2002 we implemented various

27

---

cost reduction programs reducing operating expenses, excluding these restructuring and cost reductions, from $6.5 million in the first quarter of 2002 to $4.1 million in the fourth
quarter of 2002. Based on our current expectations, the Company will incur operating losses and further usage of cash resources during 2003, although at a significantly reduced rate when compared to
2002.

Net
cash used by investing activities of continuing operations in 2002 was $3.3 million, which consisted of the net purchase of $3.1 million of available for sale
securities and the net purchase of property and equipment of $0.2 million.

Net
cash provided by financing activities of continuing operations in 2002 was $0.1 million as a result of the issuance of common stock upon the exercise of employee stock options
and issuance of shares as a result of the ESPP.

Net
cash provided by discontinued operations in 2002 was $0.1 million, which consisted primarily of a reduction in the lease obligation related to Essential.

At
December 31, 2002, we did not have any material commitments for capital expenditures. Operating lease commitments of $2.0 million are detailed below. During 2002, we
funded our operations through the use of available cash, cash equivalents and investments.

Although
we believe we have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months, the sufficiency of our cash resources may
depend to a certain extent on general economic, financial, competitive or other factors beyond our control. Moreover, despite actions to reduce our costs and improve our profitability, we expect our
operating losses and net operating cash outflows to continue during 2003. As a result, we may not be able to achieve the revenue and gross margin objectives necessary to achieve positive cash flow or
profitability without obtaining additional financing. We do not currently have any arrangements for financing as we believe our cash flows are sufficient for the next twelve months, and we may not be
able to secure additional debt or equity financing on terms acceptable to us, or at all, at the time when we need such funding. If our business does not generate sufficient cash flow from operations
and sufficient future financings are not available, we may not be able to operate or grow our business, pay our expenses when due or fund our other liquidity needs.

We
intend to explore the possible acquisitions of businesses, products and technologies that are complementary to our existing business. We are continuing to identify and prioritize
additional security
technologies, which we may wish to develop, either internally or through the licensing or acquisition of products from third parties. While we engage from time to time in discussions with respect to
potential acquisitions, there can be no assurances that any such acquisitions will be made or that we will be able to successfully integrate any acquired business. In order to finance such
acquisitions, it may be necessary for us to raise additional funds through public or private financings. Any equity or debt financings, if available at all, may be on terms, which are not favorable to
us and, in the case of equity financings, may result in dilution to our stockholders.

The
following table sets forth certain information concerning our contractual obligations at December 31, 2002 and outlines the expected future payments to be made under such
obligations and commitments.

Future minimum lease payments consisted of the following on December 31, 2002 (in thousands):2003

$
9952004


8822005


1412006 and thereafter


$
2,018


28

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New Accounting Pronouncements

In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities," ("SFAS 146"). SFAS 146
addresses financial accounting and reporting for costs associated with exit or disposal activities, such as restructurings, involuntarily terminating employees and consolidating facilities.
SFAS 146 excludes from its scope exit and disposal activities conducted in connection with a business combination and those activities to which SFAS Nos. 143 and 144 are applicable.
SFAS 146 is effective for exit and disposal activities that are initiated after December 31, 2002. We do not expect the adoption of this statement to have a material effect on our
consolidated financial position or results of operations.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

Foreign Exchange. Our revenue originating outside the U.S. in 2002, 2001 and 2000 was 33.4%, 36.4% and 19.2% of total revenues, respectively. Revenues generated
from the European region in 2002, 2001 and 2000 were 14.5%, 25.4% and 7.6% of total revenues, respectively. Revenues generated from the Asia region in 2002, 2001 and 2000 were 14.6% 6.3% and 7.4% of
total revenues, respectively. International sales are generated primarily from our foreign sales subsidiaries in the local countries and are typically denominated in U.S. dollars. These subsidiaries
incur substantially all of their expenses in the local currency.

Our
international business is subject to risks typical of an international business, including, but not limited to: differing economic conditions, changes in political climate, differing
tax structures, import and export regulations, other regulations and restrictions, and foreign exchange rate volatility. Accordingly, our results could be materially adversely impacted by changes in
these or other factors. The effect of foreign exchange rate fluctuations on our business in 2002, 2001 and 2000 was not material.

Interest
Rates. We invest our cash in a variety of investment grade financial instruments, including bank time deposits, fixed rate obligations of corporations, municipalities, and state
and national governmental entities and agencies. These investments are denominated in U.S. dollars. Cash balances in foreign currencies overseas are operating balances and are invested in
short-term time deposits of the local operating bank.

Interest
income on our investments is carried in "Interest income, net". We account for our investment instruments in accordance with Statement of Financial Accounting Standards
No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). All of the cash equivalents and short-term investments are treated as
available-for-sale under SFAS 115.

Investments
in fixed rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in
interest rates. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell
securities, which have seen a decline in market value due to changes in interest rates. Our investment securities are held for purposes other than trading. The weighted-average interest rate on
investment securities at December 31, 2002 was 6.5%. The fair value of investments held at December 31, 2002 approximated amortized cost.

Item 8. Financial Statements and Supplementary Data.

The information required by this item is included in Part IV Item 15(a)(1 and 2).

Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.

Not applicable.

29

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PART III

Certain information required by Part III is omitted from this Form 10-K because we will file a definitive Proxy Statement for our
2003 annual meeting of stockholders pursuant to Regulation 14A (the "Proxy Statement") no later than 120 days after the end of the fiscal year covered by this
Form 10-K, and certain information to be included therein is incorporated herein by reference.

Item 10. Directors and Executive Officers of Intrusion Inc..

The information regarding Directors and Executive Officers of Intrusion Inc. appearing under the captions "Election of Directors", "Compliance with
Section 16 Reporting Requirements" and "Executive Officers" contained in the Proxy Statement is incorporated herein by reference.

Item 11. Executive Compensation.

The information set forth under the caption "Executive Compensation" contained in the Proxy Statement is incorporated herein by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management.

The information set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" contained in the Proxy Statement is incorporated
herein by reference.

Item 13. Certain Relationships and Related Transactions.

The information set forth under "Certain Transactions with Management" contained in the Proxy Statement is incorporated herein by reference.

Item 14. Controls and Procedures



PART IV

Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.



30

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Page No.Report of Independent Auditors

F-1Consolidated Balance Sheets at December 31, 2002 and 2001

F-2Consolidated Statements of Operations for the years ended December 31, 2002, 2001 and 2000

F-3Consolidated Statements of Stockholders' Equity for the years ended December 31, 2002, 2001 and 2000

F-4Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000.

F-5Notes to Consolidated Financial Statements

F-6




Page No.ScheduleIIValuation and Qualifying Accounts

S-1


All
other schedules are omitted because they are either not required or not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto.





The
following Exhibits are filed herewith pursuant to Item 601 of Regulation S-K or incorporated herein by reference to previous filings as noted:

|Exhibit
Number |     | Description of Exhibit                                                                                                      
|-------------- | --- | ----------------------------------------------------------------------------------------------------------------------------
|2.1            | (6) | Certificate of Ownership and Merger Merging Intrusion.com, Inc. into Intrusion Inc.                                         
|3.1            | (6) | Amended and Restated Certificate of Incorporation of the Registrant.                                                        
|3.2            | (5) | Bylaws of the Registrant.                                                                                                   
|4.1            | (5) | Specimen Common Stock Certificate.                                                                                          
|10.1           | (1) | Lease Agreement, dated September 12, 1989, between G.D.A.F. Associates and the Registrant for the Registrant's headquarters.
|10.2           | (1) | 1983 Incentive Stock Option Plan of the Registrant, as amended.                                                             
|10.3           | (1) | 1987 Incentive Stock Option Plan of the Registrant, as amended.                                                             
|10.4           | (1) | Form of Indemnification Agreement.                                                                                          
|10.5           | (6) | 1995 Stock Option Plan of the Registrant as amended April 26, 2001.                                                         
|10.6           | (2) | 1995 Non-Employee Directors Stock Option Plan of the Registrant (amended and restated as of January 10, 2002).              

31

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|10.7  | (3) | Supplemental Lease Agreement, dated March 7, 1995, between G.D.A.F. Assoc., subsequently assigned to CIIF Assoc. II Limited Partnership, Landlord, and the Registrant, as Tenant, relative to the Registrant's
headquarters.
|----- | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.8  | (4) | Registration Rights Agreement, dated as of September 25, 1998, by and between the Registrant and Science Applications International Corporation.                                                                            
|10.9  | (4) | Stockholder and Voting Agreement, dated as of September 25, 1998, by and among Science Applications International Corporation, the Registrant and certain stockholders of the Registrant.                                   
|10.10 | (4) | Strategic Alliance Agreement, dated as of September 25, 1998, by and between Science Applications International Corporation and the Registrant.                                                                             
|10.11 | (4) | Software Royalty, Grant Back and Improvements License Agreement, dated as of September 25, 1998, by and between Science Applications International Corporation and the Registrant.                                          
|10.12 | (4) | PartnersPlus Agreement, dated September 25, 1998, by and between the Registrant and Science Applications International Corporation.                                                                                         
|10.13 | (5) | Amended and Restated 401(k) Savings Plan of the Registrant.                                                                                                                                                                 
|10.14 | (5) | 1997 Employee Stock Purchase Plan of the Registrant, as amended January 17, 2001.                                                                                                                                           
|10.15 | (6) | Resignation Agreement and General Release dated November 28, 2001 with Timothy W. Kinnear.                                                                                                                                  
|10.17 | (7) | Intrusion Inc. 401(k) Savings Plan Summary of Material Modifications.                                                                                                                                                       
|21    | (6) | List of Subsidiaries of Registrant                                                                                                                                                                                          
|23    | (8) | Consent of Independent Auditors.                                                                                                                                                                                            

---

32

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

|Dated: March 11, 2003 |  | INTRUSION INC.(Registrant)
|--------------------- |  | --------------------------
|                      |  | By:                       

Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on
the dates indicated.

|Signature                               |  | Title                                                                                                         |  | Date          
|--------------------------------------- |  | ------------------------------------------------------------------------------------------------------------- |  | --------------
|                                        |  |                                                                                                               |  |               
|/s/G. WARD PAXTONG. Ward Paxton         |  | Chairman, President,
Chief Executive Officer, and Director                                                    |  | March 11, 2003
|/s/T. JOE HEADT. Joe Head               |  | Vice Chairman, Vice President
and Director                                                                    |  | March 11, 2003
|/s/MICHAEL L. PAXTONMichael L. Paxton   |  | Vice President, Chief Financial
Officer, Treasurer and Secretary
(Principal Financial and Accounting Officer) |  | March 11, 2003
|/s/JAMES P. BUCHANANJames P. Buchanan   |  | Director                                                                                                      |  | March 11, 2003
|/s/J. FRED BUCYJ. Fred Bucy             |  | Director                                                                                                      |  | March 11, 2003
|/s/DONALD M. JOHNSTONDonald M. Johnston |  | Director                                                                                                      |  | March 11, 2003
|/s/GRANT A. DOVEGrant A. Dove           |  | Director                                                                                                      |  | March 11, 2003

33

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CERTIFICATION

I,
G. Ward Paxton, certify that:



|Date: March 11, 2003 |  | By: /s/G. WARD PAXTONG. Ward Paxton
        Chairman and Chief Executive Officer
|-------------------- |  | --------------------------------------------------------------------------------

34

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CERTIFICATION

I,
Michael L. Paxton, certify that:



|Date: March 11, 2003 |  | By: /s/MICHAEL L. PAXTONMichael L. Paxton
        Vice President, Chief Financial Officer,
        Treasurer and Secretary
|-------------------- |  | --------------------------------------------------------------------------------------------------------------------------

35

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ANNUAL REPORT ON FORM 10-K
ITEM 15(a)(1)
FINANCIAL STATEMENTS
YEAR ENDED DECEMBER 31, 2002
INTRUSION INC.
RICHARDSON, TEXAS

---

REPORT OF INDEPENDENT AUDITORS

The
Board of Directors and Stockholders
Intrusion Inc.

We
have audited the accompanying consolidated balance sheets of Intrusion Inc. and subsidiaries (the "Company") as of December 31, 2002 and 2001, and the related
consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement
schedule included in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

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

In
our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Intrusion Inc. and subsidiaries at
December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with
accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a
whole, presents fairly in all material respects the information set forth therein.

As
discussed in Note 2 to the consolidated financial statements, effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142,
"Goodwill and other Intangible Assets."

LOGO

Dallas,
Texas
January 28, 2003

F-1

---



INTRUSION INC. AND SUBSIDIARIES        CONSOLIDATED BALANCE SHEETS        (In thousands, except par value amounts)

|                                                    |                                                                                                                                                              | December 31, |       
|--------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------ | ------
|
|Assets                                              |                                                                                                                                                              |              |       
|Current Assets:                                     |                                                                                                                                                              |              |       
|                                                    | Cash and cash equivalents                                                                                                                                    |              | $     
|                                                    | Short-term investments                                                                                                                                       |              |       
|                                                    | Accounts receivable, net of allowance for doubtful accounts and returns of $934 in 2002 and $797 in 2001                                                     |              |       
|                                                    | Income tax receivable                                                                                                                                        |              |       
|                                                    | Inventories                                                                                                                                                  |              |       
|                                                    | Other current assets                                                                                                                                         |              |       
|                                                    |                                                                                                                                                              |              |       
|Total current assets                                |                                                                                                                                                              |              | 15,256
|Property and Equipment:                             |                                                                                                                                                              |              |       
|                                                    | Machinery and equipment                                                                                                                                      |              |       
|                                                    | Furniture and fixtures                                                                                                                                       |              |       
|                                                    | Leasehold improvements                                                                                                                                       |              |       
|                                                    |                                                                                                                                                              |              |       
|                                                    |                                                                                                                                                              |              | 13,284
|                                                    | Accumulated depreciation                                                                                                                                     |              |       
|                                                    |                                                                                                                                                              |              |       
|                                                    |                                                                                                                                                              |              | 1,597 
|Goodwill and intangible assets, net                 |                                                                                                                                                              |              |      
|Other assets                                        |                                                                                                                                                              |              | 86    
|Net non-current assets from discontinued operations |                                                                                                                                                              |              |      
|                                                    |                                                                                                                                                              |              |       
|TOTAL ASSETS                                        |                                                                                                                                                              | $            | 16,939
|                                                    |                                                                                                                                                              |              |       
|Liabilities and Stockholders' Equity                |                                                                                                                                                              |              |       
|Current Liabilities:                                |                                                                                                                                                              |              |       
|                                                    | Accounts payable and accrued expenses                                                                                                                        |              | $     
|                                                    | Deferred revenue                                                                                                                                             |              |       
|                                                    | Current liabilitiesdiscontinued operations                                                                                                                  |              |       
|                                                    |                                                                                                                                                              |              |       
|Total current liabilities                           |                                                                                                                                                              |              | 4,555 
|                                                    |                                                                                                                                                              |              |       
|TOTAL LIABILITIES                                   |                                                                                                                                                              |              | 4,555 
|Commitments and contingencies                       |                                                                                                                                                              |              |      
|Stockholders' Equity:                               |                                                                                                                                                              |              |       
|                                                    | Preferred stock, $0.01 par value:
Authorized shares5,000
No shares issued and outstanding                                                                   |              |       
|                                                    | Common stock, $0.01 par value:
Authorized shares80,000
Issued shares20,686 in 2002 and 20,649 in 2001
Outstanding shares20,646 in 2002 and 20,609 in 2001 |              |       
|                                                    | Additional paid-in-capital                                                                                                                                   |              |       
|                                                    | Common stock held in treasury, at cost40 shares                                                                                                             |              |       
|                                                    | Accumulated deficit                                                                                                                                          |              |       
|                                                    | Accumulated other comprehensive loss                                                                                                                         |              |       
|                                                    |                                                                                                                                                              |              |       
|Total stockholders' equity                          |                                                                                                                                                              |              | 12,384
|                                                    |                                                                                                                                                              |              |       
|TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY          |                                                                                                                                                              | $            | 16,939
|                                                    |                                                                                                                                                              |              |       

See accompanying notes.

F-2

---



INTRUSION INC. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF OPERATIONS        (In thousands, except per share amounts)

|                                                           |                             | Year Ended December 31, |        
|---------------------------------------------------------- | --------------------------- | ----------------------- | -------
|
|Net sales                                                  |                             | $                       | 7,834  
|Cost of sales                                              |                             |                         | 6,147  
|                                                           |                             |                         |        
|Gross profit                                               |                             |                         | 1,687  
|Operating expenses:                                        |                             |                         |        
|                                                           | Sales and marketing         |                         |        
|                                                           | Research and development    |                         |        
|                                                           | General and administrative  |                         |        
|                                                           | Amortization of intangibles |                         |        
|                                                           | Impairment of intangibles   |                         |        
|                                                           | Restructuring costs         |                         |        
|                                                           |                             |                         |        
|Operating loss                                             |                             |                         | (22,773
|Interest income, net                                       |                             |                         | 351    
|Other income (expense)                                     |                             |                         | (7     
|                                                           |                             |                         |        
|Income (loss) from continuing operations before income tax |                             |                         | (22,429
|Income tax provision (benefit)                             |                             |                         | (608   
|                                                           |                             |                         |        
|Income (loss) from continuing operations                   |                             |                         | (21,821
|Income (loss) from discontinued operations, net of tax     |                             |                         | 544    
|                                                           |                             |                         |        
|Net income (loss)                                          |                             | $                       | (21,277
|                                                           |                             |                         |        
|Basic earnings (loss) per share, continuing operations     |                             | $                       | (1.06  
|                                                           |                             |                         |        
|Diluted earnings (loss) per share, continuing operations   |                             | $                       | (1.06  
|                                                           |                             |                         |        
|Basic earnings (loss) per share                            |                             | $                       | (1.03  
|                                                           |                             |                         |        
|Diluted earnings (loss) per share                          |                             | $                       | (1.03  
|                                                           |                             |                         |        
|Weighted average shares outstanding                        |                             |                         |        
|                                                           | Basic                      |                         |        
|                                                           |                             |                         |        
|                                                           | Diluted                    |                         |        
|                                                           |                             |                         |        

See accompanying notes.

F-3

---



INTRUSION INC. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY        (In thousands)

|YEAR ENDED DECEMBER 31,                 |                                                                           | 2002 |         | 2001    |   | 2000    |        
|--------------------------------------- | ------------------------------------------------------------------------- | ---- | ------- | ------- | - | ------- | -------
|NUMBER OF SHARESISSUED                 |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      |         | 20,649  |   |         | 20,525 
|                                        | Issuance of common stock under warrants, stock options and purchase plans |      |         | 37      |   |         | 124    
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      |         | 20,686  |   |         | 20,649 
|                                        |                                                                           |      |         |         |   |         |        
|NUMBER OF SHARESOUTSTANDING            |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      |         | 20,609  |   |         | 20,485 
|                                        | Issuance of common stock under warrants, stock options and purchase plans |      |         | 37      |   |         | 124    
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      |         | 20,646  |   |         | 20,609 
|                                        |                                                                           |      |         |         |   |         |        
|COMMON STOCK                            |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      | $       | 206     |   | $       | 205    
|                                        | Issuance of common stock under warrants, stock options and purchase plans |      |         | 1       |   |         | 1      
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      | $       | 207     |   | $       | 206    
|                                        |                                                                           |      |         |         |   |         |        
|ADDITIONAL PAID-IN-CAPITAL              |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      | $       | 47,320  |   | $       | 46,916 
|                                        | Issuance of common stock under warrants, stock options and purchase plans |      |         | 51      |   |         | 396    
|                                        | Issuance of common stock for MimeStar acquisition                         |      |         |        |   |         |       
|                                        | Tax benefit derived from exercise of employee stock options               |      |         |        |   |         | 8      
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      | $       | 47,371  |   | $       | 47,320 
|                                        |                                                                           |      |         |         |   |         |        
|TREASURY SHARES                         |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      | $       | (362    | ) | $       | (362   
|                                        | Purchase of treasury shares                                               |      |         |        |   |         |       
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      | $       | (362    | ) | $       | (362   
|                                        |                                                                           |      |         |         |   |         |        
|ACCUMULATED OTHER COMPREHENSIVE LOSS    |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      | $       | (339    | ) | $       | (425   
|                                        | Foreign currency translation adjustment (a)                               |      |         | 111     |   |         | 86     
|                                        | Unrealized gain from securities available for sale (b)                    |      |         |        |   |         |       
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      | $       | (228    | ) | $       | (339   
|                                        |                                                                           |      |         |         |   |         |        
|NOTE RECEIVABLE FROM STOCKHOLDER        |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      | $       |        |   | $       |       
|                                        | Repayments on stockholder loan                                            |      |         |        |   |         |       
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      | $       |        |   | $       |       
|                                        |                                                                           |      |         |         |   |         |        
|RETAINED EARNINGS (ACCUMULATED DEFICIT) |                                                                           |      |         |         |   |         |        
|                                        | Balance, beginning of year                                                |      | $       | (13,327 | ) | $       | 32,453 
|                                        | Net income (loss) (c)                                                     |      |         | (21,277 | ) |         | (45,780
|                                        |                                                                           |      |         |         |   |         |        
|                                        | Balance, end of year                                                      |      | $       | (34,604 | ) | $       | (13,327
|                                        |                                                                           |      |         |         |   |         |        
|TOTAL STOCKHOLDERS' EQUITY              |                                                                           | $    | 12,384  |         | $ | 33,498  |        
|                                        |                                                                           |      |         |         |   |         |        
|TOTAL COMPREHENSIVE LOSS (a+b+c)        |                                                                           | $    | (21,166 | )       | $ | (45,694 | )      
|                                        |                                                                           |      |         |         |   |         |        

See accompanying notes.

F-4

---



INTRUSION INC. AND SUBSIDIARIES        CONSOLIDATED STATEMENTS OF CASH FLOWS        (In thousands)

|                                                                               |                                                                                                             | Year Ended December 31, |                                             
|------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------------------------------- | ----------------------- | --------------------------------------------
|
|Operating Activities:                                                          |                                                                                                             |                         |                                             
|                                                                               | Income (loss) from continuing operations                                                                    |                         | $                                           
|                                                                               | Adjustments to reconcile income (loss) from continuing operations to net cash used in operating activities: |                         |                                             
|                                                                               |                                                                                                             |                         | Gain on sale of available for sale security 
|                                                                               |                                                                                                             |                         | Depreciation and amortization               
|                                                                               |                                                                                                             |                         | Impairment of intangible assets             
|                                                                               |                                                                                                             |                         | Deferred income tax (benefit) expense       
|                                                                               |                                                                                                             |                         | Changes in operating assets and liabilities:
|                                                                               |                                                                                                             |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|Net cash used in operating activities of continuing operations                 |                                                                                                             |                         | (9,870                                      
|Investing Activities:                                                          |                                                                                                             |                         |                                             
|                                                                               | Purchase of MimeStar, Inc.                                                                                  |                         |                                             
|                                                                               | Proceeds from sale of available for sale security                                                           |                         |                                             
|                                                                               | Purchases of available for sale investments                                                                 |                         |                                             
|                                                                               | Maturities of available for sale investments                                                                |                         |                                             
|                                                                               | Purchases of property and equipment                                                                         |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|Net cash provided by (used in) investing activities of continuing operations   |                                                                                                             |                         | (3,324                                      
|Financing Activities:                                                          |                                                                                                             |                         |                                             
|                                                                               | Note receivable secured by company's common stock                                                           |                         |                                             
|                                                                               | Exercise of warrants and employee stock options                                                             |                         |                                             
|                                                                               | Other                                                                                                       |                         |                                             
|                                                                               |                                                                                                             |                         |                                             
|Net cash provided by financing activities of continuing operations             |                                                                                                             |                         | 52                                          
|                                                                               |                                                                                                             |                         |                                             
|Net cash provided by (used in) discontinued operations                         |                                                                                                             |                         | 146                                         
|Effect of foreign currency translation adjustment on cash and cash equivalents |                                                                                                             |                         | 111                                         
|Net increase (decrease) in cash and cash equivalents                           |                                                                                                             |                         | (12,885                                     
|Cash and cash equivalents at beginning of period                               |                                                                                                             |                         | 15,783                                      
|                                                                               |                                                                                                             |                         |                                             
|Cash and cash equivalents at end of period                                     |                                                                                                             | $                       | 2,898                                       
|                                                                               |                                                                                                             |                         |                                             

See accompanying notes.

F-5

---



INTRUSION INC. AND SUBSIDIARIES        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Description of Business

We develop, market and support network intrusion detection systems and VPN/firewall appliances that address vital security issues facing organizations deploying
business applications over the Internet or internally via Intranets.

We
market and distribute our products through a direct sales force to end-users, distributors and by numerous domestic and international system integrators, managed service
providers and value-added resellers. Our end-user customers include manufacturing, high-technology, telecommunications, retail, transportation, health care, insurance,
entertainment, utilities and energy companies, government agencies, financial institutions, and academic institutions.

We
organized in Texas in September 1983 and reincorporated in Delaware in October 1995. For more than 15 years, we provided local area networking equipment and were
known as Optical Data Systems or ODS Networks. On April 17, 2000, we announced plans to sell, or otherwise dispose of, our networking divisions, which include our Essential Communications
Division ("Essential") and our local area networking assets. In accordance with these plans, we have accounted for these businesses as discontinued operations. On June 1, 2000, we changed our
name from ODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ ticker symbol from ODSI to INTZ to reflect our focus on intrusion detection solutions. On November 1, 2001, we
changed our name from Intrusion.com, Inc. to Intrusion Inc.

Our
principal executive offices are located at 1101 East Arapaho Road, Richardson, Texas 75081, and our telephone number is (972) 234-6400. References to "we", "us",
"our" or "Intrusion Inc." refer to Intrusion Inc. and its subsidiaries.

As
of December 31, 2002, we had cash, cash equivalents and short-term investments in the amount of approximately $10.7 million, down from approximately
$20.4 million as of December 31, 2001. Although we believe we have sufficient cash resources to finance our operations and expected capital expenditures for the next twelve months, the
sufficiency of our cash resources may depend to a certain extent on general economic, financial, competitive or other factors beyond our control. Moreover, despite actions to reduce our costs and
improve our profitability, we expect our operating losses and net operating cash outflows to continue during 2003. As a result, we may not be able to achieve the revenue and gross margin objectives
necessary to achieve positive cash flow or profitability without obtaining additional financing. We do not currently have any arrangements for financing as we believe that our cash flows are
sufficient for the next twelve months, and we may not be able to secure additional debt or equity financing on terms acceptable to us, or at all, at the time when we need such funding. If our business
does not generate sufficient cash flow from operations and sufficient future financings are not available, we may not be able to operate or grow our business, pay our expenses when due or fund our
other liquidity needs.

2. Summary of Significant Accounting Policies

Principles of Consolidation

The consolidated financial statements include the accounts of Intrusion Inc. and its wholly owned subsidiaries. Intercompany balances and transactions have
been eliminated in consolidation.

F-6

---

Cash and Cash Equivalents

Cash and all highly liquid investments purchased with an original maturity of less than three months as of the balance sheet date are considered to be cash and
cash equivalents.

Short-term Investments

Short-term investments consist of U.S. government obligations and corporate securities with maturities between 90 days and one year as of the
balance sheet date. Short-term investments are classified as
available for sale. These investments are valued at market value, which approximates amortized cost. The difference between fair market value and amortized cost is not material.

Risk Concentration

Financial instruments which potentially subject the Company to concentrations of credit risk are primarily cash and cash equivalents, investments and accounts
receivable. The Company places its investments in U.S. government obligations, corporate securities and money market funds. Substantially all of the Company's cash, cash equivalents and investments
are maintained with two major U.S. financial institutions.

We
sell our products to customers in diversified industries worldwide, primarily in North America, Europe, Asia and Latin America. Fluctuations in currency exchange rates and adverse
economic developments in foreign countries could adversely affect the Company's operating results. We perform ongoing credit evaluations of our customers' financial condition and generally require no
collateral. We maintain reserves for potential credit losses, and such losses, in the aggregate, have not exceeded management expectations.

While
we believe that many of the materials used in the production of our products are generally readily available from a variety of sources, certain components are available from one or
a limited number of suppliers. The inability of any supplier or manufacturer to fulfill supply requirements of the Company could impact future results.

Allowance for Doubtful Accounts and Returns

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We use specific
identification to determine the amount of the allowance required.

Inventories

Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in,
first-out basis. Management estimates the allowance required to state inventory at the lower of cost or market. There is a risk that we will forecast demand for our products and market
conditions incorrectly and produce excess inventories. Therefore, there can be no assurance that we will not produce excess inventory and incur inventory lower of cost or market charges in the future.

During
the fourth quarter of 2002 we performed a slow-moving and obsolete review of our inventory. During our review, we determined that the remaining inventory related to
the SecureCom

F-7

---

line of business should be completely reserved due to lack of sales and future prospects. As a result, we recorded a $1.0 million charge to write down the value of the SecureCom inventory
during December 2002.

Property and Equipment

Property and equipment is stated at cost less accumulated depreciation and is depreciated on a straight-line basis over the estimated useful lives of
the assets. Such lives vary from 3 to 20 years. Leasehold improvements are amortized over the shorter of their useful lives or the terms of the leases. Repair and maintenance costs are expensed
as incurred. Depreciation expense totaled approximately $2.2, $3.1 and $3.6 million for the years ended December 31, 2002, 2001 and 2000, respectively, and is included in depreciation
and amortization expense in the accompanying consolidated statement of operations.

Goodwill and Other Intangible Assets

Effective January 1, 2002, we adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 142 "Goodwill and Other Intangible
Assets" ("SFAS 142"), which requires companies to cease amortizing goodwill and certain intangible assets with indefinite useful lives. Instead, SFAS 142 requires that goodwill and
intangible assets deemed to have indefinite useful lives be reviewed for impairment upon adoption of SFAS 142, annually thereafter, and upon the occurrence of any event that indicates potential
impairments.

In
accordance with SFAS 142, we discontinued recording goodwill amortization effective January 1, 2002. Operating results, excluding the effect of amortization expense
related to goodwill, for the years ended December 31, 2002, 2001 and 2000 is as follows (in thousands, except per share data):

|                                             |                      | 2002 |         | 2001  |   | 2000   
|-------------------------------------------- | -------------------- | ---- | ------- | ----- | - | -------
|Net income (loss)                            |                      | $    | (21,277 | )     | $ | (45,780
|Add back: Goodwill amortization net of taxes |                      |      |        |       |   | 578    
|                                             |                      |      |         |       |   |        
|Pro forma net income (loss)                  |                      | $    | (21,277 | )     | $ | (45,202
|                                             |                      |      |         |       |   |        
|Net income (loss) per share:                 |                      |      |         |       |   |        
|                                             | Basic, as reported   |      | $       | (1.03 | ) | $      
|                                             | Basic, pro forma     |      | $       | (1.03 | ) | $      
|                                             | Diluted, as reported |      | $       | (1.03 | ) | $      
|                                             | Diluted, pro forma   |      | $       | (1.03 | ) | $      

SFAS 142
prescribes a two-phase process for impairment testing of goodwill. The first phase screens for potential impairment, while the second phase
(if necessary) measures the impairment. Goodwill is potentially impaired if the net book value of a reporting unit exceeds its estimated fair value. We have determined that we have one reporting unit.
This methodology differs from the Company's previous policy, as permitted under accounting standards existing at that time, of using undiscounted cash flows on an enterprise-wide basis to
determine if goodwill is recoverable.

F-8

---

The
Company elected to perform its annual impairment review during the fourth quarter of each year, commencing in the fourth quarter of 2002. In connection with our annual impairment
review, we determined that the value of goodwill was impaired. At the time of our impairment review, the remaining goodwill of $0.4 million was associated with the MimeStar purchase transaction
(see Note 3). Based on the decline in the market value of the Company as indicated by the decline in its stock price over the last year, it was determined that the goodwill carrying value
should be zero at December 31, 2002. Therefore, an impairment charge of $0.4 million was recorded and is included in impairment of intangibles in the accompanying consolidated statement
of operations.

Long-Lived Assets

Effective January 1, 2002, we adopted the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("SFAS 144"), which supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," ("SFAS 121")
and accounting and reporting provisions of Accounting Principles Bulletin Opinion 30, "Reporting the Results of Operations," for a disposal of a segment. The primary objective of
SFAS 144 is to develop one accounting model based on the framework established in SFAS 121 for long-lived assets to be disposed of and significantly changes the criteria that
would have to be met to classify an asset as held for sale. SFAS 144 also requires expected future operating losses from discontinued operations to be displayed in the period(s) in which the
losses are incurred, rather than as of the measurement date. Our adoption of SFAS 144 had no effect on the Company's financial position for results of operations.

We
review long-lived assets, other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be
recoverable. Conditions that would necessitate an impairment assessment include material adverse changes in operations, significant adverse differences in actual results in comparison with initial
valuation forecasts prepared at the time of acquisition, a decision to abandon acquired products, services or technologies, or other significant adverse changes that would indicate the carrying amount
of the recorded asset might not be recoverable. Recoverability of assets held and used is measured by a comparison of the carrying amount of an asset to undiscounted pre tax future net cash flows
expected to be generated by that asset. An impairment loss is recognized for the amount by which the carrying amount of the assets exceeds the fair value of the assets. Long-lived assets
held for sale are reported at the lower of cost or fair value less costs to sell.

As
a result of the write-off of goodwill during the fourth quarter of 2002, we determined that a triggering event indicating potential impairment of the associated
intangibles had occurred. At December 31, 2002, the remaining intangibles of $2.6 million principally included purchased software associated with the MimeStar purchase transaction (see
Note 3). We determined that the undiscounted pre tax cash flows associated with this software was not likely to exceed the remaining carrying value. Due to technological changes that had taken
place with respect to the core software code acquired, it was determined that the carrying value should be zero at December 31, 2002. Therefore, an impairment charge of $2.6 million was
recorded and is included in impairment of intangibles in the accompanying consolidated statement of operations.

F-9

---

Foreign Currency Translation

Our international subsidiaries use their local currencies as their functional currencies. Assets and liabilities are translated at the exchange rate in effect at
the balance sheet date, and income and expense accounts at average exchange rates during the year. Resulting translation adjustments are recorded directly to accumulated other comprehensive income
(loss).

Accounting for Stock Options

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure" ("SFAS 148").
SFAS 148 amends FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), to provide alternative methods of transition to SFAS 123's fair value method
of accounting for stock-based employee compensation.

SFAS 148
also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, "Interim Financial Reporting," to require disclosure in the summary of significant
accounting policies of the effects of an entity's accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial
statements. While SFAS 148 does not amend SFAS 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of SFAS 148
are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of SFAS 123 or the intrinsic value
method of APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Under APB 25, if the exercise price of an employee's stock option equals or exceeds the market
price of the underlying stock on the date of grant, no compensation expense is recognized. As allowed by SFAS 123, the Company has elected to continue to utilize the accounting method
prescribed by APB 25 and has adopted the disclosure requirements of SFAS 123 and SFAS 148 as of December 31, 2002.

The
following table summarizes relevant information as to the reported results under our intrinsic value method of accounting for stock awards, with supplemental information as if the
fair value

F-10

---

recognition provision of SFAS 123 had been applied for the years ended December 31, 2002, 2001 and 2000 (in thousands, except per share data):

2002

2001

2000Net income (loss), as reported

$
(21,277
)
$
(45,780
)
$
23,211Deduct: Total stock-based compensation determined under fair value-based method for all awards


667


1,897


2,700Pro forma net income (loss)

$
(21,944
)
$
(47,677
)
$
20,511Net income (loss) per share:Basic, as reported

$
(1.03
)
$
(2.23
)
$
1.18Basic, pro forma

$
(1.06
)
$
(2.32
)
$
1.05Diluted, as reported

$
(1.03
)
$
(2.23
)
$
1.13Diluted, pro forma

$
(1.06
)
$
(2.32
)
$
1.00Weighted-average shares used in computation:Basic


20,640


20,565


19,624Diluted


20,640


20,565


20,478


As
required, the pro forma disclosures above include options granted since January 1, 1995. Consequently, the effects of applying SFAS 123 for providing pro
forma disclosures may not be representative of the effects on reported operating results for future years until all options outstanding are included in the pro forma disclosures. For purposes of pro
forma disclosures, the estimated fair value of stock-based compensation plans and other options are amortized to expense primarily over the vesting period. See Note 10 for further discussion of
our stock-based employee compensation.

Net Income Per Share

We report two separate earnings per share ("EPS") numbers, basic EPS and diluted EPS with additional disclosure made between continuing and discontinued
operations. Diluted EPS includes the dilutive impact of employee stock options and warrants.

Revenue Recognition

We generally recognize product revenue upon shipment of product. We accrue for estimated warranty costs, sales returns and other allowances at the time of
shipment based on our experience. Shipping and handling costs incurred are included in cost of sales. Revenue from maintenance contracts is deferred and recognized over the contractual period the
services are performed. To date, warranty costs and sales returns have not been material. There is a risk that technical issues on new products could result in unexpected warranty costs and returns.

We
recognize software revenue from the licensing of our software products in accordance with Statement of Position ("SOP") No. 97-2, "Software Revenue Recognition,"
and SOP 98-9, "Modification of 97-2, Software Revenue Recognition, with respect to certain transactions" whereby revenue from the licensing of our products is not
recognized until all four of the following have been

F-11

---

met: (i) execution of a written purchase order, license agreement or contract; (ii) shipment of the product has occurred; (iii) the license fee is fixed and determinable; and
(iv) collectibility is probable. The Company defers and recognizes maintenance and support revenue over the term of the contract period, which is generally one year. Allocation of revenue in an
arrangement including maintenance is based on the proportion of the fair value of the maintenance when sold separately to the fair value of other items sold in the arrangement.

We
have signed distribution agreements with distributors in the United States, Europe and Asia. In general, these relationships are non-exclusive. Distributors typically
maintain an inventory of our products. Under these agreements, Intrusion Inc. provides certain protection to the distributors for their inventory of Intrusion Inc. products for price
reductions as well as products that are slow moving or
have been discontinued by the Company. Recognition of sales to distributors and related gross profits are deferred until the distributors resell the merchandise. However, since we have legally sold
the inventory to the distributor and we no longer have care, custody or control over the inventory, we recognize the trade accounts receivable and reduce inventory related to the sale at the time of
shipment to the distributor. Revenue, offset by deferred cost of sales, is included in deferred revenue in the accompanying financial statements. Inventory held by distributors at December 31,
2002 and 2001 was approximately $0.6 million and $0.3 million, respectively.

Advertising Costs

Advertising expense is charged to operations in the period in which such costs are incurred. Total advertising included in sales and marketing expenses was
$0.02 million, $0.5 million and $1.3 million for the years ended December 31, 2002, 2001 and 2000, respectively.

Research and Development Costs

We incur research and development costs that relate primarily to the development of new security software, appliances and integrated solutions, and major
enhancements to existing services and products. Research development costs are comprised primarily of salaries and related benefits expenses, contract labor and prototype and other related expenses.

Software
development costs are included in research and development and are expensed as incurred. SFAS No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased,
or Otherwise Marketed," requires that software development costs incurred subsequent to reaching technological feasibility be capitalized, if material. If the process of developing a new product or
major enhancement does not include a detailed program design, technological feasibility is determined only after completion of a working model. To date, the period between achieving technological
feasibility and the general availability of such software has been short, and the software development costs qualifying for capitalization have been insignificant.

Restructuring Charges

Demand continued to shift to our new intrusion detection and security appliance product lines during 2001 and 2002, and as such, we streamlined operations and
activities that are not aligned with these core markets and strategies. In 2001, this shift in demand resulted in a charge of $3.1 million to recognize the impairment of intangible assets
(primarily developed technology) related to our SecurityAnalyst and SecureEnterprise product lines. We also recorded restructuring charges of

F-12

---

$1.3 million for severance as a result of reductions in force affecting 150 employees and $0.2 million for early termination of excess lease space. Substantially all severance
obligations and the lease termination payments were paid prior to December 31, 2001. In 2002, this shift in demand resulted in a charge of $0.2 million for severance as a result of
reductions in force. All severance obligations were paid prior to December 31, 2002, and the Company was not receiving further benefit from the severed individuals after December 31,
2002. In addition to the restructuring charges in 2002, further reductions in force were made in January 2003, resulting in additional severance of $0.1 million being incurred at that
time.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Estimates
are used for, but not limited to, the accounting for doubtful accounts, sales discounts, sales returns, distribution revenue, warranty costs, inventory obsolescence, depreciation and taxes. Actual
results could differ from these estimates.

Income Taxes

The income tax provision is based on pretax financial accounting income or loss. We account for income taxes pursuant to SFAS No. 109, "Accounting for
Income Taxes," which uses the liability method to calculate deferred income taxes. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between
the tax basis of assets and liabilities and their reported amounts. The realization of deferred tax assets is based on historical tax positions and expectations about future taxable income. The
liability method also requires the recognition of future tax benefits such as net operating loss carryforwards, to the extent that realization of such benefits is more likely than not.

New Accounting Standards

Accounting for Costs Associated with Exit or Disposal Activities

In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" ("SFAS 146"). SFAS 146
addresses financial accounting and reporting for costs associated with exit or disposal activities, such as restructurings, involuntarily terminating employees and consolidating facilities.
SFAS 146 excludes from its scope exit and disposal activities conducted in connection with a business combination and those activities to which SFAS Nos. 143 and 144 are applicable.
SFAS 146 is
effective for exit and disposal activities that are initiated after December 31, 2002. We do not expect the adoption of this statement to have a material effect on our consolidated financial
position or results of operations.

3. Business Combinations and Acquisition of Assets

On September 25, 1998, we completed an acquisition of certain assets from Science Applications International Corporation ("SAIC"), a privately held company
in San Diego, California. We acquired certain assets of the Computer Misuse and Detection System ("CMDS") Division of SAIC and certain other information security products under development. In
exchange for the CMDS assets, the

F-13

---

information security products under development and $1.5 million dollars in cash, we issued to SAIC 1.6 million shares of the Company's common stock and warrants to purchase an
additional 1.5 million shares of its common stock. Two separate warrants each grant SAIC the right to purchase 750,000 shares of Intrusion Inc. common stock. The first warrant had an
exercise price of $8.00 per share and a term of 18 months and was exercised on March 23, 2000. The second warrant had an exercise price of $10.50 per share and a term of 24 months
and was exercised on September 22, 2000. Our acquisition has been accounted for as a purchase of software, in-process research and development and certain other assets. The
transaction value of approximately $6.9 million less the $1.5 million cash received was allocated to the net assets acquired based on their estimated fair market value. Assets acquired
included approximately $1.1 million of in-process research and development, $0.1 million of other intangible assets and approximately $4.2 million of purchased
software to be amortized over seven years on a straight-line basis. In June 2001, we recorded a restructuring charge of $2.6 million to recognize the impairment of the
remaining net book value of this intangible asset. See "Restructuring Charges" in Note 2.

On
September 30, 1999, we entered into a technology licensing agreement with RSA Security Inc. under which we are the exclusive licensee of RSA's Kane Security Products in
North America and Europe. The Kane Security Products include the Kane SecurityAnalyst, a security assessment tool, and the Kane Security Monitor, a host-based intrusion detection tool. We
are responsible for marketing, sales, support, maintenance and development for Kane Security software. In June 2001, we recorded a restructuring charge of $0.4 million to recognize the
impairment of the remaining net book value of this intangible asset. See "Restructuring Charges" in Note 2.

On
June 30, 2000, we acquired MimeStar, Inc., a Virginia corporation. MimeStar developed an advanced, network based intrusion detection system called SecureNet
Pro. The acquisition, accounted for using the purchase method, was affected by the merger of a wholly owned subsidiary of the Company ("Merger Sub") with and into MimeStar, pursuant to an
Agreement and Plan of Merger, by and among the Company, MimeStar, the Merger Sub and the sole stockholder of MimeStar (the "Merger"). Pursuant to the Merger, the stockholder of MimeStar received
$3 million in cash with an additional $1 million in cash and 95,969 shares of the Company's common stock (which was valued at approximately $1 million on the date of the
Merger) placed in escrow, payable to the stockholder of MimeStar within one year subject to indemnification and other conditions. Transaction costs for this acquisition totaled approximately $100,000.
The acquisition costs of $5.1 million were capitalized as
approximately $3.6 million of purchased software, approximately $0.5 million of goodwill and approximately $1.0 million of other intangibles. In December 2002, we recorded
impairment charges under SFAS 142 and SFAS 144 to recognize the impairment of the remaining net book values of these intangible assets. See "Goodwill and Other Intangible Assets" and
"Long-Lived Assets" in Note 2.

F-14

---

4. Balance Sheet Detail (in thousands)

Inventories

December 31,2002

2001Raw materials

$
70

$
661Finished products


1,157


4,002Demonstration systems


184


353$
1,411

$
5,016


Accounts Payable and Accrued Expenses

December 31,2002

2001Trade accounts payable

$
1,159

$
3,027Accrued sales commissions


188


202Accrued travel


220


220Accrued payroll


112


444Accrued vacation


341


580Accrued property taxes


187


230Accrued taxesother


300


206Accrued warranty expense


300


200Other (individually less than 5% of current liabilities)


98


891$
2,905

$
6,000


5. Goodwill and Intangible Assets, Net

Amortization of intangibles for continuing operations is comprised of the following for the years ended December 31, 2002, 2001 and 2000 (in thousands):

2002

2001

2000Goodwill

$


$
64

$
32Purchased software


527


811


849Other intangible assets


271


358


94Total amortization

$
798

$
1,233

$
975


Prior
to the adoption of SFAS 142, goodwill was amortized using the straight-line method over 7 years. Purchased software and other intangible assets were also
amortized using the straight-line method over their useful lives of 7 years.

F-15

---

The
allocation of intangible assets following our adoption of SFAS 142 is summarized in the following table (in thousands):

|                                 |                         | December 31, 2002 |   | December 31, 2001
|-------------------------------- | ----------------------- | ----------------- | - | -----------------
|
|Intangibles no longer amortized: |                         |                   |   |                  
|                                 | Goodwill                |                   | $ | 354              
|Amortizable intangibles:         |                         |                   |   |                  
|                                 | Purchased software      |                   | $ | 3,610            
|                                 | Other intangible assets |                   | $ | 1,040            

As
discussed in Note 2, all intangibles were deemed to be fully impaired at December 31, 2002. As such, included in accumulated amortization at December 31, 2002 for
goodwill, purchased software and other intangibles are impairment charges of $0.4 million, $2.3 million and $0.3 million, respectively. Accordingly, there is no estimated future
annual amortization expense for intangibles.

6. Commitments and Contingencies

Leases

We lease office space for our corporate headquarters in Richardson, Texas under an operating lease, the base term of which expires in February 2005, with
two seven-year options to extend the term of the lease, subject to compliance with certain conditions. We lease office space in San Diego, California for a portion of our security software
research and development staff under an operating lease that expires in August 2004. In addition, we lease office space for our U.S. and international sales and engineering offices. Total
rental expense of $1.4 million, $1.9 million and $1.9 million was charged to operations during 2002, 2001, and 2000, respectively.

Future
minimum lease payments consisted of the following on December 31, 2002 (in thousands):

2003

$
9952004


8822005


1412006 and thereafter


$
2,018


Legal Proceedings

We are subject to legal proceedings and claims that arise in the ordinary course of business. We do not believe that the outcome of those matters will have a
material adverse affect on our consolidated financial position, operating results or cash flows. However, there can be no assurance such legal proceedings will not have a material impact.

On
March 22, 2002, Morgan Newton Company, L.P. ("Morgan Newton") filed suit against us in Dallas County District Court, Case No. DV02-02339-C, alleging
claims for breach of contract, promissory estoppel, and fraud. The claims arise out of an alleged oral representation to Morgan

F-16

---

Newton concerning a request for quotation for the purchase of a large amount of Morgan Newton's products. Morgan Newton has not specified the amount of damages it is seeking in the lawsuit, but it is
possible that Morgan Newton may be seeking damages in excess of $2.0 million. In addition to actual damages, Morgan Newton is also seeking attorney's fees and punitive damages. We believe
Morgan Newton's claims are without merit and intend to vigorously defend this lawsuit, generally denying all claims and asserting certain affirmative defenses. As of this time, discovery is
substantially underway, and trial has been scheduled for October 2003.

7. Discontinued Operations

In the second quarter of 2000, we discontinued our networking operations and accordingly have shown the networking operations as discontinued in the accompanying
financial statements.

During
the first quarter of 2001, we closed the sale of our legacy local area networking division generating a gain of $2.1 million, which was used to reduce the estimated net
realizable value of the net assets of the remaining discontinued operations of Essential. During the second quarter of 2001, in response to unfavorable market conditions and efforts to sell Essential,
we recorded additional charges to write down the net assets of Essential to reflect an estimated net realizable value of $0.8 million. The $5.0 million second quarter charge included
$0.8 million for operating losses expected to be incurred between July and the end of the first quarter of 2002, by which time we expected to have exited, disposed of or otherwise transitioned
a majority of our ownership in Essential.

In
March 2002 we sold Essential for $1.0 million, generating a gain on sale of $0.5 million. Terms of the sale included transferring $0.7 million in net
property, plant and equipment, $0.1 million in current liabilities and product maintenance obligations for which $0.4 million was recorded in deferred revenue.

A
condition of the sale was to give Essential personnel 60 days to exit Essential's leased facility, the obligation for which we retained as part of the sale. Included in the gain
on the sale of Essential was management's estimate of $0.3 million to terminate this lease agreement, which was equivalent to 2 years' lease and maintenance of the facility. The
contractual term of the lease ran through February 2009. Successful termination of the lease during the fourth quarter of 2002 for less than $0.3 million resulted in additional gain on
sale of $0.1 million.

At
December 31, 2002, there were no remaining assets or liabilities classified as discontinued operations. The following represents a summary of assets and liabilities classified
as discontinued operations at December 31, 2001 (in thousands):

Discontinued assets and liabilities consist of:Property and equipment, net

$
741Total discontinued assets

$
741Deferred revenue

$
594Accrued operating losses


545Total discontinued liabilities

$
1,139


F-17

---

The
following represents a summary of net income (loss) from discontinued operations for the years ended December 31, 2002, 2001 and 2000 (in thousands):

|                                           |  | 2002 |     | 2001 |   | 2000   |  
|------------------------------------------ |  | ---- | --- | ---- | - | ------ | -
|Net sales                                  |  | $    | 727 |      | $ | 4,693  |  
|Cost of sales                              |  |      | 323 |      |   | 2,970  |  
|                                           |  |      |     |      |   |        |  
|Gross profit                               |  |      | 404 |      |   | 1,723  |  
|Operating expenses                         |  |      | 503 |      |   | 4,774  |  
|                                           |  |      |     |      |   |        |  
|Operating loss                             |  |      | (99 | )    |   | (3,051 | )
|Gain on sale                               |  |      | 643 |      |   |       |  
|Net realizable value adjustment            |  |      |    |      |   | (3,025 | )
|                                           |  |      |     |      |   |        |  
|Income (loss) before income taxes          |  |      | 544 |      |   | (6,076 | )
|Income tax expense (benefit)               |  |      |    |      |   | 89     |  
|                                           |  |      |     |      |   |        |  
|Income (loss) from discontinued operations |  | $    | 544 |      | $ | (6,165 | )
|                                           |  |      |     |      |   |        |  

The
net realizable value adjustment was recorded in the second quarter of 2001 and was in response to unfavorable market conditions and efforts to sell Essential. The adjustment reduced
the carrying value of Essential to $0.8 million.

8. Employee Benefit Plans

Employee Stock Purchase Plan

On April 24, 1997, we adopted an Employee Stock Purchase Plan (the "Purchase Plan") under which 0.5 million shares of common stock have been
reserved for issuance. Eligible employees may designate not more than 10% of their compensation to be deducted each pay period for the purchase of common stock under the Purchase Plan. The Purchase
Plan was amended January 17, 2001 to increase the maximum number of shares that can be purchased per participant from 500 shares to 1,000 shares per offering. Each participant may
purchase up to 2,000 shares in any one calendar year. On January 31 and July 31 of each calendar year, shares of common stock are purchased with the employees' payroll deductions
over the immediately preceding six months at a price per share of 85% of the lesser of the market price of the common stock on the purchase date or the market price on the first day of the
six-month period. The Purchase Plan will terminate no later than April 24, 2007. A total of 176,374 shares have been issued under the Purchase Plan as of December 31,
2002. Subsequent to December 31, 2002, 2,000 shares of stock were issued under the Purchase Plan for an aggregate purchase price of approximately $0.26 per share related to the purchase
period, which commenced on August 1, 2002 and ended on January 31, 2003.

Employee 401(k) Plan

We adopted a plan known as the Intrusion Inc. 401(k) Savings Plan (the "Plan") to provide retirement and incidental benefits for our employees. The Plan
covers substantially all employees who meet minimum age and service requirements. As allowed under Section 401(k) of the Internal Revenue Code, the Plan provides tax deferred salary deductions
for eligible employees.

F-18

---

The
Plan was amended on January 10, 2002 to allow employees to contribute from 1% to 25% of their annual compensation to the Plan, limited to a maximum amount as set by the
Internal Revenue Service. This limit was increased from 19%. A feature was also added to the Plan to allow participants who are over the age of 50 to contribute an additional amount of their salary
per year, as defined annually by the Internal Revenue Service. The Company matches employee contributions at the rate of $0.25 per each $1.00 of contribution on the first 4% of deferred compensation.
Company matching contributions to the Plan were approximately $44,500, $110,000, and $120,000 in 2002, 2001 and 2000, respectively.

9. Income Taxes

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes. There are no deferred tax liabilities as of December 31, 2002 and 2001. Significant components of the Company's deferred tax assets as of
December 31, 2002 and 2001 are as follows (in thousands):

December 312002

2001Foreign subsidiaries net operating loss carryforward

$
374

$
374Net operating loss carryforwards


21,230


14,385Minimum tax credit





607Book over tax depreciation


273


273Intangibles


1,602


262Equity Investments


458


458Vacation accrual


125


261Allowance for doubtful accounts and returns


342


434Warranty accrual


110


73Inventory allowance


2,505


2,924Other


931


451Deferred tax assets


27,950


20,502Valuation allowance for deferred tax assets


(27,950
)

(20,502
)Deferred tax assets, net of allowance

$


$



Deferred
tax assets are required to be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized.
Realization of the future
benefits related to the deferred tax assets is dependent on many factors, including the Company's ability to generate taxable income within the near to medium term. Management has considered these
factors in determining the valuation allowance for 2002 and 2001.

F-19

---

Significant
components of the provision (benefit) for income taxes for the years ended December 31, 2002, 2001 and 2000 are as follows (in thousands):

2002

2001

2000Income tax provision (benefit)Federal:Current

$
(608
)
$
(4,050
)
$
4,864Deferred





3,063


(5,270
)State:Current





(136
)

236Deferred





(1,140
)

1,861Foreign:Current





475


$
(608
)
$
(1,788
)
$
1,691


Income
tax expense (benefit) is included in the consolidated financial statements for the years ended December 31, 2002, 2001 and 2000 as follows (in thousands):

2002

2001

2000Continuing Operations

$
(608
)
$
(1,877
)
$
1,999Discontinued Operations





89


(308
)$
(608
)
$
(1,788
)
$
1,691


The
differences between the provision for income taxes and income taxes computed using the federal statutory rate for the years ended December 31, 2002, 2001, and 2000 are as
follows (in thousands):

|                                                          |                                                       | 2002 |      | 2001   |   | 2000   |        
|--------------------------------------------------------- | ----------------------------------------------------- | ---- | ---- | ------ | - | ------ | -------
|Reconciliation of income tax provision to statutory rate: |                                                       |      |      |        |   |        |        
|                                                          | Income tax expense (benefit) at statutory rate        |      | $    | (7,660 | ) | $      | (16,649
|                                                          | State income taxes, net of federal income tax benefit |      |      | (38    | ) |        | (829   
|                                                          | Change in valuation allowance                         |      |      | 7,448  |   |        | 18,570 
|                                                          | Goodwill amortization                                 |      |      |       |   |        | 578    
|                                                          | Tax credit carryforwards                              |      |      |       |   |        | (607   
|                                                          | Other                                                 |      |      | (358   | ) |        | (2,851 
|                                                          |                                                       |      |      |        |   |        |        
|                                                          |                                                       | $    | (608 | )      | $ | (1,788 | )      
|                                                          |                                                       |      |      |        |   |        |        

At
December 31, 2002, we had federal net operating loss carryforwards of $70.6 million for income tax purposes that begin to expire in 2008 and are subject to the ownership
change limitations under Internal Revenue Code Section 382. We also had $85.2 million of state net operating loss carryforwards. Net operating loss carryforwards of the foreign
subsidiaries of $0.7 million at December 31, 2002 are available indefinitely for offset only against taxable income generated by the foreign subsidiaries.

F-20

---

We
have made income tax payments of $6.2 million during 2000. We made no federal tax payments during 2002 and 2001, and received federal income tax refunds of $3.2 million
and $0.4 million in 2001 and 2002, respectively for income taxes paid in previous years.

10. Stock, Stock Options and Warrants

On September 25, 1998, in connection with our acquisition of certain assets from SAIC we issued to SAIC 1.6 million shares of
Intrusion Inc.'s common stock and warrants to purchase an additional 1.5 million shares of its common stock. Two separate warrants each granted SAIC the right to purchase
750,000 shares of its common stock. The first warrant had an exercise price of $8.00 per share and a term of 18 months. The second warrant had an exercise price of $10.50 per share and a
term of 24 months. On March 23, 2000, SAIC exercised the first warrant for 750,000 shares at an exercise price of $8.00 per share. On September 22, 2000, SAIC exercised the
remaining 750,000 shares at an exercise price of $10.50 per share.

On
May 7, 1998, in connection with our acquisition of Essential, we issued approximately 306,000 shares of the Company's common stock for all outstanding shares of Essential
capital stock, and we issued approximately 104,000 stock options in exchange for all unexpired and unexercised options to acquire Essential capital stock. At December 31, 2002, there are
no options outstanding from the Essential assumed options.

At
December 31, 2002, we had four stock-based compensation plans, which are described below. These plans were developed to retain and attract key employees and directors.

We
established an Incentive Stock Option Plan in 1983, which provides for the issuance of options to key employees of the Company to purchase common stock of the Company. The 1983
Incentive Stock Option Plan was terminated on November 10, 1993.

In
1987, an additional Incentive Stock Option Plan was established with similar provisions to allow for further issuance of options. The 1987 Incentive Stock Option Plan was terminated
on January 26, 1997. The 1983 and 1987 plans each provided for the issuance of up to 1.2 million shares of common stock upon exercise of options granted pursuant to the plans. Options to
purchase a total of 37,400 shares of common stock are outstanding with no options remaining available for issuance for the 1983 and 1987 plans.

In
1995, the Company adopted the 1995 Stock Option Plan (the "1995 Plan"), which provides for the issuance of up to 1.6 million shares of common stock upon exercise of options
granted pursuant to the 1995 Plan. On April 19, 2000, the stockholders approved an 850,000 share increase, and on April 26, 2001, the stockholders approved an additional
850,000 share increase to the 1995 Plan. Therefore, the overall number of shares available for issuance pursuant to the plan was increased to 3.3 million shares of common stock. The 1995
Plan provides for the issuance of both non-qualified and incentive stock options to employees, officers, and employee-directors of the Company. Option to purchase a total of
1,479,567 shares of common stock are outstanding and options for 1,569,560 shares remain available for future grant.

In
1995, the Company adopted the 1995 Non-Employee Director Stock Option Plan (the "1995 Non-Employee Director Plan") which provided for the issuance of up to
160,000 shares of common stock upon exercise of options granted pursuant to the 1995 Non-Employee Director Plan. On April 25, 2002, the stockholders approved an amendment to
the 1995 Non-Employee Director Plan. This

F-21

---

amendment increased the number of shares available for option to 260,000 shares, replaced the automatic grant feature prospectively from 20,000 shares on the fifth anniversary to
10,000 shares annually and reduced the vesting schedule from five years to three years for options granted prospectively. The Plan provides for the issuance of non-qualified stock
options to non-employee directors. No shares have been exercised under the 1995 Non-Employee Director Plan. Options to purchase a total of 150,000 shares of Common Stock
are outstanding and options for 110,000 shares remain available for issuance. Since inception, 170,000 shares have been granted to directors pursuant to the 1995 Non-Employee
Director Plan, of which, 20,000 have been cancelled.

Common
shares reserved for future issuance, including outstanding options, under all of the stock option plans and employee stock purchase plans total approximately 3.7 million
shares at December 31, 2002.

Outstanding
Options

Available for
Future Grant1987 Plan

37,400

1995 Plan

1,479,567

1,569,5601995 Non-Employee Director Plan

150,000

110,000Employee Stock Purchase Plan



323,626Director Grants prior to Plan

18,000

Total

1,684,967

2,003,186


The
Compensation Committee of the Board of Directors determines the term of each option, option exercise price within limits set forth in the plans, number of shares for which each
option is granted and the rate at which each option is exercisable (generally ratably over three or five years from grant date). However, the exercise price of any incentive stock option may not be
less than the fair market value of the shares on the date granted (or less than 110% of the fair market value in the case of optionees holding more than 10% of the voting stock of the Company), and
the term cannot exceed ten years (five years for incentive stock options granted to holders of more than 10% of the Company's voting stock).

A
summary of the Company's stock option activity and related information for the years ended December 31, 2002, 2001 and 2000, is as follows:

|                                   |  | 2002   |   | 2001 |      | 2000
|---------------------------------- |  | ------ | - | ---- | ---- | ----
|
|Outstanding at beginning of year   |  | 1,989  |   | $    | 6.71 |     
|Granted                            |  | 930    |   |      | 1.31 |     
|Exercised                          |  |       |   |      |     |     
|Cancelled                          |  | (1,234 | ) |      | 5.14 |     
|                                   |  |        |   |      |      |     
|Outstanding at end of year         |  | 1,685  |   |      | 4.89 |     
|                                   |  |        |   |      |      |     
|Options exercisable at end of year |  | 565    |   | $    | 8.46 |     

F-22

---

Information
related to stock options outstanding at December 31, 2002, is summarized below:

Options Outstanding

Options ExercisableRange of Exercise Prices

Outstanding at
12/31/02 (in
thousands)

Weighted
Average
Remaining
Contractual Life

Weighted
Average
Exercise
Price

Exercisable at
12/31/02 (in
thousands)

Weighted
Average
Exercise
Price$0.32-$1.36

725

9.03 years

$
1.16

70

$
1.311.74-5.63

569

7.89 years


3.89

221


4.217.13-23.25

391

6.09 years


13.24

274


13.711,685

7.96 years


4.89

565


8.46


Pro
forma information regarding net income (loss) and net income (loss) per share, as disclosed in Note 2, has been determined as if we had accounted for employee stock-based
compensation plans and other stock options under the fair value method of SFAS 123. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing
model with the following weighted average assumptions used for grants under the option plans:

2002

2001

2000Expected dividend yield

0.0
%
0.0
%
0.0
%Risk-free interest rate

3.1
%
4.3
%
6.7
%Expected volatility

140.0
%
130.0
%
120.0
%Expected life (in years)

3.4

3.0

2.0


The
Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition,
option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded
options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options. In addition, because SFAS 123 is applicable only to options granted subsequent to December 31, 1994, the pro forma
information does not reflect the pro forma effect of all previous stock option grants of the Company, and thus the pro forma information is not necessarily indicative of future amounts until
SFAS 123 is applied to all outstanding stock options.

F-23

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Information
relating to the fair value of option grants made during 2002, 2001 and 2000 is as follows:

|                                                                               |                                                                                             | 2002 |   | 2001 |  | 2000
|------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------- | ---- | - | ---- |  | ----
|Options granted (with exercise price equal to fair value of common stock):     |                                                                                             |      |   |      |  |     
|                                                                               | Number of options (in thousands)                                                            |      |   | 898  |  |     
|                                                                               | Weighted average exercise price per share                                                   |      | $ | 1.34 |  | $   
|                                                                               | Weighted average fair value of stock options grants per Black-Sholes option valuation model |      | $ | 1.08 |  | $   
|Options granted (with exercise price greater than fair value of common stock): |                                                                                             |      |   |      |  |     
|                                                                               | Number of options (in thousands)                                                            |      |   | 32   |  |     
|                                                                               | Weighted average exercise price per share                                                   |      | $ | 0.57 |  |     
|                                                                               | Weighted average fair value of stock options grants per Black-Sholes option valuation model |      | $ | 0.41 |  |     

11. Earnings per Share

|                                                                                               |                                                                                     | For the Year Ended December 31,
|---------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | -------------------------------
|
|Numerator:                                                                                     |                                                                                     |                                
|                                                                                               | Net income (loss)                                                                   |                                
|                                                                                               |                                                                                     |                                
|                                                                                               | Numerator for basic and diluted earnings per share                                  |                                
|Income (loss) from continuing operations                                                       |                                                                                     | $                              
|                                                                                               |                                                                                     |                                
|Numerator for basic and diluted earnings per share, continuing operations                      |                                                                                     | $                              
|Denominator:                                                                                   |                                                                                     |                                
|                                                                                               | Denominator for basic earnings per shareweighted average common shares outstanding |                                
|                                                                                               | Effect of dilutive securities:                                                      |                                
|                                                                                               |                                                                                     | Stock options and warrants     
|                                                                                               |                                                                                     |                                
|Denominator for diluted earnings per shareadjusted weighted average common shares outstanding |                                                                                     |                                
|                                                                                               |                                                                                     |                                
|Basic earnings (loss) per share, continuing operations                                         |                                                                                     | $                              
|                                                                                               |                                                                                     |                                
|Diluted earnings (loss) per share, continuing operations                                       |                                                                                     | $                              
|                                                                                               |                                                                                     |                                
|Basic earnings (loss) per share                                                                |                                                                                     | $                              
|                                                                                               |                                                                                     |                                
|Diluted earnings (loss) per share                                                              |                                                                                     | $                              
|                                                                                               |                                                                                     |                                

Total
stock options and warrants outstanding in 2002, 2001 and 2000 that are not included in the diluted earnings per share computation due to the antidilutive effect are
1.7 million, 2.0 million and 378 thousand, respectively. Such options are excluded due to us incurring a net loss per share in that

F-24

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year or due to exercise prices exceeding the average market value of our common stock in the applicable period.

12. Other Income

On March 2, 2000, we sold our investment of 770,745 shares of Alteon WebSytems, Inc. common stock for $87.00 per share, net of applicable expenses,
generating cash of approximately $67.1 million. The disposition of this stock generated a pre tax gain of approximately $66.3 million, which was recognized as other income.

13. Major Customers and Geographic Information

The Company's continuing operations are concentrated in one segmentthe design, development, marketing and support of data security via a suite of
security software and appliances. Sales to customers exceeding 10% of total sales were as follows: 2002none; 2001none; 2000$3.3 million to iGov.com and
$5.6 million to TRW.

Export
sales, primarily to Europe, Asia, Latin America and Canada, were $2.6 million in 2002, $6.1 million in 2001 and $4.5 million in 2000. No significant
long-lived assets were deployed outside of the United States.

F-25

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Supplemental Financial Data

Summarized Quarterly Data (Unaudited)

|                         |                              | 2002 |  
|------------------------ | ---------------------------- | ---- | -
|
|
|Continuing Operations:   |                              |      |  
|                         | Revenue                      |      | $
|                         | Gross profit                 |      |  
|                         | Net loss                     |      |  
|                         | Net loss per shareBasic     |      |  
|                         | Net loss per shareDiluted   |      |  
|Discontinued Operations: |                              |      |  
|                         | Income, net of tax           |      |  
|                         | Net income per shareBasic   |      |  
|                         | Net income per shareDiluted |      |  

|                         |                            | 2001 |  
|------------------------ | -------------------------- | ---- | -
|
|Continuing Operations:   |                            |      |  
|                         | Revenue                    |      | $
|                         | Gross profit               |      |  
|                         | Net loss                   |      |  
|                         | Net loss per shareBasic   |      |  
|                         | Net loss per shareDiluted |      |  
|Discontinued Operations: |                            |      |  
|                         | Loss, net of tax           |      |  
|                         | Net loss per shareBasic   |      |  
|                         | Net loss per shareDiluted |      |  

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F-26

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Intrusion Inc. and Subsidiaries    Schedule IIValuation and Qualifying Accounts  (In thousands)

|                                            |                                             | Balance
at Beg.
of Period |     | Charged to
Costs and
Expense |   | Additions
(Deductions) |   | Balance
at End of
Period
|------------------------------------------- | ------------------------------------------- | ------------------------- | --- | ---------------------------- | - | ---------------------- | - | ------------------------
|Year ended December 31, 2000                |                                             |                           |     |                              |   |                        |   |                         
|Deducted from asset accounts:               |                                             |                           |     |                              |   |                        |   |                         
|                                            | Allowance for doubtful accounts and returns |                           | $   | 1,171                        |   | $                      |  |                         
|Year ended December 31, 2001                |                                             |                           |     |                              |   |                        |   |                         
|Deducted from asset accounts:               |                                             |                           |     |                              |   |                        |   |                         
|                                            | Allowance for doubtful accounts and returns |                           | $   | 919                          |   | $                      |  |                         
|Year ended December 31, 2002                |                                             |                           |     |                              |   |                        |   |                         
|Deducted from asset accounts:               |                                             |                           |     |                              |   |                        |   |                         
|Allowance for doubtful accounts and returns |                                             | $                         | 797 |                              | $ | 137                    |   | $                       

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S-1

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