##### Table of Contents









U.S. SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




---

Form 10-KSB

|  |  |                                                                                       
|- |  | --------------------------------------------------------------------------------------
|þ |  | ANNUAL REPORT UNDER SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
| 
|  |  | For the fiscal year ended December 28,
    2002                                       
| 
|o |  | TRANSITION REPORT UNDER SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
| 
|  |  | For the transition period
    from           to                                       

Commission File Number : 0-26226



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Microfield Graphics, Inc.

(Name of small business issuer in its
charter)


|                                                                                                                  |  |                                              
|----------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------
|Oregon                                                                                                            |  | 93-0935149                                   
|(State or other jurisdiction of
    incorporation or organization)                                                |  | (I. R. S. Employer
    Identification No.)   
|                                                                                                                 
|1631 NW Thurman St., Ste. 310
    Portland, Oregon 97209(Address of principal executive
    offices and zip code) |  | (503) 419-3580(Issuers telephone
    number)

Securities registered under Section 12(b)
of the Exchange Act:

None


Securities registered under Section 12(g)
of the Exchange Act:

Common Stock


Check whether the issuer (1) filed all
reports required to be filed by Section 13 or 15(d) of the
Exchange Act during the past 12 months (or for such shorter
period that the Registrant was required to file such reports),
and (2) has been subject to such filing requirements for
the past
90 days:     Yes þ          No o

Check if disclosure of delinquent filers in
response to Item 405 of Regulation S-B is not contained in
this form, and no disclosure will be contained, to the best of
registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of the
Form 10-KSB or any amendment to this
Form 10-KSB.     o

Issuers revenues for its most recent fiscal
year were $233,000.

The aggregate market value of voting stock held
by non-affiliates of the registrant at March 1, 2003 was
$1,974,000, computed by reference to the average bid and asked
prices as reported on the Nasdaq Bulletin Board Market.

The number of shares outstanding of the
Registrants Common Stock as of March 1, 2003 was
8,224,652 shares.

The index to exhibits appears on page 33 of this
document.

Documents Incorporated by Reference

The issuer has incorporated into Part III of
Form 10-KSB, by reference, portions of its Proxy Statement
dated April 11, 2003.

Transitional Small Business Disclosure Format
(check
one):     Yes o          No þ



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---

TABLE OF CONTENTS



|                  |                                                                                                                         |  |  |  |  |  |  | 
|----------------- | ----------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|FORM 10-KSB INDEX
|PART I           
|                  | Item 1. Business                                                                                                       
|                  | Item 2. Properties                                                                                                     
|                  | Item 3. Legal Proceedings                                                                                              
|                  | Item 4. Submission of Matters of a Vote of Security Holders                                                            
|PART II          
|                  | Item 5. Market for Common Equity and Related Stockholder Matters                                                       
|                  | Item 6. Managements Discussion and Analysis of Financial Condition or Plan of Operations                              
|                  | Item 7. Financial Statements                                                                                           
|                  | Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                           
|PART III         
|                  | Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act
|                  | Item 10. Executive Compensation                                                                                        
|                  | Item 11. Security Ownership of Certain Beneficial Owners and Management                                                
|                  | Item 12. Certain Relationships and Related Transactions                                                                
|                  | Item 13. Exhibits and Reports on Form 8-K                                                                              
|                  | Item 14. Controls and Procedures                                                                                       
|SIGNATURES       
|EXHIBIT 23.1     
|EXHIBIT 99.1     



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##### Table of Contents



MICROFIELD GRAPHICS, INC.






FORM 10-KSB INDEX


|         |  |                                                                                                                         |  |      |    | 
|-------- |  | ----------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|         |  |                                                                                                                         |  | Page
|         |  |                                                                                                                         |  |     
|PART I  
|Item 1.  |  | Description of Business                                                                                                 |  |      | 3  | 
|Item 2.  |  | Description of Property                                                                                                 |  |      | 8  | 
|Item 3.  |  | Legal Proceedings                                                                                                       |  |      | 8  | 
|Item 4.  |  | Submission of Matters to a Vote of Security
    Holders                                                                 |  |      | 8  | 
|PART II 
|Item 5.  |  | Market for Common Equity and Related Stockholder
    Matters                                                            |  |      | 9  | 
|Item 6.  |  | Managements Discussion and Analysis of
    Financial Condition or Plan of Operation                                    |  |      | 10 | 
|Item 7.  |  | Financial Statements                                                                                                    |  |      | 16 | 
|Item 8.  |  | Changes in and Disagreements with Accountants on
    Accounting and
    Financial Disclosure                            |  |      | 31 | 
|PART III
|Item 9.  |  | Directors, Executive Officers, Promoters and
    Control Persons; Compliance with Section 16(a) of the
    Exchange Act |  |      | 32 | 
|Item 10. |  | Executive Compensation                                                                                                  |  |      | 32 | 
|Item 11. |  | Security Ownership of Certain Beneficial Owners
    and Management                                                      |  |      | 32 | 
|Item 12. |  | Certain Relationships and Related Transactions                                                                          |  |      | 33 | 
|Item 13. |  | Exhibits and Reports on Form 8-K                                                                                        |  |      | 33 | 
|Item 14. |  | Controls and Procedures                                                                                                 |  |      | 34 | 

2



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##### Table of Contents






PART I




Item 1.Business

Introduction

Microfield Graphics, Inc. (the
Company) specializes in the acquisition and
deployment of branded products and services with strong
intellectual property asset value, broad based market appeal and
the potential for significant growth. The Companys
objective is to leverage its assets and value to acquire a
portfolio of promising emerging companies that have achieved
real revenues and have attained, or are on the threshold of
positive cash flow. The Company completed its first purchase
transaction in September 2002, with the acquisition, via merger,
of Innovative Safety Technologies, LLC. The LLC was merged into
Microfields wholly owned subsidiary Microfield Merger Sub,
Inc., which was subsequently renamed Innovative Safety
Technologies, Inc. (IST).

This acquisition established a new direction for
the Company since it had previously sold substantially all of
the assets used in its prior business, in October 2000 (see
below). The acquisition of IST was completed on
September 17, 2002. As of December 2002, IST was the only
operating entity owned by the Company.

ISTs mission is to identify, develop and
market products that improve and promote safety and security.
Currently, IST develops and markets branded safety and security
products and services under the names Internet
ObservationTM Systems (IOS) and
No Tug PlugTM Electrical Outlet Cover
(No Tug Plug).

The recently launched IOS product line was
introduced during the 4th Quarter of 2002. The IOS systems
provide state of the art digital video recorders and cameras for
surveillance, condition monitoring, theft prevention, property
protection, employee adherence, and general security and
observation applications. The output of the systems
cameras can be in monitored and viewed simultaneously in
real-time from either on-site or via the Internet anytime and
anywhere. The IOS branded products are expected to produce sales
revenue from both the wholesale and retail market segments.

ISTs first product, the No Tug Plug is
designed to replace a standard 110-volt electrical outlet
faceplate. The No Tug Plugs patented design utilizes two
horizontally sliding and locking covers over the electrical
outlet. This unique feature locks the electrical cords into the
outlet while in use, thus keeping the electrical cord from being
accidentally unplugged or removed. When the outlets are not in
use, the covers lock shut over the outlet to prevent access.
These safety features protect small children from sticking small
fingers or objects into the exposed outlet, while also securing
an uninterrupted power source to appliances and equipment.

Prior to October 24, 2000 the Company
developed, manufactured, and marketed computer conferencing and
telecommunications products designed to enhance and facilitate
group communications. The Companys product lines consisted
of a series of digital whiteboards, interactive rear projection
systems, and interactive plasma display systems sold under the
brand name SoftBoard, along with a variety of application
software packages, supplies and accessories. Information written
or drawn on the SoftBoard surface is recorded and displayed on a
personal computer simultaneously and in color. The SoftBoard
system utilized proprietary technology that had been owned by
the Company. On October 24, 2000 the assets of the Company
that were utilized in operating the SoftBoard business were sold
to Greensteel, Inc., a wholly-owned subsidiary of PolyVision
Corporation. Prior to the acquisition of IST in September 2002,
the Company had not been engaged in continuing operations since
the date of the sale of its SoftBoard assets to Greensteel.

The Company was incorporated in Oregon in 1986.
The Companys executive offices are located at
1630 NW Thurman St., Ste. 310, Portland,
OR 97209

Products



| |                                  
| | ---------------------------------
| | Internet
    ObservationTMSystems

IST has designed its IOS product line to be the
most user-friendly, fully functional and cost-effective digital
video viewing and recording systems available in the market
today. IOS is a safety and security monitoring and recording
system that is accessible from anywhere in the world over the
internet. The IOS

3



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##### Table of Contents



system consists of a digital video recorder that
is connected via fiber, CAT 5 or coaxial cable to one or a
series of cameras that monitor a particular location or
locations that our customers want to observe. IOS systems are
scalable to fit any application or job size depending on the
end-users needs. IST currently develops, manufactures and
markets its IOS brand of digital viewing and recording products
to sales channels including value added resellers
(VARs), Agents and end-users.


Utilizing the latest, state-of-the-art digital
recording equipment and camera technology, the systems are used
in applications such as management viewing systems, commercial
and residential security and surveillance, and to observe and
monitor remote facilities such as child care, assisted living,
or unmanned facilities such as power generation, communications
and water systems.

Management viewing
systems.Utilizing IOS systems as a
management tool in an on-site or remote monitoring capacity can
save the owner significant time and expense. IOS systems can
help in numerous instances where there is a risk of loss to a
company or individual. By installing cameras in critical
locations, the IOS system can help reduce or eliminate customer
and employee theft, inventory shrinkage and vandalism. Cameras
placed in strategic locations visible to all who pass by, such
as the main floors of a retail store or over the cargo docks of
an inventory warehouse, serve as a deterrent to theft. The
system is capable of operating during daylight or at night and
keeps a record of all activity occurring at each location where
a camera is located. The systems are capable of being managed
within an existing on-site network infrastructure or via the
Internet so that multiple viewers can monitor the cameras
simultaneously. The systems also have controls which enable the
management to restrict viewing of specific cameras to specific
authorized personnel or customers.

Management can also monitor employee productivity
and trends, verify accident and injury claims and observe
company policy adherence by employees. With the capacity of the
digital video recorder, activity can be recorded for up to sixty
days or longer and the recorded video can be viewed at any time,
24 hours a day, either on site or remotely via the Internet.
This is a helpful tool for a manager or business owner who is
traveling or works from another facility and wants to check in
on the locations activities. The system can also be
installed in multiple locations owned by a company, thus
reducing the amount of valuable time and expensive travel costs
previously required to visibly monitor and observe those
locations.

Commercial and residential security and
surveillance.The IOS system, when
installed at a residence, can help deter vandals and burglars.
This helps safeguard the owners personal property and
other important assets. When used in conjunction with an alarm
system, the homeowner can quickly check in on the system to see
whats occurring when he is notified of an alarm by the
security company. This may give the homeowner precious time to
react to a situation that may result in the saving of ones
life, or the protection of valuable possessions. The ability to
observe in real time, could help pinpoint the location of a fire
to assist the firemen fighting the fire, or help police in
locating a burglar who is still on the premises.

Observe and Monitor Remote
Facilities:A premier feature of the
IOS system is the ability to observe remote facilities or
specific individuals when the viewer is not able to physically
visit the location. For instance, an IOS system can be installed
in a childcare or assisted living facility. The owner of the
facility can provide the family members access to the system via
the Internet using an individually assigned password which
allows them to view a specific set of cameras. Children of
assisted living tenants can now have the ability to see at any
time what their loved-one is doing at the facility. The facility
has the responsibility to manage who has access to the system
and whether to offer this benefit for free or at a monthly fee.

An important use of the IOS system is for
protection and remote management of unmanned facilities such as
water sources, power generation, telecommunications equipment
and towers, bridges, tunnels and other critical facilities that
are remote in nature and are difficult to adequately monitor and
protect without the benefit of real-time remote viewing and
recording capabilities.



| |                  
| | -----------------
| | No Tug
    PlugTM

Electrical outlets are one of the most dangerous
hazards for small children in homes, schools and childcare
centers and are involved in over 5,300 house fires annually in
the United States. Thousands of

4



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##### Table of Contents



children are treated each year in hospital
emergency rooms for injuries caused from electrical shock in the
home. The No Tug PlugTM Electrical Outlet Cover
(No Tug Plug) was developed to help reduce these
dangerous household safety problems. The No Tug Plug protects
children from electrical shock by covering an outlet completely
and locking in dangerously exposed plugs. Some safety outlet
products available on the market cover up electrical outlets to
keep children from sticking objects into them. With the
exception of the No Tug Plug no product on the market eliminates
the possibility that an appliance or light cord can be pulled
from an outlet, exposing the outlet to children. The No Tug Plug
was named Best New Safety Product...2002 by NECA
Safety Trainer Michael Murphy.


The No Tug Plug consists of an electrical outlet
face plate designed with two safety covers for each outlet
receptacle. After removing the standard outlet face plate, the
No Tug Plug Safety Plate is installed in its place. The safety
covers when pinched together slide open to expose the outlet so
that an electrical cord can be plugged into the outlet. The
safety covers then slide back over the top of the plug, locking
the cord into the outlet. The plug can not be pulled out of the
outlet, which keeps small children from being exposed to a
dangerous situation. When the outlet is not being used, the
safety covers lock in place completely securing the outlet.

The No Tug Plug was designed to be tamper
resistant by kids. The product comes in two colors, and is made
of a high quality plastic material. The No Tug Plugs are
currently used in homes, day care centers, businesses, schools
and any other location where uninterrupted power and electrical
safety are paramount.

Product Development

Shortly after the inception of Innovative Safety
Technologies, LLC in July 2001, IST purchased the patent rights
to the No Tug Plug from its inventors. IST uses an outside
contractor to manufacture the basic face plate of the No Tug
Plug. Any development work or changes to the product are first
requested by IST and later designed by the contractor with the
input and approval of IST. IST at times has engaged the
assistance of outside experts to refine the product, the
manufacturing mold and the manufacturing process for the No Tug
Plug. Currently, IST does not have any internal engineering or
product development staff dedicated to making future changes to
the No Tug Plug product.

In September 2002, Innovative Safety
Technologies, LLC purchased the assets and the IOS name from an
individual whose company was selling security monitoring systems
under the IOS name. Innovative Safety Technologies, LLC acquired
all rights to the IOS product in that transaction, and after the
acquisition date employed the founder of that company in a sales
role with IST. IST has purchased all of the individual
components it uses in the IOS systems from outside
manufacturers, but has since developed strategic relationships
that are expected to enable IST to manufacture, brand and market
its own product line to all levels of distribution by early
second quarter 2003. This fundamental change should allow IST to
enjoy greater margins and create increased value through
development of the IOS branded product lines. In addition, as
industry technology changes and improves, the IOS systems can be
adapted to changing market conditions.

The IOS products can meet myriad business and
personal needs. These range from security applications that
protect a business or residence from break-in and theft, to
viewing a loved one from thousands of miles away. As customers
voice their specific requests, the IOS sales staff and design
team develops new applications to meet those needs. As a result,
there is constant product application development occurring as
IST designs and markets product solutions to satisfy
customers individual needs and the diverse demands of the
safety and security marketplace.

The Company had no expenditures for research and
development costs in each of fiscal years 2001 and 2002.

Marketing, Sales and Distribution

Internet
ObservationTMSystems

IST currently markets its IOS systems through
agents, VARs and directly to the end users markets within the
western United States. ISTs Vice President of Sales
oversees the relationships with the agents and

5



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##### Table of Contents



VARs, which consist of companies experienced in
the marketing and installation of digital video recording
systems and related equipment. These marketing partners purchase
the IOS systems from the Company at a significant discount off
the retail sales price and are responsible for sales, design,
system configuration and installation of the IOS branded system
into their customers locations. The Agents and VARs are
trained by Company personnel on product knowledge and how to
design and install the IOS systems before they are allowed to
participate in the marketing and installation of the products.


IST also designs, sells and installs IOS systems
directly to end-user locations and contacts its potential
customers through its direct sales team located at its Portland,
Oregon offices. Using a database compiled from several sources
and using various outbound marketing methods to generate
interest and increase market awareness, customer demonstrations
are given using an actual operating IOS system. IST has the
ability to provide the IOS product demonstrations both remotely
via a portable demonstration unit and at ISTs headquarters
using a system installed in the building. Once an end-user
customer has committed to installing an IOS system, the sales
support engineer will visit the customer location and design a
customized system based on several factors including day versus
night application, number of monitoring and view points, whether
the cameras should be hidden or exposed, weather conditions and
potential obstructions. These factors and many others are
carefully considered in determining the number and type of
cameras, the power and capacity of the digital video recorder,
and the method of most effectively installing and connecting the
system together

No Tug
PlugTM

IST first started actively selling the No Tug
Plug in January 2002. The No Tug Plug is currently sold through
both indirect and direct channels. Direct sales from IST to the
end-user market are limited and are made primarily through phone
orders and the Companys website.

IST has contractual relationships with a number
of indirect marketing partners including distributors and
product representatives through which it currently distributes
the No Tug Plug product. These indirect distribution partners
have a network of sales contacts with the buyers of major
consumer retailers such as Wal-Mart and Walgreens. Distributors
obtain orders directly from the large retailers and in turn
place orders to purchase product directly from IST in order to
re-sell the product to the retailer. Product Representatives
simply function as a broker of the transaction
between IST and the retailer and are paid a sales commission for
creating the sale. IST has no responsibility related to the
ultimate resale of products by the distributor. During the
fourth quarter of 2002, IST received an order from one of its
distributors for 107,000 units of its No Tug Plug product. These
units were sold through the distributor to Wal-Mart stores for
distribution throughout their retail stores in the United
States. These units were shipped during the fourth quarter of
2002, and the revenue from those shipments was recognized in
that quarter.

IST commenced operations in July 2001, and
therefore has limited sales history from which to predict future
sales patterns of the No Tug Plug. Depending on the acceptance
of the No Tug Plug in the marketplace, there can be no certain
assurance that retailers who currently carry the product will
continue to purchase this product on an ongoing basis, or that
other retailers will order and sell significant quantities of
the No Tug Plug product in the future. Also, as with any large
distributor relationships, order rates may be subject to
quarterly fluctuations as demand builds and inventories are
adjusted.

Manufacturing and Supply



| |                                  
| | ---------------------------------
| | Internet
    ObservationTMSystems

The principal components of the various IOS
systems consist of a digital video recorder, digital cameras,
cabling and a viewing monitor, if needed. Currently, IST
purchases off-the-shelf components manufactured by various third
parties and has them branded with the IOS name. These products
are shipped from the manufacturer to either a distributor or to
IST where they are taken to a customer site. IST or its
distribution partner then installs the product at the customer
site and trains the customer on its functionality and specific
uses.

6



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While IST does not currently manufacture the IOS
brand of digital video equipment, comparable products needed to
replace current product lines are readily available from other
various product manufacturers through current supplier resources.

No Tug
PlugTM

The principal components of the No Tug Plug
consist of a face-plate, four sliding safety clips, and an
installation screw. IST owns the two injection molds required to
produce the No Tug Plug product. There is a 4-cavity mold which
produces the main face plate and a 16-cavity mold which produces
the clip covers of the product. The mold has a useful life of
one million presses creating 4 million units. Through
December 28, 2002, approximately 125,000 No Tug Plug units
have been produced. IST has contracted with a local manufacturer
to produce its faceplate and clip covers from the molds. The
manufacturer is responsible for purchasing and storing all of
the raw materials needed to produce the face plates, product
assembly and boxing. Until used in production, the raw materials
remain the property of the manufacturer.

To fulfil product orders for the No Tug Plug, the
contracted manufacturer is given an order from IST for a certain
number of units. Once manufactured and assembled, product is
then shipped to a labor subcontractor, where the product is
properly packaged, put into boxes and palletized, if necessary,
and then shipped to the ordering customers designated
delivery sites.

Certain components of the ISTs products and
labor services are purchased from single sources. IST believes
alternative sources are readily available and could be located
and qualified for all components. IST does not, however, have
any long-term supply contracts with any vendors. Although a
component may be available from more than one supplier, IST
could incur delays in switching suppliers, which could have an
adverse effect on the Companys sales and results of
operations.

IST does not have a production facility. The
production facility for its material subcontractor is located in
Vancouver, Washington, and the production facility for its labor
subcontractor is located in Albany, Oregon. The labor
subcontractor currently warehouses a majority of the
Companys finished goods inventory for the No Tug Plug.

Competition



| |                  
| | -----------------
| | No Tug
    PlugTM

The primary competitors of the No Tug Plug
product are companies such as Safety First, Leviton
Manufacturing Company and Kidco. These companies currently offer
protective outlet cover products under their brand names and are
marketing them through retail channels. Although IST believes
that the electrical outlet safety products marketed by these
companies are significantly inferior in design, functionality,
quality and use to the No Tug Plug, these companies are
significantly larger than IST and in some cases currently
possess significantly broader and more mature distribution
outlets than IST has developed to date.



| |                                  
| | ---------------------------------
| | Internet
    ObservationTMSystems

The Company believes its ability to compete
effectively in the market for digital video recorders, cameras
and related products depends on price and key product
characteristics, including access to leading edge technology,
product functionality, product sourcing, brand value and
awareness, ease of use, reliability and durability.

The current market for digital video recorders is
primarily derived from two main product lines 
embedded-chip technology and PC-based products. IST will market
IOS systems within both of these product segments. The
embedded-chip digital video recorder market is much more mature
than the PC-based market and is currently dominated primarily by
larger providers such as Kalatel and Dedicated Micros. The
PC-based digital video recorder market is much less mature,
relatively new technology using Microsoft Windows operating
systems as the main platform. These products are generally less
stable than embedded chip systems but are much more user
friendly and feature rich in comparison. The PC-based market is
very fragmented with no clear leaders yet established as
dominant manufacturers or providers of this technology to date.

7



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##### Table of Contents



IST believes it will be well positioned to
successfully compete in both the embedded-chip and PC-based
digital video recorder markets. The advantage of the IOS branded
products will be to offer industry-leading technologies at very
competitive prices.

Many of ISTs competitors are more
established, benefit from greater name recognition and have
significantly greater financial, technological, production and
marketing resources than IST. In addition, many of these
companies have large and established sales forces and have been
selling their products to the same customers targeted by IST for
a substantial period of time. The market acceptance of certain
competing products that are based on different technologies or
approaches could have the effect of reducing the size of the
market for the IST products, resulting in lower prices and
erosion of the Companys gross profit.

Intellectual Property

As a part of the purchase of IST, the Company
owns United States Patent No. 5,288,945. This patent covers the
No Tug PlugTM and was issued in February 1994. The
patent was purchased by Innovative Safety Technologies, LLC in
July 2002 from the original inventor. IST has also applied for,
and was granted the Trademark for the mark No Tug
Plug, in November, 2002.

The Company protects its intellectual property
rights through a combination of patent, trademark, trade secret
and other intellectual property law, nondisclosure agreements
and other measures. The Company believes, however, that its
financial performance will depend more upon the innovation and
marketing abilities of its employees than upon such protection.

Government Approval or Regulations

The Companys products do not require
additional testing or approval to meet any federal safety
regulations. Certain components that are a part of the IOS
system have been tested by their respective product and/or
component manufacturers. There are no federal regulations
related to the business.

Employees

As of February 28, 2003, the Company
employed 7 persons. None of the Companys employees
are covered by collective bargaining agreements, and the Company
believes its relations with its employees are good.




Item 2.     Properties

The Companys facilities in Portland, Oregon
consist of approximately 1,500 square feet of office space. This
office facility is occupied pursuant to a month-to-month lease.
The Company currently outsources all of its manufacturing and
assembly and therefore does not own or lease any manufacturing
space.




Item 3.     Legal
Proceedings

The Company is not a party to any pending legal
proceedings.




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

No matters were submitted to a vote of the
Companys shareholders during the year ended
December 28, 2002.

8



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##### Table of Contents






PART II






|        |                                                             
|------- | ------------------------------------------------------------
|Item 5. | Market for Common Equity and Related
    Stockholder Matters

The Companys common stock is quoted on the
Nasdaq Bulletin Board Market under the symbol MICG
The following table sets forth the high and low sales prices as
reported by the Nasdaq Bulletin Board Market for the periods
indicated.

|            |                |     |   |      |  |  |   |      | 
|----------- | -------------- | --- | - | ---- |  |  | - | ---- | 
|            |                | Low |   | High
|            |                |     |   |     
|Fiscal 2001 |                |     |   |      |  |  |   |     
|            | First Quarter  |     | $ | 0.08 |  |  | $ | 0.28 | 
|            | Second Quarter |     |   | 0.07 |  |  |   | 0.18 | 
|            | Third Quarter  |     |   | 0.04 |  |  |   | 0.15 | 
|            | Fourth Quarter |     |   | 0.04 |  |  |   | 0.16 | 
|Fiscal 2002 |                |     |   |      |  |  |   |     
|            | First Quarter  |     | $ | 0.05 |  |  | $ | 0.07 | 
|            | Second Quarter |     |   | 0.04 |  |  |   | 0.06 | 
|            | Third Quarter  |     |   | 0.05 |  |  |   | 0.25 | 
|            | Fourth Quarter |     |   | 0.19 |  |  |   | 0.78 | 

There were 173 shareholders of record and the
Company believes approximately 950 beneficial shareholders at
March 6, 2003. There were no cash dividends declared or
paid in fiscal years 2002 or 2001. The Company does not
anticipate declaring such dividends in the foreseeable future.

Securities Authorized for Issuance Under
Equity Compensation Plans

The following equity compensation information, as
of December 28, 2002, is presented in compliance with SEC
regulation S-B Item 201(d).

|                                                               |  |                  |           |                   |  |                  |      |  |  |  |     | 
|-------------------------------------------------------------- |  | ---------------- | --------- | ----------------- |  | ---------------- | ---- |  |  |  | --- | 
|                                                               |  |                  |           |                   |  | Number of       
|                                                               |  |                  |           |                   |  | Securities      
|                                                               |  |                  |           |                   |  | Remaining       
|                                                               |  |                  |           |                   |  | Available for   
|                                                               |  | Number of        |           |                   |  | Future Issuance 
|                                                               |  | Securities to be |           |                   |  | under Equity    
|                                                               |  | Issued upon      |           | Weighted Average  |  | Compensation    
|                                                               |  | Exercise of      |           | Exercise Price of |  | Plans (Excluding
|                                                               |  | Outstanding      |           | Outstanding       |  | Securities      
|                                                               |  | Options and      |           | Options and       |  | Reflected in    
|Plan category                                                  |  | Warrants(a)      |           | Warrants(b)       |  | Column(a))(c)   
|                                                               |  |                  |           |                   |  |                 
|Equity compensation plans approved by security
    holders     |  |                  | 261,188   |                   |  | $                | 0.39 |  |  |  | -0- | 
|Equity compensation plans not approved by
    security holders |  |                  | 2,086,000 |                   |  | $                | 0.45 |  |  |  | -0- | 
|Total                                                          |  |                  | 2,347,188 |                   |  | $                | 0.44 |  |  |  | -0- | 

The Company has an Incentive Stock Option Plan.
At December 28, 2002, 261,188 shares of common stock were
reserved for issuance to employees, officers and directors.
Under the Plan, the options may be granted to purchase shares of
the Companys common stock at fair market value, as
determined by the Companys Board of Directors, at the date
of grant. The options are exercisable over a period of up to
five years from the date of grant or such shorter term as
provided for in the Plan. The options become exercisable over
four years.

In connection with a Subordinated Promissory Note
agreement entered into on June 30, 2000, the Company issued
two stock warrants each to purchase individually 1,033,000
common shares at a price of $0.50 per share and $0.38722 per
share, respectively. On December 24, 2000, the Company
repaid the Subordinated Promissory Note. The warrants expire on
June 30, 2005.

9



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##### Table of Contents



On October 15, 1999 the Company issued a
warrant to certain of its debt holders to purchase 20,000 shares
of the Companys common stock at an exercise price of $0.75
per share. In accordance with the terms of the warrant, the
holder, in lieu of exercising the warrant, has the option to
convert the warrant into a number of shares to be determined
based on a formula which considers the difference between the
fair market value of the Companys common stock at the time
of conversion and the exercise price of the warrant. The warrant
expires in October 2003.






|        |                                                                                      
|------- | -------------------------------------------------------------------------------------
|Item 6. | Managements Discussion and Analysis
    of Financial Condition or Plan of Operations

Overview

On September 16, 2002 Microfield Graphics,
Inc. (the Company) acquired Innovative Safety
Technologies, LLC (IST). IST designs and sells internet based
security observation systems under the name Internet
ObservationTM Systems (IOS). It also sells a child
safety product under the name No Tug
PlugTM.

The IOS product consists of state of the art
digital video cameras that monitor a series of locations. The
output of the cameras are available for immediate viewing
locally or by accessing the system over the Internet from a
remote location. The IOS products are used for monitoring
interior and exterior business locations to reduce the incidence
of customer and employee theft, break-ins and vandalism; for
residential security and surveillance; for viewing loved ones at
a day care or assisted living facility, and for a variety of
other monitoring purposes. The recorded images can also be
stored for up to 60 days without changing the database storage
medium.

The No Tug PlugTM Safety Plate
attaches to a wall outlet and prevents an electrical cord from
being pulled out of an electrical socket by a small child,
thereby preventing them from sticking small fingers or objects
into an exposed outlet.

These two products are expected to provide the
substantial majority of the Companys sales in the
foreseeable future. The Companys results will therefore
depend on continued and increased market acceptance of these
products and the Companys ability to modify them to meet
the needs of its customers. Any reduction in demand for, or
increase in competition with respect to these products could
have a material adverse effect on the Companys financial
condition and results of operations.

Prior to October 24, 2000 the Company
developed, manufactured, and marketed computer conferencing and
telecommunications products that facilitate group
communications. The Companys product lines consisted of a
series of digital whiteboards, interactive rear projection
systems, and interactive plasma display systems sold under the
brand name SoftBoard, along with a variety of application
software packages, supplies and accessories. Information written
or drawn on the SoftBoard surface is recorded and displayed on a
personal computer simultaneously and in color, and utilizes
proprietary technology that had been owned by the Company.
Following the sale of assets to Greensteel, a wholly-owned
subsidiary of PolyVision Corporation, and prior to the
acquisition of Innovative Safety Technologies, LLC, the Company
had not been engaged in continuing operations.

The Company is continuing to explore new lines of
business through specific strategic acquisitions. While the
Company has no current binding agreements with respect to any
additional acquisitions, it is actively exploring further
potential acquisition transactions.

Critical Accounting Policies

The discussion and analysis of financial
condition and results of operations is based upon the
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. The
Company evaluates, on an on-going basis, its estimates and
judgments, including those related to sales returns, bad debts,
excess inventory, warranty obligations, income taxes,
contingencies and litigation. Its estimates are based on
historical experience and assumptions that we believe to be
reasonable under the circumstances, the results of which form
the basis for making judgments about the

10



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##### Table of Contents



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.


The Company believes the following critical
accounting policies, among others, affect its more significant
judgments and estimates used in the preparation of its
Consolidated Financial Statements:



| |   |                                    
| | - | -----------------------------------
| |  | Revenue recognition and allowances;
|
| |  | Inventories;                       
|
| |  | Impairment of long-lived assets;   
|
| |  | Accounting for income taxes;       

Revenue for the No Tug PlugTM is
recognized when products are shipped from the Companys
assembly subcontractor to the Companys customer. Revenue
for the IOS system is recognized when persuasive evidence of an
arrangement exists, the IOS system is fully installed, and the
Company has completed substantially all of its obligations for
installing the system and training the customer according to the
terms of the purchase contract. If the Company receives a
deposit from a customer, and services are required to fulfill
the Companys obligations under the purchase contract,
these deposits are recorded on the Companys balance sheet
as a liability for unearned revenue. Deposits are later
recognized as revenue on the Companys statement of
operations when these obligations are completed. Estimated
allowances for sales returns are accrued based on experience at
the time of shipment.

The Company maintains allowances for doubtful
accounts for estimated losses resulting from the inability of
our customers to make required payments. Accounts receivable,
historical bad debts, customer concentrations, customer
creditworthiness, current economic trends and changes in
customer payment terms and practices are analyzed when
evaluating the adequacy of the allowance for doubtful accounts.
If the financial condition of the Companys customers were
to deteriorate, resulting in an impairment of their ability to
make payments, additional allowances and charges against
earnings may be required.

The Company writes down inventory for estimated
excess and obsolete inventory equal to the difference between
the cost of inventory and the estimated fair value based upon
assumptions about future demand and market conditions. Any
significant unanticipated changes in demand or competitive
product developments could have a significant impact on the
value of the Companys inventory, and its reported results.
If actual market conditions are less favorable than those
projected, additional inventory write-downs, and charges against
earnings may be required.

Long-lived assets to be held and used are
reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amounts of such assets
may not be recoverable. Determination of recoverability is based
on an estimate of discounted future cash flows resulting from
the use of the asset and its eventual disposition. Measurement
of an impairment loss for long-lived assets that management
expects to hold and use is based on the fair value of the asset
as estimated using a discounted cash flow model.

The Company accounts for income taxes using the
asset and liability approach in accordance with Statement of
Financial Accounting Standards (SFAS) No. 109,
Accounting for Income Taxes. The asset and liability approach
requires the recognition of deferred tax liabilities and assets
for the expected future tax consequences of temporary
differences between the carrying amounts and the tax basis of
assets and liabilities. The effect on deferred taxes of a change
in tax rates is recognized in operations in the period that
includes the enactment date. Additionally, deferred tax assets
are evaluated and a valuation allowance is established if it is
more likely than not that all or a portion of the tax asset will
not be utilized.

11



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##### Table of Contents



Results of Operations

The following table sets forth, as a percentage
of sales, certain consolidated statement of operations data
relating to the business for the periods indicated.

|                                    |                                     |        |      |        |   |  |     |     | 
|----------------------------------- | ----------------------------------- | ------ | ---- | ------ | - |  | --- | --- | 
|                                    |                                     | Fiscal |      | Fiscal
|                                    |                                     | 2002   |      | 2001* 
|                                    |                                     |        |      |       
|Net sales                           |                                     |        | 100  | %      |   |  | N/A | %  
|Cost of goods sold                  |                                     |        | 62   |        |   |  | N/A |    
|                                    |                                     |        |      |        |   |  |     |    
|                                    | Gross profit                        |        |      | 38     |   |  |     | N/A | 
|Sales expenses                      |                                     |        | (32  | )      |   |  | N/A |    
|Marketing expenses                  |                                     |        | (18  | )      |   |  | N/A |    
|General and administrative expenses |                                     |        | (164 | )      |   |  | N/A |    
|                                    |                                     |        |      |        |   |  |     |    
|                                    | Loss from continuing operations     |        |      | (176   | ) |  |     | N/A | 
|Other income                        |                                     |        | 9    |        |   |  | N/A |    
|                                    |                                     |        |      |        |   |  |     |    
|                                    | Loss before income taxes            |        |      | (167   | ) |  |     | N/A | 
|Benefit from income taxes           |                                     |        |     |        |   |  | N/A |    
|                                    |                                     |        |      |        |   |  |     |    
|                                    | Loss before discontinued operations |        |      | (167   | ) |  |     | N/A | 
|Discontinued operations             |                                     |        | 10   |        |   |  | N/A |    
|                                    |                                     |        |      |        |   |  |     |    
|Net loss                            |                                     |        | (157 | )%     |   |  | N/A | %  
|                                    |                                     |        |      |        |   |  |     |    



---



|  |                                                                                                           
|- | ----------------------------------------------------------------------------------------------------------
|* | The Company had no revenue in 2001, therefore the
    amounts as a percentage of sales are not applicable.

Prior to the acquisition of IST, the Company was
not engaged in ongoing operations after the sale of
substantially all of its assets on October 24, 2000.
Therefore, no comparative data regarding sales, gross profit, or
marketing and sales expenses can be presented based on the
Companys current activities. The financial information
presented for the twelve months ended December 28, 2002,
represents activity in IST for the three and a half months from
the date of the acquisition, September 16, 2002 to the end
of the fiscal year, combined with the other income and general
and administrative expenses incurred by Microfield Graphics,
Inc. for the twelve month period ended December 28, 2002.

Sales.Revenue for
the fiscal year ended December 28, 2002 was $233,000
compared to $0 for the same period in 2001. The revenue amount
for the current fiscal year comprises product sales during the
three and a half months from the date of the acquisition of IST
to the end of the fiscal year. The Company had no sales in the
prior fiscal year. Sales of the No Tug Plug for this period
totaled $169,000, of which $159,000 was sold to one customer.

Cost of Sales.Cost
of sales totaled $144,000 for the fiscal year ended
December 28, 2002, compared to $0 for the same period in
the prior year.

Gross Profit.Gross
profit for the fiscal year ended December 28, 2002 was
$89,000 (or 38%) compared to $0 for the same fiscal year in
2001. The gross profit amount for the current fiscal year is the
result of product sales during the three and a half months from
the date of the acquisition of IST to the end of the fiscal
year. Sales of the No Tug Plug during this period to one
customer were $159,000. The low gross profit on the sales to
this customer is not indicative of the gross profit margin that
IST achieves on sales to other lower volume customers. Future
gross profit margins will depend on the volume and mix of sales
to its customers. It is anticipated that as revenues from the
IOS product line become a larger percentage of overall sales,
the higher margins associated with the IOS products will
increase the overall gross profit margin.

Sales & Marketing Expenses.Sales and marketing expenses were
$116,000 for the fiscal year ended December 28, 2002,
compared to $0 for the fiscal year ended December 29, 2001.
The sales and marketing expenses were for activities in IST
during the three and a half months from the date of the
acquisition of IST to the end of the fiscal year and relate
primarily to marketing efforts focused on expanding the market
of the

12



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##### Table of Contents



IOS product. The Company had no sales and
marketing efforts prior to September 16, 2002 in the
current year and had none in the prior year.


General and Administrative Expenses.General and administrative expenses
declined $16,000 to $381,000 for the fiscal year ended
December 28, 2002, compared to $397,000 for the fiscal year
ended December 29, 2001. The decline is partially due to a
reduction in pay for John B. Conroy, the Companys
previous Chief Executive Officer, from an annual salary of
$180,000 in 2001 to $90,000 in 2002. The decline was offset by
additional general and administrative expenses of IST incurred
during the three and a half month period from the date of the
acquisition of IST to the end of the fiscal year. The level of
general and administrative expenses for the 2003 fiscal year is
expected to increase significantly compared to the level
incurred in the twelve months ended December 28, 2002, due
to the future operations, and a full year of operations, of IST.

Interest Income.Interest income decreased $13,000 to
$9,000 for the fiscal year ended December 28, 2002,
compared to $22,000 for the fiscal year ended December 29,
2001. The decline is due to a decrease in cash reserves on
account at financial institutions as the Company drew on its
reserves to fund operations, and lower interest rates over the
investment period.

Other Income.Other
income during the twelve months ended December 28, 2002 was
$12,000 consisting of $6,000 in equipment rental income and an
insurance rebate of $6,000. Other income during the twelve
months ended December 29, 2001 was $82,000 primarily
consisting of $60,000 in consulting fees earned as a result of
an agreement between the Company and Christenson Electric, Inc.
and $17,000 of disputed accounts payable issues that were
resolved in the Companys favor. The Christenson agreement
was discontinued effective April 30, 2001.

Income Taxes.There
was no provision for income taxes in 2002 or 2001 due to losses
incurred by the Company in both years. No tax benefit from loss
carryback was recorded in either year as there was no income tax
paid in the open loss carryback periods.

Liquidity and Capital Resources

On September 16, 2002, the Company sold
1,363,629 shares of common stock in conjunction with a private
placement at $.22 per share. The Company received proceeds from
the private placement, net of related costs, of approximately
$280,000. Since inception, the Company has financed its
operations and capital expenditures through public and private
sales of equity securities, cash from operations, and borrowings
under bank lines of credit. At December 28, 2002, the
Company had net working capital of approximately $79,000 and its
primary source of liquidity consisted of cash and cash
equivalents.

On September 16, 2002, the Company acquired
Innovative Safety Technologies, LLC (IST) in exchange for
1,818,181 restricted shares of the Companys common stock.
Other than for legal and advisory expenses, no cash was paid for
the acquisition of IST.

Accounts receivable increased to $194,000 at
December 28, 2002 from $0 at December 29, 2001. The
increase is due primarily to outstanding trade receivables
resulting from sales of product by IST. There were no sales made
by the Company in 2001 which would give rise to a receivable
balance at the end of the fiscal year 2001. Inventory increased
to $50,000 at December 28, 2002 from $0 at
December 29, 2001. The increase is due to inventory
acquired in conjunction with the Companys merger with IST.

Property and equipment, net of depreciation
increased to $134,000 at December 28, 2002 compared to $0
at December 29, 2001 as a result of the merger with IST.
The increase consists of $109,000 related to a mold used to
manufacture the Companys products and $33,000 for
miscellaneous computer equipment, net of $8,000 of related
depreciation. Other long-term assets increased $547,000 to
$562,000 at December 28, 2002 from $15,000 at
December 29, 2001. The increase was due primarily to the
purchase of intangible assets and goodwill acquired in
conjunction with the merger with IST. The intangible assets
acquired consist of $330,000 of existing technology and $250,000
of goodwill. At December 28, 2002, the existing technology,
net of related amortization was $311,000.

13



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##### Table of Contents



Accounts payable increased $187,000 to $232,000
at December 28, 2002 compared to $45,000 at
December 29, 2001. At December 28, 2002, $77,000 of
accounts payable relate to legal expenses associated with the
Companys merger with Innovative Safety Technologies. Also
included in accounts payable are $122,000 in outstanding
payables that are associated with the operations of IST.

Accrued payroll and payroll taxes decreased
$7,000 to $9,000 at December 28, 2002 compared to $16,000
at December 29, 2001. This decrease was due to a difference
in the number of weeks of payroll and related taxes that were
outstanding at the end of the periods presented.

Other current liabilities increased $3,000 to
$40,000 at December 28, 2002 compared to $37,000 at
December 29, 2001. This balance consisted primarily of
$15,000 due for commissions and accrued vacation, $15,000 for
various loss accruals, and a $9,000 note payable to the
individual from whom Innovative Safety Technologies, LLC
purchased the initial version of the IOS product concept.

The Company believes it may not have sufficient
resources to satisfy cash requirements for the next twelve
months. This liquidity situation raises substantial doubt about
the Companys ability to continue as a going concern. If
certain assumptions do not hold true and objectives are not met,
the Company will need to raise additional capital during that
period. The Company is currently reviewing several alternatives
for raising capital from both current shareholders and new
sources of capital. An additional source of funds may be
available through the acquisition of entities that will provide
ongoing cash flow to support future operations. There can be no
assurance that additional capital will be available or, if
available, will be at terms acceptable to the Company.

The Company had no commitments for capital
expenditures in material amounts at December 28, 2002. The
Company anticipates adding several new employees during the next
twelve months if its products achieve increasing levels of
acceptance in the marketplace.

14



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##### Table of Contents



REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Shareholders of
Microfield Graphics, Inc.

In our opinion, the accompanying consolidated
balance sheet and the related consolidated statements of
operations, of changes in shareholders equity, and of cash
flows present fairly, in all material respects, the financial
position of Microfield Graphics, Inc. and its subsidiary at
December 28, 2002 and December 29, 2001, and the
results of their operations and their cash flows for the years
then ended in conformity with accounting principles generally
accepted in the United States of America. These financial
statements are the responsibility of the Companys
management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our
audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which
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, assessing the accounting principles used
and significant estimates made by management, and evaluating the
overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

The accompanying financial statements have been
prepared assuming that the Company will continue as a going
concern. As discussed in Note 3 to the financial statements, the
Company has suffered recurring losses from continuing operations
and has experienced negative cash flows from continuing
operating activities. In addition, the Company may not have
sufficient cash resources to meet short-term cash requirements.
These matters raise substantial doubt about the Companys
ability to continue as a going concern. Managements plans
in regard to these matters are also discussed in Note 3. The
financial statements do not include any adjustments that might
result from the outcome of this uncertainty.

Portland, Oregon

March 6, 2003


15



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##### Table of Contents






Item 7.     Financial
Statements

MICROFIELD GRAPHICS, INC.

CONSOLIDATED BALANCE SHEET

|                                         |                                                                                                                                       |                                            |         |              |           |  |        |             |         | 
|---------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ------------ | --------- |  | ------ | ----------- | ------- | 
|                                         |                                                                                                                                       | As of                                      |         | As of       
|                                         |                                                                                                                                       | December 28,                               |         | December 29,
|                                         |                                                                                                                                       | 2002                                       |         | 2001        
|                                         |                                                                                                                                       |                                            |         |             
|ASSETS                                  
|Current assets:                          |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         | Cash and cash equivalents                                                                                                             |                                            | $       | 90,981       |           |  | $      | 473,118     |        
|                                         | Accounts receivable, net of allowance of $5,162                                                                                       |                                            |         | 193,933      |           |  |        |            |        
|                                         | Inventory, net of allowance of $7,294                                                                                                 |                                            |         | 50,411       |           |  |        |            |        
|                                         | Other current assets                                                                                                                  |                                            |         | 23,826       |           |  |        |            |        
|                                         |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         |                                                                                                                                       | Total current assets                       |         |              | 359,151   |  |        |             | 473,118 | 
|Property and equipment, net              |                                                                                                                                       |                                            | 133,856 |              |           |  |       |            
|Intangible assets, net                   |                                                                                                                                       |                                            | 311,333 |              |           |  |       |            
|Goodwill                                 |                                                                                                                                       |                                            | 250,490 |              |           |  |       |            
|Other long-term assets                   |                                                                                                                                       |                                            |        |              |           |  | 14,992 |            
|                                         |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         |                                                                                                                                       | Total assets                               |         | $            | 1,054,830 |  |        | $           | 488,110 | 
|                                         |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                        
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|Current liabilities:                     |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         | Accounts payable                                                                                                                      |                                            | $       | 231,663      |           |  | $      | 45,320      |        
|                                         | Accrued payroll and payroll taxes                                                                                                     |                                            |         | 8,711        |           |  |        | 15,524      |        
|                                         | Other current liabilities                                                                                                             |                                            |         | 39,746       |           |  |        | 36,631      |        
|                                         |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         |                                                                                                                                       | Total current liabilities                  |         |              | 280,120   |  |        |             | 97,475  | 
|Shareholders equity:                    |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         | Common stock, no par value, 25,000,000 shares
    authorized, 8,224,652 and 4,596,066 shares issued and
    outstanding, respectively |                                            |         | 16,506,034   |           |  |        | 15,757,643  |        
|                                         | Accumulated deficit                                                                                                                   |                                            |         | (15,731,324  | )         |  |        | (15,367,008 | )      
|                                         |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         |                                                                                                                                       | Total shareholders equity                 |         |              | 774,710   |  |        |             | 390,635 | 
|                                         |                                                                                                                                       |                                            |         |              |           |  |        |            
|                                         |                                                                                                                                       | Total liabilities and shareholders equity |         | $            | 1,054,830 |  |        | $           | 488,110 | 
|                                         |                                                                                                                                       |                                            |         |              |           |  |        |            

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

16



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##### Table of Contents



MICROFIELD GRAPHICS, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

|                                                                    |                                                   |               |           |               |  |   |           |         |  
|------------------------------------------------------------------- | ------------------------------------------------- | ------------- | --------- | ------------- |  | - | --------- | ------- | -
|                                                                    |                                                   | Twelve Months |           | Twelve Months
|                                                                    |                                                   | December 28,  |           | December 29, 
|                                                                    |                                                   | 2002          |           | 2001         
|                                                                    |                                                   |               |           |              
|Sales                                                               |                                                   | $             | 232,648   |               |  | $ |          |        
|Cost of sales                                                       |                                                   |               | 143,508   |               |  |   |          |        
|                                                                    |                                                   |               |           |               |  |   |           |        
|Gross profit                                                        |                                                   |               | 89,140    |               |  |   |          |        
|                                                                    |                                                   |               |           |               |  |   |           |        
|Operating expenses:                                                 |                                                   |               |           |               |  |   |           |        
|                                                                    | Sales                                             |               |           | 74,163        |  |   |           |        |  
|                                                                    | Marketing                                         |               |           | 41,628        |  |   |           |        |  
|                                                                    | General and administrative                        |               |           | 381,276       |  |   |           | 396,851 |  
|                                                                    |                                                   |               |           |               |  |   |           |        
|Loss from operations                                                |                                                   |               | (407,927  | )             |  |   | (396,851  | )      
|Other income:                                                       |                                                   |               |           |               |  |   |           |        
|                                                                    | Interest income, net                              |               |           | 9,026         |  |   |           | 21,864  |  
|                                                                    | Other income, net                                 |               |           | 11,916        |  |   |           | 82,056  |  
|                                                                    |                                                   |               |           |               |  |   |           |        
|Loss before provision for income taxes                              |                                                   |               | (386,985  | )             |  |   | (292,931  | )      
|Provision for income taxes                                          |                                                   |               |          |               |  |   |          |        
|                                                                    |                                                   |               |           |               |  |   |           |        
|Loss from continuing operations                                     |                                                   |               | (386,985  | )             |  |   | (292,931  | )      
|Discontinued operations:                                            |                                                   |               |           |               |  |   |           |        
|                                                                    | (Loss) on discontinued SoftBoard operations       |               |           |               |  |   |           | (12,058 | )
|                                                                    | Gain on sale of discontinued SoftBoard operations |               |           | 22,669        |  |   |           | 21,903  |  
|                                                                    |                                                   |               |           |               |  |   |           |        
|Net loss                                                            |                                                   | $             | (364,316  | )             |  | $ | (283,086  | )      
|                                                                    |                                                   |               |           |               |  |   |           |        
|Basic and diluted net loss per share from
    continuing operations |                                                   | $             | (0.07     | )             |  | $ | (0.06     | )      
|                                                                    |                                                   |               |           |               |  |   |           |        
|Basic and diluted net loss per share                                |                                                   | $             | (0.07     | )             |  | $ | (0.06     | )      
|                                                                    |                                                   |               |           |               |  |   |           |        
|Weighted average shares used in calculation                         |                                                   |               | 5,599,654 |               |  |   | 4,596,253 |        
|                                                                    |                                                   |               |           |               |  |   |           |        

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

17



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##### Table of Contents



MICROFIELD GRAPHICS, INC.

STATEMENT OF CHANGES IN SHAREHOLDERS
EQUITY

|                                   |                           |        |           |         |  |             |            |               |  |   |             |   |  |   |          |        | 
|---------------------------------- | ------------------------- | ------ | --------- | ------- |  | ----------- | ---------- | ------------- |  | - | ----------- | - |  | - | -------- | ------ | 
|                                   |                           |        |           |         |  |             |            | Total        
|                                   |                           |        |           |         |  | Accumulated |            | Shareholders
|                                   |                           | Shares |           | Amount  |  | Deficit     |            | Equity       
|                                   |                           |        |           |         |  |             |            |              
|Balance, December 30, 2000         |                           |        | 4,597,066 |         |  | $           | 15,758,279 |               |  | $ | (15,083,922 | ) |  | $ | 674,357  |       
|Shares repurchased                 |                           |        | (1,000    | )       |  |             | (636       | )             |  |   |             |   |  |   | (636     | )     
|Net loss                           |                           |        |           |         |  |             |            |               |  |   | (283,086    | ) |  |   | (283,086 | )     
|                                   |                           |        |           |         |  |             |            |               |  |   |             |   |  |   |          |       
|Balance, December 29, 2001         |                           |        | 4,596,066 |         |  | $           | 15,757,643 |               |  | $ | (15,367,008 | ) |  | $ | 390,635  |       
|Shares issued upon merger with IST |                           |        | 1,818,181 |         |  |             | 400,000    |               |  |   |             |   |  |   | 400,000  |       
|Shares issued in private placement |                           |        | 1,363,629 |         |  |             | 280,000    |               |  |   |             |   |  |   | 280,000  |       
|Shares issued to settle            |                           |        |           |         |  |             |            |               |  |   |             |   |  |   |          |       
|                                   | Miscellaneous liabilities |        |           | 387,776 |  |             |            | 66,000        |  |   |             |   |  |   |          | 66,000 | 
|Stock options exercised            |                           |        | 59,000    |         |  |             | 2,391      |               |  |   |             |   |  |   | 2,391    |       
|Net loss                           |                           |        |           |         |  |             |            |               |  |   | (364,316    | ) |  |   | (364,316 | )     
|                                   |                           |        |           |         |  |             |            |               |  |   |             |   |  |   |          |       
|Balance December 28, 2002          |                           |        | 8,224,652 |         |  | $           | 16,506,034 |               |  | $ | (15,731,324 | ) |  | $ | 774,710  |       
|                                   |                           |        |           |         |  |             |            |               |  |   |             |   |  |   |          |       

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

18



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##### Table of Contents



MICROFIELD GRAPHICS, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |          |          |          |  
|------------------------------------------------------------------------------------- | ----------------------------------------------------------------- | --------------------------------------------------------- | ----------------------------------------------- | ------------ | -------- | -------- | -------- | -------- | -------- | -------- | -
|                                                                                      |                                                                   | Year Ended                                                |                                                 | Year Ended  
|                                                                                      |                                                                   | December 28,                                              |                                                 | December 29,
|                                                                                      |                                                                   | 2002                                                      |                                                 | 2001        
|                                                                                      |                                                                   |                                                           |                                                 |             
|Cash flows from operating activities:                                                 |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      | Net loss                                                          |                                                           | $                                               | (364,316     | )        |          | $        | (283,086 | )       
|Add (deduct)                                                                          |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      | Loss from discontinued operations                                 |                                                           |                                                 |             |          |          |          | 12,058   |         
|                                                                                      | Gain on sale of discontinued operations                           |                                                           |                                                 | (22,669      | )        |          |          | (21,903  | )       
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|Loss from continuing operations                                                       |                                                                   |                                                           | (386,985                                        | )            |          |          | (292,931 | )       
|Adjustments to reconcile loss from continuing
    operations to operating cash flows: |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      | Depreciation and amortization                                     |                                                           |                                                 | 26,586       |          |          |          |          |         
|                                                                                      | Changes in current assets and liabilities:                        |                                                           |                                                 |              |          |          |          |          |         
|                                                                                      |                                                                   | Accounts receivable                                       |                                                 |              | (184,340 | )        |          |          |          |         
|                                                                                      |                                                                   | Inventories                                               |                                                 |              | (25,806  | )        |          |          |          |         
|                                                                                      |                                                                   | Other current and long-term assets                        |                                                 |              | (8,801   | )        |          |          | 43,612   |         
|                                                                                      |                                                                   | Accounts payable                                          |                                                 |              | 127,681  |          |          |          | (35,830  | )       
|                                                                                      |                                                                   | Accrued payroll and payroll taxes                         |                                                 |              | (6,813   | )        |          |          | 7,504    |         
|                                                                                      |                                                                   | Other current liabilities                                 |                                                 |              | (222,565 | )        |          |          | (182,705 | )       
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      |                                                                   |                                                           | Net cash used by continuing operations          |              |          | (681,043 | )        |          |          | (460,350 | )
|                                                                                      |                                                                   |                                                           | Net cash provided by discontinued operations    |              |          | 22,669   |          |          |          | 103,470  |  
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      |                                                                   |                                                           | Net cash used by operating activities           |              |          | (658,374 | )        |          |          | (356,880 | )
|Cash flows from investing activities:                                                 |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      | Purchases of property and equipment                               |                                                           |                                                 | (8,348       | )        |          |          |          |         
|                                                                                      | Net cash acquired in merger with IST                              |                                                           |                                                 | 2,194        |          |          |          |          |         
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      |                                                                   |                                                           | Net cash flows used in investing activities     |              |          | (6,154   | )        |          |          |          |  
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|Cash flows from financing activities:                                                 |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      | Proceeds from issuance of common stock, net of
    issuance costs |                                                           |                                                 | 280,000      |          |          |          |          |         
|                                                                                      | Proceeds from exercise of stock options                           |                                                           |                                                 | 2,391        |          |          |          |          |         
|                                                                                      | Payment for repurchase of common stock                            |                                                           |                                                 |              |          |          |          | (636     | )       
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      |                                                                   |                                                           | Net cash flows provided by financing activities |              |          | 282,391  |          |          |          | (636     | )
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|Decrease in cash and cash equivalents                                                 |                                                                   |                                                           | (382,137                                        | )            |          |          | (357,516 | )       
|Cash and cash equivalents, beginning of year                                          |                                                                   |                                                           | 473,118                                         |              |          |          | 830,634  |         
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|Cash and cash equivalents, end of year                                                |                                                                   | $                                                         | 90,981                                          |              |          | $        | 473,118  |         
|                                                                                      |                                                                   |                                                           |                                                 |              |          |          |          |         
|Supplemental Disclosures of Cash Flow Information:                                    |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      |                                                                   | Cash paid during the year for:                            |                                                 |              |          |          |          |          |          |         
|                                                                                      |                                                                   |                                                           | Interest                                        |              | $        | 117      |          |          | $        |         |  
|                                                                                      |                                                                   |                                                           | Taxes                                           |              | $        |         |          |          | $        |         |  
|Supplemental schedule of noncash financing and
    investing activities:              |                                                                   |                                                           |                                                 |              |          |          |          |         
|                                                                                      |                                                                   | Common stock issued upon merger with IST                  |                                                 | $            | 400,000  |          |          | $        |         |         
|                                                                                      |                                                                   | Liabilities assumed from merger with IST                  |                                                 | $            | 113,400  |          |          | $        |         |         
|                                                                                      |                                                                   | Net intangible assets acquired in merger with IST         |                                                 | $            | (580,400 | )        |          | $        |         |         
|                                                                                      |                                                                   | Issuance of stock to settle miscellaneous
    liabilities |                                                 | $            | 66,000   |          |          | $        |         |         

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

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##### Table of Contents



MICROFIELD GRAPHICS, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

1. Description of Business

Microfield Graphics, Inc. (the
Company) specializes in the acquisition and
deployment of branded products and services with strong
intellectual property asset value, broad based market appeal and
the potential for significant growth. The Companys
objective is to leverage its assets and value to acquire a
portfolio of promising emerging companies that have achieved
real revenues and have attained, or are on the threshold of
positive cash flow. The Company currently develops, designs,
markets and sells safety and security related products under the
names No Tug PlugTM, and Internet
ObservationTM Systems. The Companys products
are marketed and sold to end users through distribution partners
and directly by the Company.

The Company was incorporated in October 1986 as
an Oregon Corporation, succeeding operations that began in
October 1984. The Companys headquarters are located in
Portland, Oregon.

2. Summary of Significant Accounting
Policies



| |            
| | -----------
| | Fiscal Year

The Companys fiscal year is the 52- or
53-week period ending on the Saturday closest to the last day of
December. The Companys current fiscal year is the 52-week
period ending December 28, 2002. The Companys last
fiscal year was the 52-week period ended December 29, 2001.



| |                            
| | ---------------------------
| | Principles of Consolidation

The Consolidated Statements of Operations
presented above, contain revenue and expense data of Microfield
Graphics, Inc. for the twelve months ended December 28, 2002 and
December 29, 2001, and revenue and expense data of its
subsidiary Innovative Safety Technologies for the 103 days
from the acquisition date, September 16, 2002, to the end
of the period presented. All significant inter-company accounts
and transactions between the Company and its subsidiary have
been eliminated in consolidation.



| |                          
| | -------------------------
| | Cash and Cash Equivalents

The Company considers all highly liquid
investments with an original maturity or remaining maturity of
three months or less at the date of purchase to be cash
equivalents. Cash and cash equivalents are primarily maintained
at one financial institution.



| |            
| | -----------
| | Inventories

Inventories are stated at the lower of cost or
market, using the first-in, first-out method. Inventory costs
include material, labor and overhead. The Company provides
inventory allowances based on estimates of excess and obsolete
inventories.



| |                  
| | -----------------
| | Advertising Costs

Advertising costs are expensed as incurred.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation of
computer equipment and software is computed using the
accelerated declining balance method over the estimated useful
lives of the assets. Estimated lives of five years are used for
computer equipment and software. The Companys No Tug
PlugTM mold is being depreciated using the units of
production method based on an estimated production of
4,000,000 units.

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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Concentrations

Financial instruments that potentially subject
the Company to concentrations of credit risk consist primarily
of accounts receivable. At December 28, 2002, 79% of
accounts receivable was concentrated with one customer. The
Company performs credit evaluations of its customers and does
not require collateral on accounts receivable balances. The
Company has not experienced material credit losses for the
periods presented. The level of sales to any single customer may
vary and the loss of any one of these customers, or a decrease
in the level of sales to any one of these customers, could have
a material adverse impact on the Companys financial
condition and results of operations.

The Company currently relies on single and
limited supply sources for key components used in the
manufacture of its products. Additionally, the Company relies on
two contract manufacturers for the production of its products.
The Company believes it can supplement or replace either of
these manufacturers should they fail to meet the Companys
production requirements. The inability of any single and limited
source suppliers or the inability of either contract
manufacturer to fulfill supply and production requirements,
respectively, could materially impact future operating results.

The Companys business is concentrated in
the safety and security area. Its future success depends on the
buying patterns of its customers and continued demand by
customers for the Companys products. The Companys
success will depend on its ability to enhance its existing
products and to develop and introduce, on a timely basis, new
cost-effective products as a result of the acquisition of
successful companies in line with its mission statement.

The Company classifies shipping costs as a cost
of sales in the month products associated with these costs are
shipped to customers.

Revenue
Recognition

No Tug
PlugTM.
Revenue is recognized when product is shipped from the
Companys assembly subcontractor to the Companys
customer, the price is fixed and collection is probable. Sales
terms are FOB shipping point.

Internet
ObservationTMSystems. Revenue is recognized when persuasive evidence of an
arrangement exists, the IOS system is fully installed, and the
Company has completed substantially all of its obligations for
installing the system and training the customer according to the
terms of the purchase contract. If the Company receives a
deposit from a customer, and services are required to fulfil the
Companys obligations under the purchase contract, these
deposits are listed on the Companys balance sheet as a
liability for unearned revenue. This is later recognized as
revenue on the Companys statement of operations when these
obligations are substantially complete.

IST has sales arrangements with agents and VARs
through which the IOS systems are sold. These marketing partners
purchase the IOS systems from the IST at a significant discount
off the retail sales price and are responsible for sales,
design, system configuration and installation of the IOS branded
system into their customers locations. Revenue on these
sales arrangements is recognized upon shipment of the product
from IST, or ISTs product vendors, to these agents or
VARs. IST is not responsible in these arrangements for any
installation, service or customer training before the revenue is
recognized.

As of December 28, 2002 IST did not offer
warranties on its products. Nevertheless, at the time of
shipment, IST accrues for potential claims for unusable product
or returns. Subsequent to year-end IST instituted a 12-month
warranty on parts and labor for the IOS systems.

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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Impairment of
Long-lived Assets

Long-lived assets to be held and used are
reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amounts of such assets
may not be recoverable. Determination of recoverability is based
on an estimate of discounted future cash flows resulting from
the use of the asset and its eventual disposition. Measurement
of an impairment loss for long-lived assets that management
expects to hold and use is based on the fair value of the asset
as estimated using a discounted cash flow model.



| |             
| | ------------
| | Income Taxes

The Company accounts for income taxes using the
asset and liability approach in accordance with Statement of
Financial Accounting Standards (SFAS) No. 109,
Accounting for Income Taxes. The asset and liability approach
requires the recognition of deferred tax liabilities and assets
for the expected future tax consequences of temporary
differences between the carrying amounts and the tax basis of
assets and liabilities. The effect on deferred taxes of a change
in tax rates is recognized in operations in the period that
includes the enactment date.



| |                                        
| | ---------------------------------------
| | Computation of Net Income per
    Share

Basic earnings (loss) per common share is
computed using the weighted-average number of common shares
outstanding during the period. Diluted earnings per common share
is computed using the combination of dilutive common share
equivalents and the weighted-average number of common shares
outstanding during the period. Diluted loss per common share for
2002 and 2001 is based only on the weighted-average number of
common shares outstanding during the period, as the inclusion of
2,347,188 and 2,155,000 common share equivalents would have been
antidilutive.



| |              
| | -------------
| | Stock Options

The Company adopted SFAS No. 123,
Accounting for Stock-Based Compensation, in 1996.
SFAS No. 123 allows companies to choose whether to account
for stock-based compensation on a fair value method or to
continue to account for stock-based compensation under the
current intrinsic value method as prescribed by APB Opinion
No. 25, Accounting for Stock Issued to
Employees. The Company has elected to continue to follow
the provisions of APB Opinion No. 25.

Had compensation cost for the Companys plan
been determined based on the fair value at the grant dates
consistent with the method of SFAS No. 123, the total value
of options granted would have been $85,835 for the year ended
December 28, 2002 and $2,353 for the year ended
December 29, 2001. Such amounts would be amortized over the
vesting period of the options. The total compensation expense
that would have been recognized if the Company had determined
such costs based on the fair value method would have been $4,545
and $1,631 for the years ended December 28, 2002 and
December 29, 2001, respectively.

Accordingly, under SFAS No. 123, the
Companys net loss and loss per share for the years ended
December 28, 2002 and December 29, 2001, would have
been changed to the pro forma amounts indicated below:

|                                     |  |             |  |            |  |           
|------------------------------------ |  | ----------- |  | ---------- |  | ----------
|                                     |  |             |  | 2002       |  | 2001      
|                                     |  |             |  |            |  |           
|Net loss                             |  | As reported |  | $(364,316) |  | $(283,086)
|                                     |  | Pro forma   |  | $(368,861) |  | $(284,717)
|Basic and diluted net loss per share |  | As reported |  | $(0.07)    |  | $(0.06)   
|                                     |  | Pro forma   |  | $(0.07)    |  | $(0.06)   

22



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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The effects of applying SFAS 123 for providing
pro forma disclosures for 2002 and 2001 are not likely to be
representative of the effects on reported net loss and net loss
per share for future years, because options vest over several
years and additional awards generally are made each year.



| |                     
| | --------------------
| | Comprehensive Income

The Company has no items of other comprehensive
income or expense. Accordingly, the Companys comprehensive
loss and net loss are the same for all periods presented.



| |                 
| | ----------------
| | Use of Estimates

The preparation of financial statements and
related disclosures in conformity with accounting principles
generally accepted in the United States requires management to
make estimates and assumptions that affect the amounts reported
in the Consolidated Financial Statements and accompanying notes.
Estimates are used for, but not limited to, the useful lives of
assets, allowances for doubtful accounts, product returns,
deferred tax assets, inventory reserves, accrued liabilities and
other reserves and contingencies. Actual results could differ
materially from these estimates.



| |                                     
| | ------------------------------------
| | Recent Accounting
    Pronouncements

SFAS 142.In July
2001, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards
No. 142 (SFAS 142), Goodwill and Other
Intangible Assets. SFAS 142, among other things,
establishes new standards for intangible assets acquired in a
business combination, eliminates amortization of goodwill and
sets forth requirements to periodically evaluate goodwill for
impairment. We adopted this standard during the current year in
connection with the purchase of IST. Accordingly, the goodwill
acquired is not being amortized. We have completed an initial
goodwill impairment assessment as of December 28, 2002 and
have determined that there is no impairment.

SFAS 144.In October
2001, the FASB issued SFAS No. 144 Accounting for the
Impairment or Disposal of Long-Lived Assets
(SFAS 144). SFAS 144 supersedes SFAS No. 121
Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of, and certain
provisions of APB Opinion No. 30 Reporting the
Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual
and Infrequently Occurring Events and Transactions.
SFAS 144 establishes standards for long-lived assets to be
disposed of, and redefines the valuation and presentation of
discontinued operations. SFAS 144 is effective for fiscal
years beginning after December 15, 2001, and interim
periods within those fiscal years. Management has completed its
evaluation of long-lived assets and has determined there to be
no impairments.

SFAS 145.In April
2002, the FASB issued SFAS 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections. The most relevant
provision of SFAS 145 is the rescission of SFAS 4,
Reporting Gains and Losses from Extinguishment of
Debt  An Amendment of APB Opinion No. 30,
which required all gains and losses from extinguishment of debt
to be aggregated and, if material, classified as an
extraordinary item, net of related income tax effect. As a
result of the rescission, the criteria in APB Opinion
No. 30 will now be used to classify those gains and losses.
The provisions of SFAS 145 related to the rescission of
SFAS 4 shall be applied in fiscal years beginning after
May 15, 2002, with early application encouraged. The
adoption of SFAS 145 will not have a material impact on the
Company.

SFAS 146.In June
2002, the FASB issued SFAS 146, Accounting for Costs
Associated with Exit or Disposal Activities. SFAS 146
addresses financial accounting and reporting for costs
associated with exit or disposal activities and nullifies
EITF 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring).
SFAS 146

23



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MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

requires the recognition of a liability when it
has been incurred. The initial measurement of that liability
shall approximate fair value. The provisions of SFAS 146 are
effective for exit or disposal activities initiated after
December 31, 2002, with earlier application encouraged. The
adoption of SFAS 146 will not have a material impact on the
Company, but may impact future disposal or exit activities, if
any.

FIN 45.In November
2002, the FASB issued FASB Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements
for Guarantees, including Indirect Guarantees of Others.
FIN 45 requires that upon issuance of a guarantee, a
guarantor must recognize a liability for the fair value of an
obligation assumed under a guarantee. FIN 45 also requires
additional disclosures by a guarantor in its interim and annual
financial statements about the obligations associated with
guarantees issued. The recognition provisions of FIN 45 are
effective for any guarantees issued or modified after
December 15, 2002. Management does not expect that the
adoption of FIN 45 will have a material effect on the
Companys financial position, results of operations, or
cash flows.

SFAS 148.In
December 2002, the FASB issued Statement of Financial Standards
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure.
SFAS 148 amends SFAS 123, Accounting for Stock
Based Compensation, to provide alternative methods of
transition for a voluntary change to the fair value based method
of accounting for stock-based compensation. In addition,
SFAS 148 amends the disclosure requirements of
SFAS 123 to require prominent disclosures in both annual
and interim financial statements about the method of accounting
for stock-based compensation and the effect of the method used
on reported results. The annual disclosure provisions of SFAS
148 are effective for periods ending after December 15,
2002. The interim disclosure provisions are effective for
financial reports containing financial statements for interim
periods beginning after December 15, 2002. Management does
not expect that the adoption of SFAS 148 will have a
material effect on the Companys financial position,
results of operations, or cash flows.

FIN 46.In January
2003, the FASB issued Interpretation No. 46,
Consolidation of Variable Interest Entities, an
interpretation of ARB No. 51. FIN 46 clarifies
that variable interest entities, as defined therein, that do not
disperse risks among the parties involved should be consolidated
by the entity that is determined to be the primary beneficiary.
FIN 46 also requires certain disclosures to be made by the
primary beneficiary and by an enterprise that holds a
significant variable interest in a variable interest entity but
is not the primary beneficiary. FIN 46 applies immediately
to variable interest entities created after January 31,
2003 and to variable interest entities in which an enterprise
obtains an interest after January 31, 2003. For variable
interest entities in which an enterprise holds a variable
interest that was acquired before February 1, 2003,
FIN 46 must be adopted no later than the first fiscal year
or interim period beginning after June 15, 2003.
FIN 46 is not currently applicable to the Company, as no
such arrangements exist, but may impact future arrangements, if
any.

3. Going Concern

The Company has suffered recurring losses from
ongoing operations and has experienced negative cash flows from
continuing operating activities. Additionally, the Company has
no significant available sources of liquidity. Such matters
raise substantial doubt about the Companys ability to
continue as a going concern. The Company believes it may not
have sufficient resources to satisfy cash requirements for the
next twelve months. If certain assumptions do not hold true and
objectives are not met, the Company will need to raise
additional capital during that period. The Company is currently
reviewing several alternatives for raising capital from both
current shareholders and new sources of capital. An additional
source of funds may be available through the acquisition of
entities that will provide ongoing cash flow to support future
operations. There can be no assurance that additional capital
will be available or, if available, will be at terms acceptable
to the Company. The consolidated financial statements do not
include any adjustments that could result from the outcome of
this uncertainty.

24



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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

4. Inventories

Inventories are stated at the lower of first-in,
first-out, cost or market value, and consist of the following:

|                                      |  |              |        |              |  |   |     | 
|------------------------------------- |  | ------------ | ------ | ------------ |  | - | --- | 
|                                      |  | December 28, |        | December 29,
|                                      |  | 2002         |        | 2001        
|                                      |  |              |        |             
|Raw materials                         |  | $            | 54,971 |              |  | $ | -0- | 
|Finished Goods                        |  |              | 2,734  |              |  |   | -0- | 
|                                      |  |              |        |              |  |   |     | 
|                                      |  |              | 57,705 |              |  |   | -0- | 
|Less allowance for obsolete inventory |  |              | (7,294 | )            |  |   | -0- | 
|                                      |  |              |        |              |  |   |     | 
|                                      |  | $            | 50,411 |              |  | $ | -0- | 
|                                      |  |              |        |              |  |   |     | 

5. Property and Equipment

|                                                 |  |              |         |              |  |   |     | 
|------------------------------------------------ |  | ------------ | ------- | ------------ |  | - | --- | 
|                                                 |  | December 28, |         | December 29,
|                                                 |  | 2002         |         | 2001        
|                                                 |  |              |         |             
|Property and equipment consist of the following: |  |              |         |              |  |   |     | 
|Equipment                                        |  | $            | 33,241  |              |  | $ | -0- | 
|Product mold                                     |  |              | 108,534 |              |  |   | -0- | 
|                                                 |  |              |         |              |  |   |     | 
|                                                 |  |              | 141,775 |              |  |   | -0- | 
|Less accumulated depreciation and amortization   |  |              | (7,919  | )            |  |   | -0- | 
|                                                 |  |              |         |              |  |   |     | 
|                                                 |  | $            | 133,856 |              |  | $ | -0- | 
|                                                 |  |              |         |              |  |   |     | 

6. Intangible Assets

The Company amortizes its intangible assets on a
straight line basis. The IOS purchased technology is being
amortized over five years, and the No Tug Plug purchased
technology over ten years.

|                                               |  |              |         |              |  |   |     | 
|---------------------------------------------- |  | ------------ | ------- | ------------ |  | - | --- | 
|                                               |  | December 28, |         | December 29,
|                                               |  | 2002         |         | 2001        
|                                               |  |              |         |             
|Intangible assets consist of the following:    |  |              |         |              |  |   |     | 
|Purchased technology-IOS                       |  | $            | 310,000 |              |  | $ | 0 | 
|Purchased technology-No Tug PlugTM             |  |              | 20,000  |              |  |   | 0 | 
|                                               |  |              |         |              |  |   |     | 
|                                               |  |              | 330,000 |              |  |   | 0 | 
|Less accumulated depreciation and amortization |  |              | (18,667 | )            |  |   |     | 
|                                               |  |              |         |              |  |   |     | 
|                                               |  | $            | 311,333 |              |  | $ | 0 | 
|                                               |  |              |         |              |  |   |     | 

Based on the Companys current intangible
assets, amortization expense for the five succeeding years will
be as follows:

|            |  |              |        | 
|----------- |  | ------------ | ------ | 
|            |  | Amortization
|Fiscal year |  | Expense     
|            |  |             
|2003        |  | $            | 64,000 | 
|2004        |  |              | 64,000 | 
|2005        |  |              | 64,000 | 
|2006        |  |              | 64,000 | 
|2007        |  |              | 45,917 | 

25



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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

7. Acquisition of Innovative Safety
Technologies, LLC.

On September 16, 2002, the Company acquired
Innovative Safety Technologies, LLC (IST) in exchange for
1,818,181 shares of the Companys common stock. The
shares of common stock issued in conjunction with the merger
were not registered under the Securities Act of 1933. The
acquisition of IST was accounted for using the purchase method
in accordance with SFAS 141, Business
Combinations. The results of operations for IST have been
included in the Consolidated Statements of Operations for the
year ended December 28, 2002, since the date of acquisition.

IST designs and sells safety and security related
products under the brand names No Tug PlugTM and
Internet ObservationTM Systems. The Company owns the
patent for the No Tug PlugTM which has a remaining
life of approximately 10 years. The Internet
ObservationTM Systems product is an application of
digital video security cameras that relay the signal to a
monitoring station that can be accessed locally, or using the
internet, from anywhere around the world. The Company
anticipates revenue from these acquired technologies will
provide the majority of the Companys revenues for the
foreseeable future.

The value of the Companys common stock was
determined based on the price of the Companys common stock
sold simultaneously with the merger in a private placement
offering to private investors on September 16, 2002. The
components of the purchase price were as follows:

|                         |  |   |         | 
|------------------------ |  | - | ------- | 
|Common Stock             |  | $ | 400,000 | 
|Direct acquisition costs |  |   | 67,000  | 
|                         |  |   |         | 
|Total purchase price     |  | $ | 467,000 | 
|                         |  |   |         | 

In accordance with Financial Accounting Standard
(SFAS) No. 141, Business Combinations, the total
purchase price was allocated to the estimated fair value of
assets acquired and liabilities assumed. The estimate of fair
value of the assets acquired was based on managements
estimates. The total purchase price was allocated to the assets
and liabilities acquired as follows:

|                              |  |   |          |  
|----------------------------- |  | - | -------- | -
|Cash and other current assets |  | $ | 36,400   |  
|Equipment                     |  |   | 133,400  |  
|Amortizable intangible assets |  |   | 330,000  |  
|Goodwill                      |  |   | 250,400  |  
|Current liabilities           |  |   | (230,800 | )
|Note payable                  |  |   | (52,400  | )
|                              |  |   |          |  
|Total                         |  | $ | 467,000  |  
|                              |  |   |          |  

Amortizable intangible assets consist of patents
and developed technology used in the Companys No Tug
PlugTM and Internet ObservationTM System
(IOS). These intangible assets acquired have estimated useful
lives as follows: Patent and existing technology relative to the
Companys No Tug PlugTM 
ten years; Developed technology relative to the IOS
product  five years. Goodwill of $250,490
represents the excess of the purchase price over the fair value
of the net tangible and intangible assets acquired. In
accordance with SFAS 142, goodwill is not amortized and
will be tested for impairment at least annually.

In accordance with the terms of the acquisition,
on September 26, 2002, the Company issued an additional
281,346 shares of common stock to employees of IST as settlement
for $46,000 of past due wages incurred prior to the acquisition.
These shares of stock are not registered under the Securities
Act of 1933 and must be held for the time required by
Rule 144 promulgated under the Securities Act. Subsequent
to that date, the Company paid an additional $64,000 in cash to
employees of IST for the remaining amounts owed for past due
wages. These amounts were included in the liabilities assumed on
September 16, 2002.

26



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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Also in accordance with the terms of the
acquisition, the Company issued an additional 45,454 shares of
its common stock in payment of $10,000 of past due amounts owed
by IST to a financial advisor. These shares of stock are not
registered under the Securities Act of 1933 and must be held for
the time required by Rule 144 promulgated under the
Securities Act. Subsequent to the acquisition, the Company paid
an additional $20,500 for the remaining amount owed to this
creditor. These amounts were included in the liabilities assumed
on September 16, 2002.

On November 6, 2002, the Company issued
60,976 of its common stock in payment of $10,000 of a note
payable owed by IST to the individual from whom Innovative
Safety Technologies, LLC purchased the initial version of the
IOS product concept. These shares of stock are not registered
under the Securities Act of 1933 and must be held for the time
required by Rule 144 promulgated under the Securities Act.
Subsequent to the common stock issuance, the note payable
balance was $10,000. The balance as of December 28, 2002
was $9,000 and is included in current liabilities.

The following unaudited pro forma information
presents a summary of the results of operations of the Company
assuming the acquisition of IST occurred on January 1, 2001.

|                                     |  |              |          |              |  |   |          |  
|------------------------------------ |  | ------------ | -------- | ------------ |  | - | -------- | -
|                                     |  | Year Ended   |          | Year Ended  
|                                     |  | December 28, |          | December 29,
|                                     |  | 2002         |          | 2001        
|                                     |  |              |          |             
|Sales                                |  | $            | 273,235  |              |  | $ | 769      |  
|Gross profit                         |  |              | 112,653  |              |  |   | 380      |  
|S G & A expenses                     |  |              | 912,891  |              |  |   | 535,768  |  
|                                     |  |              |          |              |  |   |          |  
|Operating loss                       |  |              | (800,238 | )            |  |   | (535,388 | )
|Other income & expense               |  |              | 21,642   |              |  |   | 102,184  |  
|                                     |  |              |          |              |  |   |          |  
|Loss from continuing operations      |  |              | (778,596 | )            |  |   | (433,204 | )
|Gain on discontinued operations      |  |              | 22,669   |              |  |   | 21,903   |  
|                                     |  |              |          |              |  |   |          |  
|Net loss                             |  | $            | (755,927 | )            |  | $ | (411,301 | )
|                                     |  |              |          |              |  |   |          |  
|Basic and diluted net loss per share |  | $            | (.13     | )            |  | $ | (.09     | )
|                                     |  |              |          |              |  |   |          |  

8. Private Placement

Concurrent with the acquisition on
September 16, 2002, the Company issued 1,363,629 shares of
restricted common stock in conjunction with a private placement
at $.22 per share. In total, the Company received net proceeds
from the private placement of approximately $280,000. Issuance
costs relative to the private placement were $20,000. These
shares of stock are not registered under the Securities Act of
1933 and must be held for the time required by Rule 144
promulgated under the Securities Act.

9. Discontinued Operations

On September 7, 2000, the Company entered
into a definitive agreement with Greensteel, Inc. (Greensteel),
a wholly-owned subsidiary of Polyvision Corporation, for the
sale of substantially all of the Companys assets used in
the Softboard operations. The terms of the asset sale called for
Greensteel to pay the Company up to $3,500,000, with $2,000,000
payable at the closing of the transaction and up to an
additional $1,500,000 in contingent earn-out payments based on
net sales of the Companys Softboard products over a
five-year period. Shareholders approved the agreement and the
transaction was finalized on October 24, 2000 and resulted
in a gain of $1,221,852.

A total of $22,669 in contingent earn-out
payments were received by the Company during the year ended
December 28, 2002. The Company received $21,903 during the
year ended December 29, 2001. These

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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

amounts were recorded as gain on the sale of
discontinued operations in the Consolidated Statements of
Operations.

As a result of shareholder approval of the
Greensteel agreement, discontinued operations accounting
treatment has been applied to the Softboard operation.
Accordingly, the net gain incurred from the Softboard operations
is reported in gain from discontinued operations for all periods
presented to reflect the reclassification of these operations as
discontinued. Also, cash flows from the Softboard operations are
reported as net cash provided by (used in) discontinued
operations whether associated with operating, investing or
financing activities.

10. Commitments and
Contingencies



| |       
| | ------
| | Leases

The Company leases its facilities on a
month-to-month basis. Rent expense for the years ended
December 28, 2002 and December 29, 2001 was $13,600
and $0, respectively.



| |                                           
| | ------------------------------------------
| | Manufacturing and Purchase
    Commitments

The Company has agreements with two
subcontractors for the production and assembly of the No Tug
PlugTM. These agreements are for services, under
which the Company places orders with these contractors for
product on an as needed basis. The Company does not provide
either of the subcontractors with a forecast and is not required
to give orders any specific amount of time in advance. These
agreements do not contain any material commitments for purchase
or assembly of product beyond the as needed basis.

11. Shareholders Equity



| |                            
| | ---------------------------
| | Incentive Stock Option Plan

The Company has a Stock Option Plan (the
Plan). At December 28, 2002 and
December 29, 2001, 261,188 and 69,000 shares of common
stock were reserved, respectively, for issuance to employees,
officers and directors. Under the Plan, the options may be
granted to purchase shares of the Companys common stock at
fair market value, as determined by the Companys Board of
Directors, at the date of grant. The options are exercisable
over a period of up to five years from the date of grant or such
shorter term as provided for in the Plan. The options become
exercisable over four years.

A summary of the status of the Companys
Stock Option Plan as of December 28, 2002 and
December 29, 2001 and for the years then ended is presented
below:

|                                 |                                      |                   |         |                   |   |        |     |          |   |  |        |        |  |   |     |     | 
|-------------------------------- | ------------------------------------ | ----------------- | ------- | ----------------- | - | ------ | --- | -------- | - |  | ------ | ------ |  | - | --- | --- | 
|                                 |                                      |                   |         |                  
|                                 |                                      | December 28, 2002 |         | December 29, 2001
|                                 |                                      |                   |         |                  
|                                 |                                      |                   |         | Weighted          |   |        |     | Weighted
|                                 |                                      |                   |         | Average           |   |        |     | Average 
|                                 |                                      |                   |         | Exercise          |   |        |     | Exercise
|                                 |                                      | Shares            |         | Price             |   | Shares |     | Price   
|                                 |                                      |                   |         |                   |   |        |     |         
|Outstanding at beginning of year |                                      |                   | 69,000  |                   |   | $      | .04 |          |   |  |       |        |  | $ |    |    
|                                 | Granted at market price              |                   |         | 176,188           |   |        |     | .39      |   |  |        | 69,000 |  |   |     | .04 | 
|                                 | Granted at greater than market price |                   |         | 75,000            |   |        |     | .44      |   |  |        |        |  |   |     |     | 
|                                 | Exercised                            |                   |         | (59,000           | ) |        |     | (.04     | ) |  |        |        |  |   |     |     | 
|                                 | Cancelled                            |                   |         |                   |   |        |     |          |   |  |        |        |  |   |     |     | 
|                                 |                                      |                   |         |                   |   |        |     |          |   |  |        |        |  |   |     |    
|Outstanding at end of year       |                                      |                   | 261,188 |                   |   | $      | .39 |          |   |  | 69,000 |        |  | $ | .04 |    
|Options exercisable at year end  |                                      |                   | 26,216  |                   |   | $      | .19 |          |   |  | 47,836 |        |  | $ | .04 |    

28



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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|               |             |                   |  |                  |         |                            |  |  |        |  |  |  |           | 
|-------------- | ----------- | ----------------- |  | ---------------- | ------- | -------------------------- |  |  | ------ |  |  |  | --------- | 
|               |             |                   |  |                 
|               |             | Number of Options |  |                 
|               |             |                   |  | Weighted Average
|Exercise price |             | Outstanding       |  | Exercisable      |         | Contractual Life Remaining
|               |             |                   |  |                  |         |                           
|$              | 0.04  0.05 |                   |  |                  | 16,000  |                            |  |  | 16,000 |  |  |  | 3.9 years | 
|$              | 0.40  0.44 |                   |  |                  | 245,188 |                            |  |  | 10,216 |  |  |  | 4.8 years | 
|               |             |                   |  |                  |         |                            |  |  |        |  |  |  |           | 
|               |             |                   |  |                  | 261,188 |                            |  |  | 26,216 |  |  |  |           | 

On October 2, 2001, the Company granted
69,000 options to purchase shares of the Companys common
stock to directors of the Company, with 44,000 shares
immediately exercisable and the remaining shares to become
exercisable ratably over 12 months. On June 5, 2002,
the Company granted 6,000 options to purchase shares of the
Companys common stock to directors of the Company. These
options were 100% vested upon grant. On October 30, 2002,
the Company granted 245,188 options to purchase shares of the
Companys common stock to employees of the Company. The
weighted average per share value of options granted during the
years ended December 28, 2002 and December 29, 2001
was $0.34 and $0.03, respectively. These options vest ratably
over forty-eight months starting with the month of grant. All
options granted in 2002 and 2001 are forfeited if not exercised
within five years.

The Company has computed for pro forma disclosure
purposes the value of all options granted during fiscal years
2002 and 2001 using the Black-Scholes pricing model as
prescribed by SFAS No. 123 (see note 2). The following
assumptions were used to calculate the value of options granted
during 2002 and 2001:

|                        |  |      |         |      |  |  |         | 
|----------------------- |  | ---- | ------- | ---- |  |  | ------- | 
|                        |  | 2002 |         | 2001
|                        |  |      |         |     
|Risk-free interest rate |  |      | 2.78%   |      |  |  | 4.6%    | 
|Expected dividend yield |  |      |        |      |  |  |        | 
|Expected lives          |  |      | 5 years |      |  |  | 5 years | 
|Expected volatility     |  |      | 133%    |      |  |  | 124%    | 



| |                      
| | ---------------------
| | Common stock warrants

On October 15, 1999 the Company issued a
warrant to certain of its debt holders to purchase
20,000 shares of the Companys common stock at an
exercise price of $0.75 per share. In accordance with the terms
of the warrant, the holder, in lieu of exercising the warrant,
has the option to convert the warrant into a number of shares to
be determined based on a formula which considers the difference
between the fair market value of the Companys common stock
at the time of conversion and the exercise price of the warrant.
The fair value of the warrants determined utilizing the
Black-Scholes pricing model at the time of issuance is
immaterial. The warrant expires in October 2003.

In connection with a Subordinated Promissory Note
agreement entered into on June 30, 2000, the Company issued
two stock warrants each to purchase individually 1,033,000
common shares at a price of $0.50 per share and $0.38722
per share, respectively. The fair value of the warrants was
determined using the Black-Scholes pricing model at the time of
issuance and was recorded as a debt discount upon issuance. On
December 24, 2000, the Company repaid the Subordinated
Promissory Note. The warrants expire on June 30, 2005.

12. Segment Information

IST operates in one individual segment comprised
of products that improve and promote safety and security. All
sales were to customers located in the United States. Sales of
the IOS product line were $64,000 and sales of the No Tug Plug
product line were $169,000 during the year ended
December 28, 2002.

29



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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

13. Income Taxes

The provision for income taxes for the years
ended December 28, 2002 and December 29, 2001 differs
from the amount which would be expected as a result of applying
the statutory tax rates to the losses before income taxes due
primarily to changes in the valuation allowance to fully reserve
net deferred tax assets.

Deferred tax assets are comprised of the
following components:

|                                             |  |              |            |              |  |   |            |  
|-------------------------------------------- |  | ------------ | ---------- | ------------ |  | - | ---------- | -
|                                             |  | December 28, |            | December 29,
|                                             |  | 2002         |            | 2001        
|                                             |  |              |            |             
|Current                                      |  |              |            |              |  |   |            |  
|Allowance for doubtful accounts              |  | $            | 1,980      |              |  | $ |           |  
|Employee benefits                            |  |              |           |              |  |   | 10,587     |  
|Start-up costs                               |  |              | 31,372     |              |  |   |           |  
|Inventory, warranty and other allowances     |  |              | 8,648      |              |  |   |           |  
|                                             |  |              |            |              |  |   |            |  
|                                             |  |              | 42,000     |              |  |   | 10,587     |  
|                                             |  |              |            |              |  |   |            |  
|Non-current Net operating loss carryforwards |  |              | 5,726,210  |              |  |   | 5,745,038  |  
|Start-up costs                               |  |              | 94,115     |              |  |   |           |  
|Research and development credits             |  |              | 176,829    |              |  |   | 218,616    |  
|                                             |  |              |            |              |  |   |            |  
|                                             |  |              | 5,997,154  |              |  |   | 5,963,654  |  
|                                             |  |              |            |              |  |   |            |  
|Total deferred tax asset                     |  |              | 6,039,154  |              |  |   | 5,974,241  |  
|Deferred tax asset valuation allowance       |  |              | (6,039,154 | )            |  |   | (5,974,241 | )
|                                             |  |              |            |              |  |   |            |  
|Net deferred tax assets                      |  | $            |           |              |  | $ |           |  
|                                             |  |              |            |              |  |   |            |  

At December 28, 2002, the Company had
available net operating loss carryforwards of approximately
$14,927,554 for federal income tax purposes. Such carryforwards
may be used to reduce consolidated taxable income, if any, in
future years through their expiration in 2004 to 2022.
Utilization of net operating loss carryforwards may be limited
due to the ownership changes resulting from the Companys
initial public offering in 1995 and the Companys
acquisition of IST on September 16, 2002. In addition, the
Company has research and development credits aggregating
$176,829 for income tax purposes at December 28, 2002. Such
credits may be used to reduce taxes payable, if any, in future
years through their expiration in 2003 to 2012.

14. Subsequent Event

On February 28, 2003, the Company entered
into a Stock Purchase and Pledge Agreement (the
Agreement) with Steelcase, Inc.
(Steelcase) to repurchase 951,445 of the
Companys common shares held by Steelcase. Pursuant to the
terms of the Agreement, the Company repurchased these shares for
a base amount of approximately $209,319, or $0.22 per share,
subject to adjustment. The Company issued a three year
Promissory Note (the Note) for payment of this
amount. Payments of principal under the Note will be made in
three equal annual installments of approximately $69,773, on the
first, second and third anniversaries of the date of the Note.
The Note carries an interest rate of 12%, payable quarterly,
starting on June 1, 2003 until the principal amount of the
Note is paid in full.

The terms of the Agreement allow for early
payment of the Note. If the entire purchase price and accrued
interest owed under the Note is paid in full within
180 days from the date of the Note, the purchase price paid
for the common shares will be adjusted down to $190,289 or $0.20
per common share.

If the Note and accrued interest is paid
according to the terms of the Note, on the third anniversary
date of the Note the parties shall calculate a new purchase
price based on the average market closing price of the

30



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##### Table of Contents



MICROFIELD GRAPHICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Companys common stock for the 180 days
prior to the third anniversary date. If the average market
closing price per common share over this 180 period is less than
$0.22 per common share, then the purchase price payable under
the Agreement will remain at $209,319 or $0.22 per common share.
If the average market closing price per share over this 180
period is greater than $0.22 per common share, then the purchase
price payable under the Agreement will be increased by an amount
equal to the excess of this 180 day average market closing
price per common share over $0.22 per common share, times
951,445 shares. Under this purchase price adjustment, the
maximum purchase price paid will not exceed approximately
$333,006, or $0.35 per common share.

For purposes of all purchase price adjustments
under the Agreement, the number of common shares and per share
amounts are subject to adjustments to give effect to stock
splits, dividends, reorganizations and recapitalizations and
other similar transactions occurring after the date of the
Agreement.






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

None

31



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##### Table of Contents






PART III






|        |                                                                                                                        
|------- | -----------------------------------------------------------------------------------------------------------------------
|Item 9. | Directors, Executive Officers, Promoters
    and Control Persons; Compliance with Section 16(a) of the
    Exchange Act

The names, ages and positions of the
Companys executive officers and directors are as follows:

|                    |  |     |    |                                  |  |                                      
|------------------- |  | --- | -- | -------------------------------- |  | -------------------------------------
|Name                |  | Age |    | Current Position(s) with Company
|                    |  |     |    |                                 
|Steven M. Wright    |  |     | 40 |                                  |  | President and Chief Executive Officer
|R. Patrick Hanlin   |  |     | 42 |                                  |  | Chairman of the Board                
|John B. Conroy      |  |     | 64 |                                  |  | Director                             
|Michael W. Stansell |  |     | 60 |                                  |  | Director                             

Steven M. Wrightjoined Microfield in September 2002
and was appointed President and Chief Executive Officer that
same month. Prior to joining Microfield, Mr. Wright was the
founder and Managing Partner of Innovative Safety Technologies,
LLC from its inception in July 2001 to September 2002.
Mr. Wright was Chief Operating Officer, Director and
Co-founder of Card Capture Services, Inc. an international ATM
provider, from March 1992 through May 2000. Mr. Wright
holds a BBS in Marketing and Management from the University of
Oregon.

R. Patrick Hanlinjoined the Company as its Chairman in
September 2002. Mr. Hanlin was the founder and has been the
President and a director of Livebridge, Inc. a multi-channel
communications service provider from February 1988 to the
present time. Mr. Hanlin holds a BA in Business and
Communications from the University of Oregon.

John B. Conroyjoined the Company in May 1986 and was
appointed President and elected a Director that same month.
Mr. Conroy was designated Chief Executive Officer by the
Board of Directors in January 1987, and appointed Chairman of
the Board of Directors in June 1996. Mr. Conroy resigned as
President in November 1999, and resigned as Chairman and Chief
Executive Officer in September 2002. Mr. Conroy remains a
Director. Mr. Conroy previously held executive management
positions with a number of computer industry companies, has
served as a Director of several, and holds a BSEE from New York
University.

Michael W. Stanselljoined the Company in November 1985 as
Director of Manufacturing and was appointed Vice President,
Operations, in January 1987. Mr. Stansell was appointed to
the Companys board of directors in November 1999 and
served as the Companys President from November 1999 until
October 2000. Mr. Stansell remains a Director.
Mr. Stansell is currently the Vice President of Support
Services for Christenson Electric, Inc. an electrical
contractor. Mr. Stansell was a division manufacturing
manager, among other positions, at Tektronix Corporation from
August 1965 through October 1985.

All of the information with respect to directors
of the Company and Section 16(a) required by this item is
included in the Companys definitive proxy statement for
its 2003 Annual Meeting of Shareholders under the captions
Election of Directorsand Section 16(a)
Beneficial Ownership Reporting Compliance,respectively, and
is incorporated herein by reference.






|         |                       
|-------- | ----------------------
|Item 10. | Executive Compensation

The information required by this item is included
in the Companys definitive proxy statement for its 2003
Annual Meeting of Shareholders under the caption Executive
Compensation and Other Mattersand is incorporated herein by
reference.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 11. | Security Ownership of Certain Beneficial
    Owners and Management

The information required by this item is included
in the Companys definitive proxy statement for its 2003
Annual Meeting of Shareholders under the caption Security
Ownership of Certain Beneficial Owners and Managementand is
incorporated herein by reference.

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|         |                                                   
|-------- | --------------------------------------------------
|Item 12. | Certain Relationships and Related
    Transactions

The information required by this item is included
in the Companys definitive proxy statement for its 2003
Annual Meeting of Shareholders under the caption Certain
Relationships and Related Transactionsand is incorporated
herein by reference.




Item 13.     Exhibits
and Reports on Form 8-K

(a) Exhibits included herein:

|            |           |  |  |                                                                                                                                                                                                                                      
|----------- | --------- |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |           | 
|            |           | 
|            | *3.1      |  |  | Articles of Incorporation, as amended                                                                                                                                                                                                
|            | *3.2      |  |  | Bylaws, as amended                                                                                                                                                                                                                   
|            | *4.1      |  |  | See Article III of Exhibit 3.1 and
    Articles I and VI of Exhibit 3.2 #                                                                                                                                                            
|            | *10.1     |  |  | 1986 Stock Option Plan, as amended                                                                                                                                                                                                   
|            | *10.3     |  |  | Form of Incentive Stock Option Agreement                                                                                                                                                                                             
|            | *10.7     |  |  | Form of Representatives Warrants                                                                                                                                                                                                    
|            | **10.11   |  |  | Restated 1995 Stock Incentive Plan dated
    May 11, 1998.                                                                                                                                                                           
|            | ***10.14  |  |  | Form of $400,000 Subordinated Promissory Note
    issued to JMW Capital Partners, Inc., dated June 30, 2000.                                                                                                                         
|            | ***10.15  |  |  | Form of Stock Purchase Warrants to Purchase
    Shares of Common Stock of Microfield Graphics, Inc. issued to
    JMW Capital Partners, Inc., dated June 30, 2000.                                                                   
|            | ***10.16  |  |  | Form of Registration Rights Agreement between the
    Company and JMW Capital Partners, Inc., dated June 30, 2000.                                                                                                                   
|            | ***10.17  |  |  | Form of Note and Warrant Purchase Agreement
    between the Company and JMW Capital Partners, Inc. dated
    June 30, 2000.                                                                                                          
|            | ****10.18 |  |  | Form of Asset Purchase Agreement between
    Greensteel, Inc., and Microfield Graphics, Inc., dated
    September 7, 2000, incorporated by reference to the
    Companys Proxy Statement dated October 3, 2000.                     
|            | 10.19     |  |  | Form of Agreement and Plan of Merger between
    Microfield Graphics, Inc., and Innovative Safety Technologies,
    LLC. dated September 16, 2002 incorporated by reference to
    the Registrants Form 8-K dated September 17, 2002.
|            | 23.1      |  |  | Consent of PricewaterhouseCoopers LLP,
    Independent Accountants, filed herewith.                                                                                                                                                  
|            | 99.1      |  |  | Certification pursuant to 18 U.S.C.
    Section 1350, as adopted pursuant to Section 906 of
    the Sarbanes-Oxley Act of 2002.                                                                                                      



---



| |   |                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | Incorporated by reference to Exhibits 3.1,
    3.2, 4.1, 10.1, 10.3, 10.7, as applicable, to Registrants
    Registration Statement on Form SB-2 (Registration
    No. 33-918900).



| |    |                                                                                                                                                 
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------
| | ** | Incorporated by reference to Exhibit 10.11
    to Registrants Quarterly Report on Form 10-QSB for the
    three month period ended July 3, 1999.



| |     |                                                                                                                                                                                           
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | *** | Incorporated by reference to Exhibits 10.14,
    10.15, 10.16, 10.17, as applicable, to Registrants Quarterly
    Report on Form 10-QSB for the three month period ended
    July 1, 2000.



|     |                                                                                                                                                       
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------
|**** | Incorporated by reference to Exhibit 10.18
    to Registrants Quarterly Report on Form 10-QSB for the
    three month period ended September 30, 2000.



| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| | # | This exhibit constitutes a management contract,
    or compensatory plan or arrangement.

(b)     Reports filed
during the quarter on Form 8-K

|            |       |  |  |                                                                                                                                                                                                                                        
|----------- | ----- |  |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |       | 
|            |       | 
|            | 10.19 |  |  | Form of Agreement and Plan of Merger between
    Microfield Graphics, Inc., and Innovative Safety Technologies,
    LLC., dated September 16, 2002. incorporated by reference
    to the Registrants Form 8-K dated September 17, 2002.

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|         |                        
|-------- | -----------------------
|Item 14. | Controls and Procedures

Within the 90-day period prior to the date of
this report, the Company carried out an evaluation, under the
supervision and with the participation of the Companys
management, including the Companys Chief Executive
Officer, of the effectiveness of the design and operation of the
Companys disclosure controls and procedures pursuant to
Rule 13a-14 of the Securities Exchange Act of 1934 (the
Exchange Act). Based upon that evaluation, the Chief
Executive Officer concluded that the Companys disclosure
controls and procedures are effective in timely alerting them to
material information relating to the Company (including its
consolidated subsidiaries) required to be included in the
Companys Exchange Act filings. The Company does not
currently have a Chief Financial Officer.

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SIGNATURES

In accordance with Section 13 or 15(d) of
the Exchange Act, the registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.



| |                          
| | -------------------------
| | MICROFIELD GRAPHICS, INC.



| |     |                     
| | --- | --------------------
| | By: | /s/ STEVEN M. WRIGHT

| |                                          
| | -----------------------------------------
| |                                          
| | Steven M. Wright                         
| | President and Chief Executive
    Officer

Dated: March 21, 2003

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/ STEVEN M. WRIGHTSteven M. Wright       |  | President, Chief Executive Officer and Director |  | March 21, 2003
|                                          
|/s/ R. PATRICK HANLINR. Patrick Hanlin     |  | Chairman of the Board and Director              |  | March 21, 2003
|                                          
|/s/ JOHN B. CONROYJohn B. Conroy           |  | Director                                        |  | March 21, 2003
|                                          
|/s/ MICHAEL W. STANSELLMichael W. Stansell |  | Director                                        |  | March 21, 2003

35



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CERTIFICATIONS

I, Steven M. Wright, certify that:

1. I have reviewed this annual report on
Form 10-KSB of Microfield Graphics, Inc.;

2. Based on my knowledge, this annual report
does not contain any untrue statement of a material fact or omit
to state a material fact necessary to make the statements made,
in light of the circumstances under which such statements were
made, not misleading with respect to the period covered by this
annual report;

3. Based on my knowledge, the financial
statements, and other financial information included in this
annual report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual
report;

4. The registrants other certifying
officers and I are responsible for establishing and maintaining
disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we have:



| |                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this annual report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this annual
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this annual report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date;                                                                                                                                

5. The registrants other certifying
officers and I have disclosed, based on our most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent function):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6. The registrants other certifying
officers and I have indicated in this annual report whether or
not there were significant changes in internal controls or in
other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



| |                                          
| | -----------------------------------------
| | /s/ STEVEN M. WRIGHT                     
| |                                          
| | Steven M. Wright                         
| | President and Chief Executive
    Officer

Date: March 21, 2003

36