##### 









UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


WASHINGTON D.C. 20549




---

ANNUAL REPORT ON FORM 10-K

|    |  |                                                                                             
|--- |  | --------------------------------------------------------------------------------------------
|[X] |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF
    THE SECURITIES EXCHANGE ACT OF 1934
|   
|    |  | For the fiscal year ended December 31,
    2002                                             

Commission file number 0-21013




Xybernaut Corporation

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                     
|------------------------------------------------------------------ |  | ------------------------------------
|DELAWARE                                                           |  | 54-1799851                          
|(State or other jurisdiction of incorporation
    or organization) |  | (I.R.S. Employer Identification No.)
|                                                                  
|12701 Fair Lakes Circle
    Fairfax, VA                            |  | 22033                               
|(Address of principal executive
    offices)                       |  | (Zip Code)                          

(703) 631-6925

(Issuers telephone number, including
area code)


Securities registered under Section 12(b)
of the Exchange
Act:None

Securities registered under section 12(g) of
the Exchange
Act:Common
Stock, $0.01 par value

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

Check if there is no disclosure of delinquent
filers in response to Item 405 of Regulation S-K 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
this Form 10-K or any amendment to this
Form 10-K:     o

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Exchange Act
Rule 12b-2).     Yes o  No x

The aggregate market value of the Common Stock of
the issuer, its only class of voting stock, was $41,295,351, of
which $39,307,083 was held by non-affiliates, calculated on the
basis of the closing sale price of such stock on the National
Association of Securities Dealers Automated Quotation System as
of June 28, 2002, the last business day of the
registrants most recently completed second fiscal quarter.
The market value of non-affiliates excludes shares owned by all
executive officers and directors (but includes shares owned by
their spouses) which should not be construed as indicating that
all such persons are affiliates.

The number of shares outstanding of the
registrants Common Stock as of March 26, 2003 was
128,824,057.

Documents Incorporated by
Reference:     None









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##### 



XYBERNAUT CORPORATION

ANNUAL REPORT ON FORM 10-K

INDEX

|             |  |                                                                                           |  |      |    | 
|------------ |  | ----------------------------------------------------------------------------------------- |  | ---- | -- | 
|             |  |                                                                                           |  | Page |   
|             |  |                                                                                           |  |      |   
|             |  | PART I                                                                                    |  |      |    | 
|Item 1.      |  | Business                                                                                  |  |      | 2  | 
|Item 2.      |  | Properties                                                                                |  |      | 16 | 
|Item 3.      |  | Legal Proceedings                                                                         |  |      | 17 | 
|Item 4.      |  | Submission of Matters to a Vote of Security
    Holders                                   |  |      | 17 | 
|             |  | PART II                                                                                   |  |      |    | 
|Item 5.      |  | Market for Common Equity and Related Stockholder
    Matters                              |  |      | 17 | 
|Item 6.      |  | Selected Financial Data                                                                   |  |      | 18 | 
|Item 7.      |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations |  |      | 18 | 
|Item 7A.     |  | Quantitative and Qualitative Disclosures about
    Market Risk                            |  |      | 37 | 
|Item 8.      |  | Financial Statements and Supplementary Data                                               |  |      | 39 | 
|Item 9.      |  | Changes in and Disagreements with Accountants on
    Accounting and Financial Disclosure  |  |      | 40 | 
|             |  | PART III                                                                                  |  |      |    | 
|Items 1013. |  | Not included herein                                                                       |  |      | 40 | 
|Item 14.     |  | Controls and Procedures                                                                   |  |      | 40 | 
|Item 15.     |  | Principal Accountant Fees and Services                                                    |  |      | 40 | 
|             |  | PART IV                                                                                   |  |      |    | 
|Item 16.     |  | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K Signatures            |  |      | 40 | 

1



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PART I

Item 1.     Business.



Introduction


Xybernaut Corporation, a Delaware corporation
(Xybernaut or the Company), originally
incorporated in 1990, is engaged in the research, development,
manufacture, marketing and sales of mobile, wearable computing
and communication systems as well as software and service
solutions designed to enhance productivity and improve product
management, asset management and the accuracy, timeliness and
utilization of captured data. The Company offers solutions with
a software and services focus through its wholly-owned
subsidiary Xybernaut Solutions, Inc. (XSI). The
Company offers solutions with a hardware focus through its U.S.
operations and through its wholly-owned subsidiaries Xybernaut
K.K. (Japan) and Xybernaut GmbH (Germany).

The Mobile Assistant® (MA®)
series is the Companys primary line of hardware products,
the current versions of which are the Mobile Assistant V
(MA V) and MA TC. Since its commercial introduction
in 1995, the Company has recognized revenue of approximately
$19,500,000 on sales of approximately 4,000 units of the MA
series. During 2002, the Company introduced the Atigo
product line, a family of wireless web panels that can be used
either as stand-alone handheld personal computers
(PCs) or as displays for an MA system, a laptop or a
conventional PC.

The MA is a wearable PC which combines the speed,
memory, processing, multimedia and communications capabilities
of a desktop PC in a lightweight, user-supported unit with
hands-free operation and simultaneous user mobility. The MA is a
combination of hardware and software designed to be worn on the
body to perform complex tasks such as installation, maintenance,
repair and inspection of complex technological and mechanical
systems; remote video teleconferencing; the retrieval and
analysis of information from remote locations; the coordination
of remote commercial and industrial activities; military field
operations and homeland defense; retail services; and
queue-busting. The lightweight body-worn MA
computing unit is designed to allow operation in conditions in
which conventional portable computers can not effectively or
efficiently operate and supports software applications designed
for Microsoft® Windows®, MS-DOS, LINUX and UNIX.

The MA supports technologically advanced features
such as real-time, two-way video and audio communications
through radio frequency transmissions or cellular linkups,
global positioning system (GPS) tracking
capabilities and wireless access to information through
corporate intranets, the Internet and the World Wide Web. The MA
can be used with several proprietary versions of light-weight,
all-light readable, full color flat panel display
(FPDs). Additionally, the MA can be used with
head-mounted displays (HMDs), which are offered for
sale by Xybernaut as well as our partners and other vendors.
Available HMDs present desk-top quality color images equivalent
to that of a desktop PC monitor at a distance of 18 inches and
allow for full hands-free operation, two-way video and audio
capabilities.

The Atigo product line can be used as a
stand-alone handheld computer and/or as a wireless FPD for a MA
or standard PC. As a stand-alone device, it offers a more
flexible platform than many other mobile computing devices
including personal digital assistants (PDAs),
laptops and tablet PCs. As a wireless display, it provides the
full functionality of the MA, laptop or conventional PC while
maintaining its user-friendly mobile form factor. Since Atigo
can switch from functioning as a stand-alone computer to
wireless FPD in real-time, it provides a unique and seamless
computing environment between mobile employees and
centrally-located servers. Atigo products are built-to-order to
meet specific customer requirements. Customers often take
advantage of customized Atigo features, including use of
corporate logos or colors for branding, unique wearability
accessories, custom software configurations and existing
application support. The unique nature of the dual-purpose Atigo
display is protected by the Companys patents filed
worldwide.

Two early adopters of Atigo technology are the
retail and transportation industries. In the retail sector,
Atigo can provide customer relationship management solutions as
well as real-time access to critical data, including information
such as detailed merchandise specifications, competitive product
analysis, warranty/

2



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service offerings and more. This information can
be remotely pulled from centrally located databases and
delivered directly to retail sales representatives in order to
supply customers with a more complete perspective of product
options. In the transportation industry, Atigo can be used in a
broad array of applications for field personnel, including
inventory management, quality assurance, workflow, remote data
collection, knowledge management and security.


Through XSI, the Company provides software,
application development and implementation services in support
of clients in a variety of industries. XSI programming
capabilities include advanced languages that are developed to
run on Wintel based operating systems in conjunction
with industry standard database technologies. In addition, XSI
sells asset management software used for linear referenced
assets including roads, railways, utility, and pipelines and
enterprise project management software for the management of
business critical projects, costs and resources across a wide
range of industries.

XSI offers the proprietary OPMIST asset
management system that has been installed in over 200 sites
worldwide at shipyards, utilities, manufacturers, Departments of
Transportation (DOTs), military bases and railroads.
Also offered by XSI is the Program and Project Management System
(PPMS) solution that has been provided to several
state DOTs. The PPMS is a fully integrated program, project and
task management system designed by XSI in conjunction with state
DOTs to help them manage their capital improvement programs. The
PPMS is a total solution that includes commercial-off-the-shelf
(COTS) project scheduling systems, such as Artemis,
Primavera, OPX2 and Microsoft Project. By using the PPMS, state
DOT organizations have the ability to model every project
included in capital improvement programs.

The Companys executive and administrative
offices are located at 12701 Fair Lakes Circle, Fairfax,
Virginia 22033. The Companys telephone number is
(703) 631-6925, and e-mail address for investor inquiries
is investorrel@xybernaut.com.

Forward-Looking Statements

To keep investors informed of the Companys
future plans and objectives, this Annual Report on
Form 10-K and other reports and statements issued by the
Company and its officers from time to time contain certain
statements concerning the Companys future results, future
performance, intentions, objectives, plans and expectations that
are, or may be deemed to be, forward-looking
statements. The Companys ability to do this has been
fostered by the Private Securities Litigation Reform Act of 1995
which provides a safe harbor for forward-looking
statements to encourage companies to provide prospective
information so long as those statements are accompanied by
meaningful cautionary statements identifying important factors
that could cause actual results to differ materially from those
discussed in the statement. Such forward-looking statements are
subject to a number of known and unknown risks and uncertainties
that, in addition to general economic and business conditions,
could cause the Companys actual results, performance, and
achievements to differ materially from those described or
implied in the forward-looking statements. Factors that could
cause or contribute to such differences include, but are not
limited to, the Companys ability to execute its business
strategy (see Business Strategy), to profit from its
products and services as expected (see Products and
Product Development), to compete (see
Competition), to maintain superior technological
capability, to foresee changes and to continue to identify,
develop and commercialize innovative and competitive products
and services, to penetrate different markets and successfully
expand its revenue (see Marketing and Sales), to
attract and retain technologically qualified personnel,
particularly in the areas of research and development (see
Employees), and the Companys ability to
generate cash flow and obtain financing to support its
operations and growth (see generally Managements
Discussion and Analysis of Financial Condition and Results of
Operations and Liquidity and Capital Resources
contained therein) and other risks described in this Annual
Report on Form 10-K and other filings with the SEC.

Industry Overview

During the past few years, there has been an
increasing shift in the mobile market to provide computing and
communications power in devices that can be worn or carried, the
most notable examples of which are

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PDAs, internet-enabled cell phones,
multi-function pagers and portable email devices. This shift in
the hardware markets has been paralleled by an increasing move
in commercial software and services to provide better
information and control of a wide variety of processes, from
manufacturing to maintenance to repair. On a consumer level,
these devices offer access to specialized web sites that provide
information useful to the consumer, such as stocks, market data,
news, weather and sports.


The Company believes that users looking for
mobile computing and communications capabilities through
cellular phones, interactive pagers, PDAs, portable email
devices, MP3 players, gaming devices and portable computers will
increasingly demand that one device provide several or all of
these capabilities rather than the many devices that are
currently required. In addition, the prevalent practice of
attaching files to emails often means that a full-function
computer is required to process these files, rather than a
limited function computing device. The Company believes that its
wearable PC products are uniquely suited to meet this demand for
convergence, and that limited-capability or
special-purpose devices will eventually be replaced by wearable
PCs that provide consistent interfaces and full functionality
whether they are used in an office, travel or home environment.
The Company believes that the potential to develop a large
market for its mobile computing and communication hardware and
software products is demonstrated by the substantial historic
and projected growth in many other types of mobile computing and
communication devices, such as cell phones, PDAs and wireless
email devices.

Over recent decades, there has been an ongoing
evolution to personalize the computer and move it physically
closer to the user. This is evident as computing capabilities
have moved from remote mainframes, to distributed systems, to
desktops, to notebooks, to tablets and now to wearable systems.
The growth of wireless local area networks (LANs) in
corporate markets allows the Companys products to function
as just another node on the network by running
existing desktop applications wirelessly on a corporate network
with little to no modification.

In conjunction with this personalization of
hardware has come a personalization of software to provide users
with the information needed to perform a specific task at hand,
and the expansion of enterprise resource planning
(ERP) systems that extend computing capabilities
across an organization, not just within certain functions of the
organization. A 1999 study on wearable computers by IDC, an
independent market research firm, stated that over half of the
workers at large U.S. companies do not work at a fixed location
and do not have access to their companys information
technology as they move around. A December 2000 report by IDC
estimates that the number of mobile workers in the U.S. will
increase from over 40 million in 2001 to 55 million in
2004. A 2001 report by Gartner Group included wearable computers
as one of four key emerging technology trends for the first
decade of the millennium. Based on these reports and other
independent findings from industry analysts such as Gartner
Group, the Company believes that there are currently over
100 million mobile workers worldwide. In addition, Gartner
Group estimates that by 2007, more than 60 percent of the
European Union and U.S. population aged 15 to 50 will carry or
wear a wireless computing and communications device at least six
hours a day, and by 2010, more than 75 percent will do so.
The Company believes that its products and services are ideally
positioned to provide information access and computing
capabilities to this pool of workers, and allow companies to
leverage their existing investment in information technology to
this other half of their workforces. Further, the
Company believes that its products and services are also well
suited to capture the growing consumer interest in mobile
computing and communications devices.

Business Strategy

The Companys objective is to be the leading
provider of hands-free mobile computing and communication
systems, as well as to provide world-class hardware and
architectural solutions and software to enhance productivity in
a wide variety of applications. To achieve this objective, the
Company intends to pursue the following strategies:

Grow Sales by Focusing on Defined Target
Markets.The Company has identified a
number of horizontal and vertical market segments (see
Markets) that it intends to continue penetrating
through its direct sales force, partners, and the effective use
of value-added resellers (VARs), independent software

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vendors (ISVs) and distributor
channels that demonstrate comprehensive market knowledge in
their sectors. The Company believes that by combining the
established customer base of partners, VARs, ISVs and
distributors with the benefits provided by the Companys
know-how, patented products and services, sales can accelerate
faster than by using a direct sales force alone. Through the use
of strategic partners, the Company intends to leverage its own
internal marketing and sales resources to achieve more rapid
foreign and domestic market penetration. The Company also
intends to continue marketing to key national accounts in these
target segments to build multiple reference accounts, expand
sales within those segments, and to expand into other segments.
These reference accounts can also provide the Companys
product and R&D organizations with valuable direct feedback
from customers for future product development.


Leverage Core Competencies.The Company believes its core
competencies, which have been developed since its inception, are
the integration and adaptation of innovative computer and
communications hardware and software technologies into patented
and copywrited hands-free, mobile computing and communications
solutions that enhance end-user productivity. The Company will
seek to expand applications for its technologies and to
capitalize on the breadth of its expertise by developing new
hardware and software products, or combining its products with
technology available from third parties. Consistent with this
strategy, the Company will continue to focus on the integration
of hands-free mobile computing and communications hardware with
software applications and hardware products from its partners or
licensed, acquired or internally developed applications and
products. To leverage these core competencies, the Company has
established a number of strategic alliances and intends to
continue to have its strategic partners play a significant role
in executing the Companys manufacturing, service, sales
and marketing functions, under close coordination with Company
management. The Company believes that this structure will allow
the Company to expand its operations without the need to add
internal resources in direct proportion to such growth.

Develop and Strengthen Strategic Alliances.The Company has established and
intends to continue to establish strategic alliances with
world-class partners such as IBM, Hitachi and Mitsubishi Heavy
Industries to provide the execution capabilities required by the
Company in such areas as product development, manufacturing,
sales, distribution and marketing. The benefits that the Company
receives from these associations include access to a larger
potential customer base, complementary technologies, reduced
capital investment through utilization of outside resources, and
access to the expertise and efficiencies of these world-class
manufacturing and sales organizations. The Company will continue
to pursue additional strategic associations, including joint
ventures and partnering arrangements, to enhance its product
offerings and expand its marketing activities.

Pursue Acquisitions and Mergers.The Company is actively investigating
potential mergers and acquisitions to add to its customer base
and intellectual property, obtain access to enabling and
complementary technologies and products, and allow the Company
to provide a broader range of goods and services. However, there
can be no assurances that the Company will be successful in
identifying and completing such mergers or acquisitions on
suitable terms. During 2000, the Company completed the
acquisition of XSI.

Strengthen Portfolio of Patents and
Intellectual Property.The Company has
developed a portfolio of over 550 patent applications granted or
pending worldwide as the base of its intellectual property
(IP) for mobile/wearable computing and
communications and related software solutions (see
Intellectual Property). Additionally, in the 10+
years that the Company has operated in the mobile/wearable
computing and communications space, it has developed a
significant amount of knowledge, proprietary know-how and
expertise, which the Company also believes adds significant
value to its IP portfolio. The Company intends to continue
building and strengthening this portfolio, which it considers to
be one of its most significant assets and potential revenue
sources.

Utilize Licensing to Enhance Revenues.The Company intends to establish
licenses with industry leaders to leverage its patent portfolio
and to increase the size and number of markets from which the
Company can realize revenues. In 2001, the Company established
such a license with Hitachi and is in active discussions with
other companies regarding licensing. In March 2003, the Company
announced a new licensing plan designed to increase revenue from
its intellectual property. Under this plan, the Company entered
into an agreement with DeltaTech International, a leader in
technology transfer, to implement and

5



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manage licensing activities related to the
Companys dual-use computing device
intellectual property. This plan offers potential licensees as
well as current or potential infringers a non-exclusive
licensing opportunity. More than 50 such companies have already
been identified and formally contacted by DeltaTech on the
behalf of the Company. The Company expects to continue to pursue
licensing activities for all of its intellectual property.
Additionally, the Company has had advanced discussions with
various leading law firms and believes that it can obtain
world-class legal defense against potential infringement by
others of its intellectual property on a contingency basis. This
would result in significantly reduced legal costs to the Company
associated with such a patent infringement defense.


Provide Customized Solutions for Diverse
Customer Needs.Through XSI, the
Company has in-house software and service evaluation, design and
execution capabilities to complement its product strengths. With
XSI and its partners, the Company has expanded resources to
continue acquiring, developing or licensing software that
enables its customers to more rapidly create customized software
applications to improve productivity with the MA, Atigo and
conventional PCs. The Company believes that its experience in
wearable and mobile technologies will help it differentiate
itself from its competition as it markets its integration
services to customers and potential customers that may implement
mobile computing technologies in the future.

Maintain Technology Leadership.The Company is committed to achieving
and maintaining technological superiority of its services,
hardware and software through the continuous reassessment of
product performance and the utilization and integration of
state-of-the-art hardware and software technologies. The MA and
Atigo product lines, for example, are the result of the
Companys successful relationships with companies such as
IBM, Sony Digital Products, Texas Instruments, DT Research,
Zykronix, Hitachi, MicroVision, MicroOptical, Shimadzu, Toshiba,
JAE and NEC, all under the direction of, or in conjunction with,
the Companys staff. Additionally, recent product
development has been largely driven by direct and in-depth
communication with the Companys customers and partners
(see Products and Product Development).

Commitment to Open Architecture.The Company utilizes standard PC
hardware and software architectures and designs its products
using open systems technologies, including industry standard
operating systems. This open approach has allowed the Company to
readily incorporate the latest wireless communications, chip
design, GPS, sensor and other capabilities as soon as they are
available for use in laptops and other mobile computers. In
addition, this strategy has allowed the Company to take
advantage of developments in operating systems, such as new
generations of Windows and Linux, and applications software,
such as speech, and video capture and transmission. By remaining
technologically agnostic, the Companys
customers are also able to use the products in virtually any
standard computing environment.

Products and Product Development

In order to address the market for body-worn
mobile computing and communication systems, the Mobile Assistant
series has been designed to provide hands-free user-supported
operation on a when-needed, where-needed basis.

The hardware used in the MA series features:



| |   |                                                                                                                                                                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Intel processors with up to 512 Megabytes
    (MB) of random access memory (RAM); an
    internal hard disk of up to 32 Gigabytes (GB);
    and complete desktop functionality with a complete array of USB,
    IEEE 1394 (Firewire), serial, parallel, monitor, keyboard, power
    and replicator ports.       
|
| |  | PCMCIA (PC Card) and/or Compact Flash
    (CF) readers; a sealed enclosure to allow for use in
    a wide range of environmental conditions; hot-swappable
    lithium-ion battery and charger; and a built-in sound system for
    speech recognition and generation.                                              
|
| |  | Head mounted and/or flat panel displays with
    camera to allow for real-time, two-way audio/video
    teleconferencing in full color at standard PC resolutions. The
    head-mounted display uses advanced optics to present an image to
    the user that is equivalent to a desktop PC monitor at a
    distance of

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| |   |                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | 18 inches. The light-weight, all-light
    readable, full color FPD includes an integrated digitizer and
    allows for speech-activation through its built-in speaker and
    microphone.
|
| |  | Compatibility with Microsoft Windows, DOS, LINUX
    and UNIX.                                                                                                                            

The hardware used in Atigo features:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Windows CE.NET and wireless communications
    through built in CompactFlash (CF-IO) and PC card slots;
    built-in IEEE 802.11b WLAN networking support; an Intel XScale
    (PXA255) processor with 128MB of SDRAM and 32MB of Flash ROM;
    multiple USB ports, one master port on board and one slave port
    (in docking cradle), which enable easier ActiveSync to other
    computers.
|
| |  | 8.4-inch touch-screen enabled TFT displays with
    800 x 600 SVGA resolution that are readable under all light
    conditions.                                                                                                                                                                                                                                                                 
|
| |  | Internal rechargeable Lithium-Ion batteries with
    a run-time of approximately 3 to 4 hours; an optional extended
    life battery doubles run-time.                                                                                                                                                                                                                                          
|
| |  | Multimedia functionality including a built-in
    16-bit sound microphone/speaker and a stereo headphone jack.                                                                                                                                                                                                                                                                                  
|
| |  | A host of accessory options including desktop
    charging cradle, AC charger, car charger, external battery pouch
    and wireless keyboard/mouse options, as well as a variety of
    soft goods for wearability and ergonomics.                                                                                                                                                              
|
| |  | Configuration with Pocket WordPad; Pocket Inbox;
    Pocket Internet Explorer 5.5; Microsoft Transcriber; PDF Viewer;
    Macromedia® Flash Player; Microsoft Windows Media
    Player (providing support for MP3, WAV, AIFF, MIDI and AU
    formatted files); and RDP and ICA clients for Microsoft Terminal
    and Citrix® MetaFrame.                                                     

Full Functionality.The MA and Atigo can both act as
full-function computing and communications devices. The MA is a
stand-alone full function computing machine; Atigo can function
in this manner when performing as a wireless display to a MA or
PC. The MA and Atigo can also be used with a wide range of
peripherals, such as portable CD-ROM readers, bar code readers,
car chargers, battery-operated printers, still and motion video
cameras, global positioning technologies, cellular and radio
frequency communications and interfaces for medical, test and
sensor equipment.

Hands-Free Control.Since the origination of the concept
for wearable computers, the Company has believed that hands-free
control of the computer is essential to realizing the maximum
benefits of wearable computing and communications. The most
common method of hands-free control is speech recognition. The
MA supports state-of-the-art speech recognition software to
allow for hands-free operation using spoken commands in most
commonly-used languages. The MA V product incorporates advanced
digital signal processing (DSP) technology from
Texas Instruments to provide enhanced speech recognition and
wireless communications capabilities. The combination of voice
recognition and body-worn displays provides the user of the MA
with hands-free access to information and the ability to apply
this information to operations and tasks with direct lines of
sight and tactile access. User-independent speech generally
requires little or no training and is ideal for
command-and-control applications that operate the computer from
menu-driven software. User-dependent speech systems generally
require some training to provide for a richer, task-specific
usable vocabulary and the ability to offer a wider range of
dictation. The selection of which speech system to use is
generally driven by the application requirements. In addition to
speech control, the Company has included brain-wave activation,
eye-tracking and motion-tracking in its patents as alternative
approaches to speech for hands-free control. Such hands-free
control may be used by itself or in conjunction with more
conventional means such as keying, touchpad or mouse. While the
Companys various FPDs, including Atigo, can be used as
hand-held displays, they can also be used in a hands-free manner
by utilizing the various soft goods that the Company has
designed and marketed. These soft goods include, for example, a
vest with a built-in flap in which the FPD fits. A user can flip
down the panel when he or she needs to view or access the
display and then flip the panel back up when it is no longer
needed. The Company believes that such low-tech
designs will help the proliferation of wearable and mobile
computing.

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Product Development.The Companys approach to
development of wearable computer products is to internally
establish functional requirements, specifications and design
criteria. The establishment of these specifications is a process
that involves our customers, partners as well as the corporate
know-how developed over more than a decade of
designing and developing mobile computing devices. These
specifications are then taken to potential development partners
under non-disclosure agreements to evaluate the ability of those
partners to meet the Companys development needs. The
Company then selects the partner that best fits its specific
needs. During the development process, the Company provides
detailed project management and oversight. By outsourcing the
detailed development of its mobile computer product lines, the
Company believes that it is better able to quickly adapt to
changing markets and technology by working with partners with
selected areas of expertise. Additionally, the Company is able
to avoid the significant capital and operating costs needed to
establish and maintain full state-of-the-art development
facilities that would cover all of the various computing and
communications issues related to its products. The Company is in
discussions with a number of world-class technology companies
regarding collaboration on future generations of wearable
computers. The Companys selection criteria for partners to
develop its next-generation products will likely be based on
pricing, the ability to provide reliable, advanced technology,
production capacity, potential sales and marketing capabilities
and reputation in the worldwide markets for technology products.
While the MA and Atigo product lines are primarily targeted at
commercial users, the Company intends to directly address
segments of the consumer market in upcoming years.

Marketing and Sales

Markets

In the consulting portion of its business, XSI
provides project management, asset management and software
development products and services to federal, state and local
governments, and to the transportation, manufacturing, oil and
gas and software markets. Increasingly, XSI has also been
providing integration services related to the Companys
wearable and mobile technologies. These integration services
have been, and continue to be, focused largely on Department of
Defense (DOD), state and local governments, security
and homeland defense. For example, one existing security
solution involves a Critical Incident Response Tool Set that
runs on MA V systems. This solution allows first
responders and subsequent emergency personnel to manage
operations by having various types of critical information at
their fingertips, including building floor plans, specific
images related to a facility or site, incident command
protocols, and other critical response data. In addition, the
Company has also been providing significant integration and
consulting services to many of its commercial customers as they
roll out the Companys various hardware products.

In the hardware portion of its business, the
Company has divided its potential markets into two main
horizontal segments that cover a number of industries and a
number of industry-specific vertical segments that the Company
believes have the potential for high rates of return on the
deployment of the Companys products. Each segment
represents a significant portion of the mobile worldwide
workforce, which the Company believes totals more than
100 million workers (see Industry Overview).
Selected market segments are as follows (unless noted otherwise,
information on U.S. workers is from the most recent data
included in the U.S. Census Bureau, Statistical Abstract of the
United States: 2002.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Inspection, Maintenance and Repair:this segment has been the
    Companys primary focus since its inception. The increased
    complexity of commercial and consumer products, coupled with the
    need to access a great deal of technical material to maintain
    and repair these products, made this segment one of the first to
    look to wearable computers to assist users in diagnosing and
    repairing such products, which include aircraft, motor vehicles
    and heavy machinery. Applications include remote
    teleconferencing to obtain over the shoulder
    guidance from experts around the world, the use of video clips
    to provide just-in-time training or refreshing, and automatic
    tabulation and transmission of inspection results without the
    need for manual input of data. Through the use of mobile
    computing devices, inspection, maintenance and repairs can be
    accomplished more quickly, cheaply and effectively. For example,
    in the U.S., the annual cost of bridge inspections nationwide is
    estimated at $400 million; an independent study concluded
    that wearable computers could reduce that cost significantly.
    FedEx

8



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | currently uses the MA V to maintain, repair and
    inspect a portion of its airline fleet. Internal studies have
    shown that FedEx has increased the efficiency of its maintenance
    team and also cut costs through the use of the Companys
    wearable technologies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| |  | Manufacturing:in
    the U.S., this segment includes approximately 20 million
    workers. Primary applications include mobile monitoring of
    manufacturing processes, logistics and materials management,
    precision measurement, and in-process inspection. For example,
    the manufacture of aircraft requires precision production
    techniques and access to a large amount of technical data. A
    Boeing 747 aircraft has approximately six million parts provided
    by over 16,000 suppliers that must be assembled to exacting
    standards. The Company believes that the need to move in and
    around an aircraft during construction and the complex nature of
    aircraft manufacture and maintenance make the Companys
    products well suited for this market.                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | Telecommunications:the primary applications in this
    segment are for field service applications and include
    maintenance and repair of field assets. The Company has
    completed a pilot program with Bell Canada involving
    19 field service technicians who wore the MA for full work
    shifts in order to establish returns on investment and to
    evaluate the MA for use in a wide variety of commercial and
    residential tasks. Results showed that Bell Canada technicians
    could save more than 50 minutes per day as a result of the
    improved portability and reduced computing time from using the
    MA V. The Company also believes that its products will be
    well suited as delivery devices for the next generation of
    wireless communications services.                                                                                                                                                                                                                                                                                                                                                                                                              
|
| |  | Education:in the
    U.S., this segment includes approximately 11 million
    workers. Applications include facilities maintenance, field data
    collection and remote learning by linking mobile teachers,
    students and researchers on a real-time basis. Additionally, the
    Companys MA products have proven to be valuable resources
    in the education of handicapped children and adults, including
    those with autism and Tourettes Syndrome.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|
| |  | Utilities:the
    primary applications in this segment include maintenance,
    inspection and repair of field assets. The utility segment is
    characterized by high-dollar assets requiring significant
    maintenance and repair activities and the ability to readily
    determine the costs of downtime for these assets. One pilot
    program used the MA with a customized database to track
    equipment inventory during scheduled shutdowns of nuclear power
    plants. The results of this pilot showed savings of between a
    half and a full day in the inspection schedule. This translated
    into savings to the utility of over $250,000 through the
    reduction in the amount of power that must be purchased to
    supply its customer base during such a shutdown. The New York
    Power Authority estimates that it spends 80% of its budget for
    maintenance operations for overhead transmission lines. These
    examples highlight the significant amount of resources required
    for maintenance and repair in this segment and the potential the
    Company believes exists for significant savings through the use
    of wearable computers to assist in these tasks.
|
| |  | Transportation:this
    segment is also characterized by high-dollar assets and the
    ability to readily determine the costs of downtime for these
    assets. This segment includes airlines, railways, trucking,
    automobile and maritime transportation. There are over
    approximately 5 million workers in the U.S. involved in
    transportation. The transportation industry has proven to be an
    early adopter of both the MA and Atigo products. Atigo can be
    used in a broad array of applications for field personnel,
    including inventory management, quality assurance, workflow,
    remote data collection, knowledge management and security.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|
| |  | Medical:in the
    U.S., this segment includes approximately 12 million
    workers and wearable applications range from field and remote
    diagnostics to inventory management. The Company believes that
    wearable technologies will present great potential in field
    medical operations by providing on-board and remote diagnostics,
    audio and/or video communication with doctors for emergency
    procedures, and transmission of locations for helicopter pickup
    through integrated global positioning systems. Another
    anticipated benefit of the Companys hands-free mobile
    computing technologies is that fewer healthcare personnel will
    be needed to perform complex tasks. By providing remote delivery
    of medical information (telemedicine), the
    Companys mobile computing and communications systems can                                                                                                                                                                                                                                                                                                                                                    

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | become a key component within both managed care
    and telemedicine organizations, which are two key submarkets
    developing within the healthcare industry. Additionally,
    patients suffering from Parkinsons Disease have seen
    significant improvements in coordination, mobility (particularly
    walking, reaching and grasping), awareness and lifestyle while
    using the MA.                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | Media:the Mobile
    Assistant series allows for use of a head-mounted camera and
    wireless communications to allow real-time transmission of
    events and shows. Both the Democratic and Republican national
    conventions in 2000 were covered by an independent news
    organization which used the MA V to obtain remote access to the
    events. Additionally, events related to the 2003 Academy Awards
    were also covered using the MA V.                                                                                                                                                                                                                                                                                                                                                                                       
|
| |  | Government/Military:the military has long been an early
    adopter of advanced weapons technologies and as a result, was
    one of the first sectors to experience problems with the ability
    of personnel to maintain, diagnose and repair the advanced
    technology employed in weapons and equipment. The Company
    believes that its wearable computing and communications devices
    are well suited for such complex military applications, which
    typically require a rugged and versatile device such as the MA.
    Over the last three years, the DOD budget has included separate
    line items for wearable computer technology, which amounts have
    approximately doubled each year. The Company has been a
    significant beneficiary of these funds and expects to continue
    to be so in the future.           
|
| |  | Retail:There are
    approximately 28 million workers in the U.S. involved in
    retail and wholesale trade. Primary applications for the
    Companys products include mobile checkout, inventory
    warehousing and counting, sales support and facility maintenance
    and repair. The retail industry has proven to be an early
    adopter of Atigo products. Atigo can provide customer
    relationship management solutions as well as real-time access to
    critical data, including detailed merchandise specifications,
    competitive product analysis, warranty/service offerings and
    more. This information can be wirelessly pulled from centrally
    located databases and delivered directly to retail sales
    representatives in order to supply customers with a more
    complete perspective of product options.

Marketing

The segments identified in the above
Markets section were selected as the most promising
in which the Company believes it can achieve productivity
savings and rapid paybacks for customers through the use of its
products and services. The Company has established pilot
projects with customers that it considers to be the leaders
within each identified segment. Many of these same customers
also serve on the Companys CEOs Customer Advisory
Board (CAB). These pilot projects typically involve
the purchase of a number of systems to be used in the
customers operations to test the use of wearable computing
systems and to establish the benefits derived from doing so. The
Company typically uses these pilot projects to: provide detailed
data on productivity improvements and returns on investment from
the use of its products; obtain reference accounts for
prospective customers; generate sales to customers participating
in the pilot-projects; generate sales to additional customers
within the segment; and use the benefits generated within that
segment to position the product within other segments.

The Company has established a five level
marketing and distribution strategy to maximize market
penetration through the generation of revenues from the
following channels:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Direct Company sales force:Targeting major accounts, such as
    Fortune 1000 companies, the purpose of the direct sales force is
    to sell wearable solutions directly to targeted customers
    without the use of third parties. The direct sales force guides
    the customer through the initial testing and trial process. Once
    the products are accepted and established, the customer may be
    turned over to a channel partner, if appropriate, or may remain
    as a house account.
|
| |  | Value-Added Resellers (VARs):In addition to VARs, this channel also
    includes system integrators, partners and original equipment
    manufacturers (OEMs). The Company has established
    Team Xybernaut, a community of over 100 active VARs and
    partners worldwide. Members of Team Xybernaut typically have
    significant technical and industry expertise and may couple the
    Companys                                                                                           

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | products with their own products and services.
    The end result is often a solution tailored to the specific
    requirements of a customer or industry. By utilizing the
    VARs expertise and relationships, the Company is able to
    typically penetrate markets and customers more quickly and at a
    lower fixed cost than trying to establish the customer and
    industry specific solutions and relationships necessary for a
    successful sale.
|
| |  | High-volume generic distributors:This channel is designed to be used
    when unit shipments expand significantly, particularly in the
    consumer markets. To date, sales through generic distributors
    have been limited.                                                                                                                                                                                                                                    
|
| |  | Telemarketing and e-commerce:This channel obtains revenues from
    existing and new customers by using our website or in response
    to direct telephone queries.                                                                                                                                                                                                                                                                                                
|
| |  | Licensing:We
    maintain a portfolio of over 550 worldwide issued and pending
    patents, along with technical know-how, that we believe will be
    a source of licensing revenues in the future (see
    Intellectual Property).                                                                                                                                                                                                                             

To position the Company within these identified
segments and in the market for mobile computing as a whole, the
Company is continuing a marketing program that includes
participation in industry-specific trade shows, selected press
coverage, and exhibitions at special events such as the annual
International Conference on Wearable Computing.

The Company also conducts periodic meetings of
the CEOs CAB, which consists of decision-making executives
from prominent international organizations that are customers or
partners of the Company. Formal meetings of the full CAB
typically occur about twice per year while informal meetings
with individual members occur much more frequently. For the
members, the CAB provides a discrete forum to discuss mobile
wearable and wireless computing technologies, real-world
practical experiences and solutions, productivity results and
suggestions for the use of wearable computer applications. For
the Company, the CAB provides valuable feedback related to
product development and enhancements, the chance to share its
marketing and product road map and an opportunity to further
nurture its relationship with its key partners and customers.
For example, the development of the Atigo product line was
largely based on direct input from CAB members. Further
discussions and consultations with these partners have already
resulted in the development and launch of the third Atigo model
in the approximate six month period since its launch. Some of
the prominent organizations that serve on the CAB include:
American TransAir, Bell Canada, Boeing Company, Daimler Benz,
FedEx Express, General Electric, International Truck and Engine
Corporation, Mitsubishi Heavy Industries, NTT Communications
Corporation, Rocketdyne and Siemens.

Sales and
Backlog

Historically, most of the Companys hardware
orders, especially for the MA product line, are filled within a
short period after the receipt of the customer order. Therefore,
the Company has not historically had a significant hardware
backlog for MA orders, including at December 31, 2002.
Since large Atigo sales are typically built to order, the
Company has recently seen a hardware backlog of between one and
three months for individual customer Atigo orders. This covers
the time it takes the Company to order, build, test, configure
and ship the Atigo products to the customer.

As of December 31, 2002, the Company had a
backlog of approximately $2.2 million for its hardware products,
which consisted primarily of one customer purchase order for
Atigo products. This order is expected to be delivered during
2003 and the first quarter of 2004. Prior to shipment of the
Companys products, purchase orders are generally
cancelable by the customers without penalty and are not binding
upon the customer. As of December 31, 2001, the Company had
a negligible backlog of orders for its hardware products.

As of December 31, 2002 and 2001, the
Company had backlogs of approximately $3.2 million and
$3.9 million, respectively, for its services business,
primarily consisting of multi-year contracts that are in
progress.

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Key Suppliers

The Company has entered into design, production,
supply and support agreements with selected companies in the
U.S., Europe and Asia to produce and/or support its products
(see Production).

Although the Company believes there are multiple
sources for many hardware and software components, the Company
depends heavily on its suppliers. While management believes that
the Company could adapt to supply interruptions, such
occurrences could necessitate changes in product design or
assembly methods for its hardware products and cause the Company
to experience temporary delays or interruptions in supply while
such changes are incorporated. Further, because the order time
for certain components, including FPDs, is often lengthy, the
Company could experience delays or interruptions in supply in
the event the Company is required to find a new supplier for any
of these components. Any disruptions in supply of necessary
parts and components from the Companys key suppliers could
have a material adverse effect on the Company.

Production

The Company has manufacturing agreements with IBM
for the manufacture of the MA V, DT Research for the
manufacture of Atigo and Digital Logic in Geneva, Switzerland
for the manufacture of the MA TC. Several companies,
including Shimadzu, Olympus, MicroOptical and Microvision have
separately produced head-mounted displays that are suitable for
use with the Companys products. The Companys current
flat panel displays are produced by IBM, DT Research and
Zykronix. Most of the internal parts used in the Mobile
Assistant CPUs are existing PC components that are readily
available from multiple vendors. By outsourcing the production
of its wearable computer product line, the Company believes that
it is better able to quickly adapt to changing markets and
technology through the selection of production partners with
different areas of expertise. Additionally, the Company is able
to avoid the significant capital and operating costs needed to
establish and maintain full state-of-the-art production
facilities capable of producing all of the various computing and
communications components. Although the Company outsources the
actual manufacture of its hardware products, the Company
typically retains the underlying intellectual property, tools
and molds necessary for it to enable other partners to
manufacture its products.

Warranties

For sales of its hardware products, the Company
generally provides customers with warranty terms that are
competitive with those for computing products of the local
market in which the products are sold. In the U.S., the Company
generally provides a standard one-year warranty on its parts and
a six-month warranty on labor. The Companys suppliers for
the significant components of the Companys hardware
products, including the computing unit, FPD, HMD and batteries,
provide the Company with similar warranties. The Companys
distribution partners are generally responsible for user and
software support for channel sales. The Company currently
provides call center support in-house.

In certain instances, the Company offers extended
warranties for up to two years beyond the standard one-year
warranty on Atigo and the MA V. The supplier of Atigo provides
the Company with a corresponding warranty. The Company is
negotiating with the suppliers of the MA to offer similar
warranties to the Company with similar terms to the extended
warranties offered to the Companys customers. In the event
that the Company is not able to obtain such warranties from its
suppliers, the Company may incur warranty expenses in the future
that are significantly greater than those incurred in the past.

Certain government contracts of XSI require that
between five and twenty percent of direct labor reimbursements
per contract be withheld from payments remitted to the Company
until such time as the contract is completed and a final
accounting and approval has been made. Such amounts total
$384,359 and are recorded as long-term other assets on the
Companys balance sheet as of December 31, 2002.

12



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Competition

Several other companies are engaged in the
manufacture and development of body-worn or hand-held computing
and communications systems, which can also compete with the
Mobile Assistant and Atigo series, including CDI, ViA Inc.,
Texas Microsystems, Symbol, Raytheon, Panasonic and others. The
Company believes that, as the markets for mobile computing and
communications converge, its competitors will consist of these
companies as well as companies that offer mobile computing
devices with wireless communications capabilities and companies
that offer wireless communications devices with computing
capabilities. Companies with mobile computing devices that are
adding wireless communications capabilities include Palm, Inc.,
Handspring, Compaq and Sony, and manufacturers of notebook,
tablet and handheld computers such as Fujitsu, Mitsubishi,
Toshiba, IBM, Compaq, and Sharp. Companies with wireless
communications devices that offer computing capabilities include
Samsung, Motorola, Nokia, and Ericsson. Competitors for the
Companys software and services includes Accenture, KPMG,
Booze Allen Hamilton, Primavera, and Artemis. Many of the
Companys competitors are large domestic and foreign
companies which possess far more resources than the Company and
can be expected to compete vigorously with the Company. There
can be no assurance that the Company will be able to compete
successfully against its competitors, or competing products, or
that the competitive pressures faced by the Company will not
adversely affect its financial performance. However, the Company
believes that the entry into the market for wearable PCs by
reputable, large computer and communications manufacturers will
accelerate the validation of the market for wearable PCs. In
addition, the Company believes that its patent portfolio puts
the Company in a position to command royalties from such
companies in the future.

Intellectual Property

The Company relies on a combination of patent,
trade secret, copyright and trademark laws and contractual
restrictions to establish and protect its proprietary rights.
The Company has entered into confidentiality and invention
assignment agreements with its employees, and enters into
non-disclosure agreements with its suppliers, VARs, OEMs and
actual and potential customers to limit access to and disclosure
of its proprietary information.

The Company has developed a portfolio of over 550
patent applications granted or pending worldwide. Of these, 79
are filed with the United States Patent and Trademark Office
(U.S. Patent Office), consisting of 37 granted
patents and 42 pending patent applications. Of the U.S. patents
issued or pending, 64 are utility patents that cover the
concepts in the patents regardless of specific execution or
design and the remaining 15 are design patents that cover a
specific design of a product or its components. The remaining
patents, virtually all of which are utility pantents, have been
granted or are pending in over 20 countries outside of the U.S.
In addition, the Company has registered a number of trademarks
and service marks on the Principal Register of the U.S. Patent
Office, including its Mobile Assistant and Xybernaut trademarks,
and with the government patent and trademark offices in several
other countries.

The Company believes that these patents are a
valuable asset of the Company and will present significant
opportunities for royalty revenues in the future. The most
significant utility patents for the Company are described below.
All inventions made by employees of the Company, including those
described below, are assigned to the Company by agreement with
the employee upon the initiation of employment with the Company.
The Company retains full title to these patents regardless of
the inventors employment status with the Company. The
sections in quotations below are taken directly from the
relevant patents. Complete detail on the patents can be found on
the U.S. Patent Office website at http://www.uspto.gov, through
a search by patent number or Xybernaut, for all
patents other than 5,305,244, which was filed under
CPSI, which was the prior name of the Company.

U.S. Patent 5,305,244, Hands-free,
user-supported portable
computers.This patent was
applied for in April 1992, issued in April 1994 and expires in
April 2011. This patent includes a compact, self-contained
computing apparatus is provided which is completely supported by
a user for hands-free retrieval and display of information for
the user. This patent has been successfully upheld in two
challenges to the validity of the patent (re-examination) at the
U.S. Patent Office that were initiated by a competitor of the
Company.

13



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U.S. Patent 5,844,824, Hands-free
portable computer and system.This patent was applied for in October
1995, issued in December 1998 and expires in May 2017. This
patent describes a body-worn, hands-free computer system.
The system does not rely upon a keyboard input or activation
apparatus but rather has various activation means all of which
are hands-free. The system can be used with other systems, other
system components and communication apparatus. Also, various
components of the present system can be body worn or placed in a
disconnected location if desired. Specifically, this
patent covers among other things:



| |   |                                                                                                                                                                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | A number of hands-free activation means,including speech, eye-tracking, head
    tracking, arm tracking, muscle and brain-wave activation;                                                                                                                                                                      
|
| |  | Wireless communications and computing,wherein said computer apparatus
    has means for communicating and interacting with a communication
    means selected from the group consisting of cellular telephones,
    hard line telephones, infrared transceivers, two-way radio means
    and mixtures thereof;
|
| |  | A variety of modes of operation,from having the display, computer and
    activation means in one housing worn by the user, to having a
    number of users with head-mounted displays with a wireless
    connection to a single computer to form a local area network for
    workgroups; and                 
|
| |  | Wireless networking and internet access,such that the mobile computer of
    this invention may be interfaced with or used in connection with
    any desired computer local networks such as Novel, Banyan or
    Arcnet or wide area networks such as Internet or the
    like.                           

The Companys wearable computer
patents, including those described above, are not limited to the
conventional sense of wearable. They also cover
user supported computing and communications devices,
including those that may be woven into clothing, carried in
vests or even imbedded inside the body of the user.

U.S. Patent 5,948,047, Detachable
computer structure.This patent
was applied for in August 1996, issued in September 1999 and
expires in August 2016. U.S. Patent 5,999,952, Core
computer unit.This patent was applied for in January
1998, issued in December 1999 and expires in January 2018.
U.S. Patent 6,029,183, Transferable core
computer.This patent was applied for in August 1997,
issued in February 2000 and expires in August 2018.

These three issued patents, and others pending,
cover various aspects of what the Company calls core
computing, or the use of a small device about the size of
a current PDA that contains a processor, non-volatile storage
and other components that would dock into various enclosures
such as a notebook, desktop, airplane seatback, wearable
computing/communicating device or automobile. This core computer
allows the user to always have his or her preferred operating
system, graphical user interface, applications software and data
available in almost any environment and, importantly, without
the need to synchronize these items among multiple computers in
multiple locations.

For example, whether a user is answering email at
home, in the office, in a car or while walking around, the same
email settings, wireless communication settings, address book,
past emails and email strings would be available in each of
these environments. Similarly, a traveler could insert his or
her core computer into an enclosure in the bed stand of a hotel
room upon arrival. The core could interact with the hotel
computer so the room can be set to the travelers preferred
temperature setting, order room service, arrange for a wake-up
call, confirm a flight with the airlines website and
arrange for a car pickup. The core could then automatically
obtain directions to the locations of scheduled meetings in the
area and interact with the hotel computer system to provide a
list of recommended restaurants, entertainment events, or
sporting events. The traveler might then place the core in a
rented enclosure with an integrated global positioning system
and take a guided tour of the city, which would direct him or
her to sites that are of interest based on the predetermined
personal profile.

U.S. Patent 6,421,232, Dual FPD and Thin
Client.This patent was filed in
April 2001 and is a Continuation-In-Part of Application Ser.
No. 09/630,474 which was filed in August 2000. The
invention which the Company often refers to as the
dual-use computing device patent, is essentially a
flat panel display (FPD), preferably for use with
computers, which utilizes a display which is separate from the
CPU, which can perform as a static FPD when connected to or in
communication with the computer, but can also

14



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function as a thin client PDA-type device when
independent from the computer to which it was originally
connected. The device will look and function as a FPD and
include integral activation means either through stylus, touch
panel, integrated pointing device, voice, or other activation
means. The activation means will be available whether the device
is functioning as a FPD or as a thin client PDA. The device will
be small enough to be worn, carried or otherwise supported by
the user, but can be utilized independently as a PDA to perform
data input, calendars and scheduling, memo inputting and other
thin client functions, and will run a thin client operating
system such as Windows CE, .Net or Palm OS. The enclosure itself
will contain hardware sufficient to support display functions as
well as a thin client motherboard. It will also contain either a
wired or wireless communication bus for communicating data to
the computer from which it was disconnected. Additionally, it
will possess a standard or proprietary video input plug for
displaying output from the underlying computer.


U.S. Patent 6,377,793 System and method
of accessing and recording messages at coordinate way
points.This patent was filed in
December 2000 and issued in April 2002. The present invention is
essentially a method and system for leaving and retrieving
messages at specific coordinate virtual way points
within a commercial mobile radio service (CMRS) provider
network. Users carry or transport interface devices for
communicating over the network and are able to record and view
messages at or within a specific range of a coordinate location
while traveling in the network. The location of the device is
calculated by the device or by the network while the device is
powered on and in within the physical boundaries of the network,
or through a combination of both. Messages can be made available
to network subscribers when their interface devices come within
an area centered about a physical coordinate location.
Subscribers at any coordinate point within the boundaries of the
network can also leave personalized messages. The invention can
also be used to facilitate access of information about an asset
when a technician comes within a physical proximity threshold
relative to said asset.

As an example, the present invention would allow
a French restaurant to target drivers that have selected French
dining as a preference on their personal profile when their cars
reach a certain distance from the restaurant. This alert could
occur through the drivers wearable computer, GPS system,
cell phone or similar device. Similarly, a maintenance worker
could be alerted to recent repair issues when the worker is
within 25 feet of a transformer station or other physical
location.

In March 2003, the Company announced a new
licensing plan designed to increase revenue from its
intellectual property. Under this plan, the Company entered into
an agreement with DeltaTech International, a leader in
technology transfer, to implement and manage licensing
activities related to the Companys dual-use computing
device intellectual property. This plan offers potential
licensees as well as current or potential infringers a
non-exclusive licensing opportunity. More than 50 such companies
have already been identified and formally contacted by DeltaTech
on behalf of the Company. The Company expects to continue to
pursue licensing activities for all of its intellectual property
and to begin active defense of key intellectual property with
potential infringers in 2003.

As part of the Companys cost cutting
efforts undertaken during 2002 and 2003, management performed an
extensive cost-benefit analysis of its patent portfolio. As a
result of this review, the Company decided to maintain all
patents that have already been granted as well as all those
pending that management considers its key patents,
including those related to wearable computers, the transferable
core, way point and the dual-use computing device.

However, the Company concluded that it could
achieve considerable cost savings by not investing significant
future time or capital resources on certain of its foreign
patent applications. Management believes that these cost savings
can occur while not materially negatively impacting the
Companys business plan. The patents that the Company
expects to not pursue are often those that are not significantly
through the patent application process. This is due to the fact
that the process of having a patent granted is expensive while
the process of maintaining a patent subsequent to grant is
relatively inexpensive. Additionally, due to the concentration
of revenues, the strategic importance of the Companys U.S.
operations, and the lower cost of obtaining a patent in the
U.S., the Company expects to continue to pursue all domestic
patents, whether granted or pending. Additionally, the Company
has determined to not pursue patents pending in other instances,
including those in which it determined that it had filed for
patents for which it has similar or better

15



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##### 



protection through other patents in its
portfolio, in countries that do not play a strategic role in the
Companys current business plan or that it has otherwise
determined will likely not meet the internal criteria management
deems necessary to justify the continued cost to complete the
patent application process.


The Company believes that the strategic value of
its IP portfolio has not been materially negatively impacted by
this review. The Company continues to view its IP portfolio as
one of its most valuable and critical assets and continues to
invest significant time and resources in developing new IP and
expects to continue to do so in the future.

Notwithstanding the foregoing, there can be no
assurance that the Companys pending patent applications
will issue as patents, that any issued patent will provide the
Company with significant competitive advantages or that
challenges will not be instituted against the validity or
enforceability of any patent held by the Company. Even if the
Company is successful in retaining legal counsel on a
contingency basis, the cost of litigation to uphold the validity
and prevent infringement of patents can be substantial. There
also can be no assurance that others will not independently
develop similar or more advanced products, design patentable
alternatives to the Companys products or duplicate the
Companys trade secrets. The Company may in some cases be
required to obtain licenses from third parties or to redesign
its products or processes to avoid infringement. The Company
also relies on trade secrets and proprietary technology and
enters into confidentiality agreements with its employees and
consultants. The Company has implemented a trade secret
management program to further protect the Companys trade
secrets and proprietary information. There can be no assurance
that the obligation to maintain the confidentiality of such
trade secrets or proprietary information will not be breached by
employees or consultants or that the Companys trade
secrets or proprietary technology will not otherwise become
known or be independently developed by competitors in such a
manner that the Company has no practical recourse. The Company
intends to take any and all appropriate measures, including
legal action, necessary to maintain and enforce its rights under
the patents held by the Company and to recover any damages
suffered as a result of any alleged infringement.

Employees and Consultants

As of December 31, 2002, the Company had 83
full-time equivalent employees, and had consulting arrangements
with 10 individuals or firms for advice and assistance on
selected technical and business matters. Of the Companys
full-time equivalent employees, 4 are executive officers, 18 are
technical and administrative support employees, 4 are engaged in
research and development, and 57 are engaged in consulting
services, sales, marketing and customer service. None of the
Companys employees are represented by a labor organization
and management believes that the Companys relations with
its employees are good.



|        |           
|------- | ----------
|Item 2. | Properties

The Companys U.S. headquarters are 19,690
square feet of office and development space located at 12701
Fair Lakes Circle, Fairfax, Virginia. The Companys lease
is for a five-year term expiring September 30, 2003 and
requires monthly rent of $39,788. The Company vacated a portion
of this space and is subleasing it for a $10,199 loss recorded
as a restructuring charge in 2002.

XSIs facility consists of 5,000 square feet
of office space located at 8618 Westwood Center Drive, Vienna,
Virginia. The Companys lease is for a 7-year term expiring
December 31, 2005 and requires monthly rent of $11,886. The
Company has vacated this space and intends to sublease it,
although likely at an amount that is less than the total rent
owed by the Company. The Company recognized a $223,305
restructuring charge related to this lease in 2002.

To minimize lodging expenses related to visiting
consultants and visiting or relocating employees, the Company
leases two apartments in Fairfax, Virginia with combined monthly
rental costs of $3,966. Management believes that the cost of
these apartments is less than what would be incurred if these
visitors stayed in hotels.

16



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##### 



The Companys European facility consists of
3,500 square feet of office space located at the SBS Software
Center, Otto Lilienthal Strasse 36, D-71034 Böblingen,
Germany. The Companys lease is for a three-year term
expiring on January 31, 2005. The lease requires monthly
rent of $3,800.

The Companys Asian facility consists of 184
square feet of office space located at Wako Denshi Bldg.,
No. 13-32, 6 chome Tsunashima Nishi, Kohoku-ku, Yokohama,
Japan. The Companys lease is for a one-year term expiring
September 30, 2003 with automatically renewable 3-month
terms. The lease requires monthly rent of $1,180.



|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

The Company has no material pending legal
proceedings, other than ordinary routine litigation incidental
to the Companys business, to which the Company or any of
its subsidiaries is a party or of which any property is the
subject.



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

No matter was submitted during the fourth quarter
of the fiscal year covered by this report to a vote of security
holders, through the solicitation of proxies or otherwise.

PART II



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

On July 18, 1996, the Company completed its
initial public offering. The Companys common stock,
representing its only class of publicly traded equity
securities, trades under the ticker XYBR. In October
2002, the Company was granted a transfer to the Nasdaq SmallCap
Market from the Nasdaq National Market.

During November 2002, the Company received gross
proceeds of $4,100,000 through a private placement of 17,083,332
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 8,541,668 shares of common stock
at an exercise price of $1.25 per share. The private placement
was exempt from registration pursuant to Section 4(2) of
the Securities Act of 1933 and Rule 506 promulgated
thereunder.

As of recent dates subsequent to
December 31, 2002, there were approximately 1,200
shareholders of record, representing over approximately 58,000
individual or institutional shareholders of the Companys
common stock.

The table below sets forth the high and low
closing prices of the Companys common stock in dollars per
share by quarter, for the years ended December 31, 2002 and
2001, as reported in published financial sources. These prices
reflect inter-dealer prices, without retail markup, markdown or
commission and may not necessarily represent actual transactions.

|                 |  |              |      |  |     |   |      | 
|---------------- |  | ------------ | ---- |  | --- | - | ---- | 
|                 |  |             
|                 |  | Common Stock |     
|                 |  |              |     
|                 |  | High         |      |  | Low |  
|                 |  |              |      |  |     |  
|1st Quarter 2001 |  | $            | 4.16 |  |     | $ | 1.99 | 
|2nd Quarter 2001 |  | $            | 5.46 |  |     | $ | 1.97 | 
|3rd Quarter 2001 |  | $            | 4.34 |  |     | $ | 1.84 | 
|4th Quarter 2001 |  | $            | 2.89 |  |     | $ | 1.91 | 
|1st Quarter 2002 |  | $            | 2.66 |  |     | $ | 1.60 | 
|2nd Quarter 2002 |  | $            | 1.63 |  |     | $ | 0.55 | 
|3rd Quarter 2002 |  | $            | 0.73 |  |     | $ | 0.23 | 
|4th Quarter 2002 |  | $            | 0.83 |  |     | $ | 0.21 | 

17



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Dividends

The Company has never declared or paid any cash
dividends on its common stock and does not anticipate paying
cash dividends on its common stock in the foreseeable future.
The Company currently intends to retain future earnings to
finance its operations and fund the growth of the business. Any
payment of future dividends will be at the discretion of the
Board of Directors of the Company and will depend upon, among
other things, the Companys earnings, financial condition,
capital requirements, level of indebtedness, contractual
restrictions in respect to the payment of dividends and other
factors that the Companys Board of Directors deems
relevant.



|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

The following selected consolidated financial
data sets forth, for the periods and the dates indicated,
summary financial data of the Company and its subsidiaries. The
selected consolidated financial data have been derived from the
Companys financial statements, which have been audited by
independent public accountants.

|                          |  |      |             |   |      |   |             |      |  |   |             |   |  |      |             |   |  |   |             |  
|------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | - |  | ---- | ----------- | - |  | - | ----------- | -
|                          |  | 2002 |             |   | 2001 |   |             | 2000 |  |   | 1999        |   |  | 1998 |            
|                          |  |      |             |   |      |   |             |      |  |   |             |   |  |      |            
|Total revenue             |  | $    | 9,973,561   |   |      | $ | 9,819,993   |      |  | $ | 9,504,891   |   |  | $    | 8,352,774   |   |  | $ | 5,447,370   |  
|Net loss                  |  | $    | (26,580,833 | ) |      | $ | (32,199,579 | )    |  | $ | (24,185,222 | ) |  | $    | (16,697,413 | ) |  | $ | (13,001,338 | )
|Net loss per common share |  | $    | (0.37       | ) |      | $ | (0.63       | )    |  | $ | (0.63       | ) |  | $    | (0.76       | ) |  | $ | (0.77       | )
|Total assets              |  | $    | 12,135,371  |   |      | $ | 16,664,318  |      |  | $ | 19,244,701  |   |  | $    | 12,870,679  |   |  | $ | 7,049,010   |  
|Long-term obligations     |  | $    | 119,295     |   |      | $ |            |      |  | $ |            |   |  | $    |            |   |  | $ | 713,141     |  



|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

Overview

Xybernaut Corporation, a Delaware corporation
(Xybernaut or the Company), is engaged
in the research, development, manufacture, marketing and sales
of mobile, wearable computing and communication systems as well
as software and service solutions designed to enhance
productivity and improve product management, asset management,
and the accuracy, timeliness and utilization of captured data.
The Company offers solutions with a software and services focus
through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(XSI). The Company offers solutions with a hardware
focus through its U.S. operations and through its wholly-owned
subsidiaries Xybernaut K.K. (Japan) and Xybernaut GmbH (Germany).

The Company was formed in 1990 and completed its
initial public offering (IPO) on July 18, 1996.
On April 7, 2000, Xybernaut acquired XSI, formerly known as
Selfware, Inc. The merger was accounted for as a pooling of
interests.

All financial data of the Company, including
Xybernauts previously issued operations for the periods
presented in this Form 10-K, have been restated to include
the historical financial information of XSI. The consolidated
financial statements include the accounts of the Company and its
wholly owned subsidiaries: XSI (Virginia, U.S.), Xybernaut
Development Corporation (Virginia, U.S.), Xybernaut K.K.
(Yokohama, Japan), and Xybernaut GmbH (Böblingen, Germany).
All significant intercompany accounts and transactions have been
eliminated in the consolidation.

The Mobile Assistant® (MA®)
series is the Companys primary line of hardware products,
the current versions of which are the Mobile Assistant V
(MA V) and MA TC. Since its commercial
introduction in 1995, the Company has recognized revenue of
approximately $19,500,000 on sales of approximately 4,000 units
of the MA series. During 2002, the Company introduced the
Atigo product line, a family of wireless web panels that
can be used either as stand-alone handheld personal computers
(PCs) or as displays for an MA system, a laptop or a
conventional PC. The Company derives its revenues from sales of
its wearable

18



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computers, software products and consulting
services. In the future, the Company expects to obtain
additional revenues from the licensing of its intellectual
property.


A number of trends are expected to have a
significant effect on the Companys operations in the
future. In recent quarters, many of the Companys large
customers deferred or delayed anticipated purchases of Company
products because of uncertain economic conditions. If these
conditions persist or worsen, it is possible that more potential
customers will defer, delay or cancel scheduled purchases, which
would have an adverse effect on Company operations. While the
Company expects general economic conditions to begin improving
during the second half of 2003, there can be no assurance that
this expectation will be realized. Additionally, to the extent
that potential customers have concerns about purchases from
smaller suppliers as a result of challenging economic conditions
for small capitalization technology companies, such concerns
could have a negative impact on the Companys revenues.

Beginning with the widespread use of the internet
on desktop computers, there has been an increasing demand for
mobile computing and wireless communications devices that can
bring the desktop internet experience to mobile users. The rapid
growth of internet-enabled cell phones, PDAs, interactive pagers
and similar products result in a growing number of devices that
cater to the mobile data user and which may compete with the
Companys products and which may also present opportunities
for licensing in the future.

The Company believes that sales of its wearable
and mobile computers will rely to a large extent on the
availability of wireless broadband services that can take
advantage of the extensive processing power and display
capabilities of the Companys hardware products. Wireless
LANs are now well established in commercial markets worldwide
that provide broadband capabilities over a limited physical
range in places such as corporate offices, warehouses, factory
floors and airfields. However, wide-range wireless access that
allows a user to move freely over large geographic areas and
still maintain broadband access (commonly referred to as
Third Generation or 3G) is still only
available in limited areas, including Japan and certain European
nations. The Company predicts that 3G service will be available
in large metropolitan areas worldwide in the next few years. For
example, NTT DoCoMo has announced plans to launch 3G service in
select U.S. cities in 2004. The Company believes that while the
commercial markets can still be successfully penetrated prior to
the widespread introduction of wireless broadband access, such
service will be needed prior to successful large-scale sales in
the far larger consumer markets.

Critical Accounting Policies

In accounting for the financial results of the
Companys operations, management employs several critical
accounting methods and policies and makes estimates and
assumptions which materially affect the manner in which such
results are presented. The Companys critical accounting
policies are as follows:

Inventory and Tooling.Inventory consists primarily of
wearable computer component parts held for resale and allocated
tooling costs, and is primarily comprised of finished goods. The
capitalized tooling asset consists of payments made to
third-party vendors for their products and services that are
used in the manufacture of the Companys proprietary
hardware products.

Periodically, the Company records charges and
reserves against its inventory and tooling asset balances. To
determine the size of the charges and reserves to record, if
any, management performs a review of the carrying value of its
inventory and tooling. As a result of this review, it may be
determined that certain of the Companys inventory is
slow-moving, risks becoming obsolete or may likely be sold at
below historical cost. Based upon a specific review of the
carrying costs for the inventory items, management estimates the
quantity of each inventory item that the Company expects to be
able to sell and, if appropriate, quantifies inventory amounts
that may not be recoverable. Subsequent to recording such
charges and reserves, if any, management does not expect to
record significant profits or losses upon the ultimate sale of
this inventory.

This review is based on a number of assumptions
and estimates made by management, including but not limited to
those related to the introduction of new and competing product
lines, the Companys ability to sell the quantities of
inventory on hand as well as the quantities expected to be
received in the future, the net sales price the Company
ultimately expects to achieve, the introduction of competing
products, customer demand

19



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##### 



and general economic conditions. This analysis
takes into account estimated price concessions which management
believes are likely to be necessary in disposing of this
inventory. To the extent that actual future events are different
from the assumptions and estimates used by management,
additional charges, reserves or adjustments may be recorded by
the Company.


The capitalized tooling asset is systematically
allocated to inventory and property and equipment and is
amortized as a component of cost of sales or depreciation based
upon the number of units sold or used as demonstration units in
a given period compared to the total number of units management
expects to make in a products production run.
Managements expectation of the number of units to be made
during a given products production run is based on a
number of assumptions and estimates, including but not limited
to those related to the introduction of new product lines, the
Companys ability to procure and sell the quantities of
inventory, the introduction of competing products, customer
demand and general economic conditions. To the extent that
actual future events are different from the assumptions and
estimates used by management, additional charges, reserves or
adjustments may be recorded by the Company.

Patents.The Company
capitalizes legal fees, filing fees and other direct costs
incurred to obtain patents and trademarks. These costs are
amortized over a five-year period which management believes
approximates the economic life of such patents even though the
legal life of the patents is usually longer. The costs of
maintaining patents are expensed as incurred. Whenever events or
changes in circumstances occur that indicate that there is the
potential for the impairment of the carrying values of these
patent assets, management performs an analysis to determine the
recoverability of the assets carrying value. As a result
of such analysis, management may reserve against or write down
the carrying value of the patent asset.

As part of the Companys cost cutting
efforts undertaken during 2002 and 2003, management performed an
extensive cost-benefit analysis of its patent portfolio. As a
result of this review, the Company decided to maintain all
patents that have already been granted as well as all those
pending that management considers its key patents,
including those related to wearable computers, the transferable
core, way point and the dual-use computing device. This review
resulted in a write-down of the carrying value of certain
patents of $157,307 in the 2002 restructuring charge.

However, the Company concluded that it could
achieve considerable cost savings by not investing significant
future time or capital resources on certain of its foreign
patent applications. Management believes that these cost savings
can occur while not materially negatively impacting the
Companys business plan. The patents that the Company
expects to not pursue are often those that are not significantly
through the patent application process. This is due to the fact
that the process of having a patent granted is expensive while
the process of maintaining a patent subsequent to grant is
relatively inexpensive. Additionally, due to the concentration
of revenues, the strategic importance of the Companys U.S.
operations, and the lower cost of obtaining a patent in the
U.S., the Company expects to continue to pursue all domestic
patents, whether granted or pending. Additionally, the Company
has determined to not pursue patents pending in other instances,
including those in which it determined that it had filed for
patents for which it has similar or better protection through
other patents in its portfolio, in countries that do not play a
strategic role in the Companys current business plan or
that it has otherwise determined will likely not meet the
internal criteria management deems necessary to justify the
continued cost to complete the patent application process.

These reviews were based on a number of
assumptions and estimates made by management, including but not
limited to those related to the outcome of potential litigation
against competitors who may infringe on the Companys
patents, the outcome of potential litigation brought against the
Company related to infringement of another companys
patents, impairment of trade secrets and know-how and the
Companys intentions to use a given patent in the future.
To the extent that actual future events are different from the
assumptions and estimates used by management, additional
charges, reserves or adjustments may be recorded by the Company.

Warranties for Hardware Product Sales.For sales of its hardware products
within the U.S., the Company generally provides a standard
one-year warranty on its parts and a six-month warranty on
labor. The Companys suppliers for the significant
components of the Companys hardware products, including
the computing unit, FPD, HMD and batteries, provide the Company
with similar warranties. The Companys

20



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distribution partners are generally responsible
for user and software support for channel sales. In certain
instances, the Company offers extended warranties for up to two
years beyond the standard one-year warranty on Atigo and the
MA V. The supplier of Atigo provides the Company with a
corresponding warranty. The Company is negotiating with the
suppliers of the MA to offer similar warranties to the Company
with similar terms to the extended warranties offered to the
Companys customers. In the event that the Company is not
able to obtain such warranties from its suppliers, the Company
may incur warranty expenses in the future that are significantly
greater than those incurred in the past.


Warranty expense is recorded by management using
a number of assumptions and estimates, including but not limited
to those related to estimates for future warranty claims based
on reviews of historical warranty experience as well as other
general and customer-specific factors, industry warranty trends,
intended uses by customers, successful negotiation of extended
warranty coverage from the Companys vendors and continued
warranty support from vendors. Additionally, because of the
recent introduction of the MA V, MA TC and Atigo
product lines, the Company only has limited historical data on
which to forecast future warranty claims. To the extent that
actual future events are different from the assumptions and
estimates used by management, additional warranty expenses may
be recorded by the Company.

Revenue Recognition on Fixed Price Contracts.The Company recognizes revenue from
long-term service contracts in accordance with Accounting
Research Bulletin No. 45, Long-Term Construction Type
Contracts, using the relevant guidance in Statement of
Position No. 81-1, Accounting for Performance of
Construction-Type and Certain Production-Type Contracts,
as determined by the terms and conditions of the Companys
various consulting contracts with its customers, which typically
involve software engineering and related services. Revenue is
recognized in fixed price contracts based on the percentage of
completion method by calculating the ratio of costs incurred
over total estimated costs to complete.

Historically, the Company has not recorded losses
related to its fixed price contracts. However, in the event that
the costs to complete increase, or are anticipated to increase,
to a level that will result in a negative gross margin to the
Company, a loss will be recognized in the period that this
determination is made. Possible events that could cause the
total estimated costs to complete a project to change include,
but are not limited to, the occurrence of unanticipated
complications, technical or otherwise, changes to a
clients requirements, general inefficiencies in the
management of the engagement, a change in key personnel or the
cost of personnel.

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Results of Operations

The following table sets forth certain
consolidated financial data as a percentage of revenues for the
years ended December 31, 2002, 2001 and 2000.

|                                    |                            |              |        |       |      |  |        |       |  |  |        |       | 
|----------------------------------- | -------------------------- | ------------ | ------ | ----- | ---- |  | ------ | ----- |  |  | ------ | ----- | 
|                                    |                            |             
|                                    |                            | December 31, |       
|                                    |                            |              |       
|                                    |                            | 2002         |        |       | 2001 |  |        | 2000  | 
|                                    |                            |              |        |       |      |  |        |       | 
|Revenue                             |                            |              | 100.0  | %     |      |  | 100.0  | %     |  |  | 100.0  | %    
|Cost of sales                       |                            |              | 77.8   |       |      |  | 70.3   |       |  |  | 74.5   |      
|Provision for inventory and tooling |                            |              | 9.2    |       |      |  | 18.6   |       |  |  | 15.8   |      
|                                    |                            |              |        |       |      |  |        |       | 
|                                    | Gross income               |              |        | 13.0  |      |  |        | 11.1  |  |  |        | 9.7   | 
|                                    |                            |              |        |       |      |  |        |       | 
|Operating expenses:                 |                            |              |        |       |      |  |        |       |  |  |        |      
|                                    | Sales and marketing        |              |        | 149.8 |      |  |        | 178.5 |  |  |        | 120.8 | 
|                                    | General and administrative |              |        | 57.2  |      |  |        | 67.9  |  |  |        | 63.8  | 
|                                    | Research and development   |              |        | 63.8  |      |  |        | 95.8  |  |  |        | 62.3  | 
|                                    | Restructuring charges      |              |        | 10.4  |      |  |        | 0.0   |  |  |        | 0.0   | 
|                                    | Merger costs               |              |        | 0.0   |      |  |        | 0.0   |  |  |        | 6.5   | 
|                                    |                            |              |        |       |      |  |        |       | 
|Total operating expenses            |                            |              | 281.2  |       |      |  | 342.2  |       |  |  | 253.5  |      
|                                    |                            |              |        |       |      |  |        |       | 
|Interest and other                  |                            |              | 1.6    |       |      |  | 3.2    |       |  |  | 10.7   |      
|                                    |                            |              |        |       |      |  |        |       | 
|Net loss                            |                            |              | (266.5 | )%    |      |  | (327.9 | )%    |  |  | (254.5 | )%   
|                                    |                            |              |        |       |      |  |        |       | 

Years Ended December 31, 2002 and
December 31, 2001

Revenue.The Company
derives its revenue from product sales of its mobile/ wearable
computers and components, product sales of software and
consulting services. Total revenue for the year ended
December 31, 2002 was $9,973,561, an increase of $153,568,
or 2%, compared to $9,819,993 for the year ended
December 31, 2001. Product revenue for the year ended
December 31, 2002 was $6,131,759, an increase of $225,357,
or 4%, compared to $5,906,402 for 2001. The increase in product
revenue was attributable to sales of the Companys
mobile/wearable computer systems, which increased 17% from
$5,227,502 in 2001 to $6,131,759 in 2002. The increase in
hardware sales resulted primarily from sales of two new product
lines introduced in 2002, the pomaand Atigo. Additional
hardware product revenue resulted from the Companys
emphasis on new and enhanced product lines, the MA V and
MA TC, which were introduced late in 2001. Hardware
revenues from U.S. operations increased 69% to $4,470,762 in
2002 compared to 2001, driven primarily by Atigo and MA V
sales. This increase was offset by a 40% decrease to $1,204,215
in European hardware sales in 2002 compared to 2001, due
primarily to a decrease in orders from a large European
customer. Hardware revenues from Asia, consisting primarily of
MA V systems, decreased by 18% to $456,782 in 2002 compared
to 2001. Offsetting this overall increase in wearable computer
sales was a decrease in software product revenue from $678,900
in 2001 to $0 in 2002. Revenue from software products generally
consists of a few large transactions that occur throughout the
year that are unrelated to the Companys hardware products.
Therefore, it is not uncommon to have significant fluctuations
in software revenue from year to year. The Companys
consulting, licensing and other revenue remained consistent
between the year ended December 31, 2002 and 2001 at
$3,841,802 and $3,913,591, respectively, representing a 2%
decrease, as the number of ongoing consulting contracts remained
relatively consistent between 2002 and 2001.

Cost of Sales.The
Companys cost of sales include the costs of components for
the Companys wearable computer product lines, purchased
software, direct labor and materials, amortization of tooling
costs, warranty costs, fulfillment and shipping costs, and
inventory and tooling reserves. Total cost of sales remained
consistent between the year ended December 31, 2002 and
2001 at $8,674,805 and $8,730,384, respectively, representing
less than a one percent decrease. The cost of sales related to
the Companys hardware products increased 38% to $5,399,265
for the year ended December 31, 2002. This increase in
hardware product cost of sales is significantly greater than the
17% increase in hardware product sales. This fluctuation was
caused by

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several factors. First, total warranty costs for
the year ended December 31, 2002 increased $323,897
compared to the same period in 2001 due to certain charges for
product replacement related to sales of the MA V to two of
the Companys U.S. customers. The Company believes that the
warranty expenses specific to these customers were non-recurring
in nature and does not anticipate that it will continue to
record similar warranty expenses in the future. In addition,
margins on sales of the MA V and TC were higher in the 2001
period than in the 2002 period, since both the MA V and
MA TC product lines were introduced in 2001 and margins are
typically highest following a products commercial launch.
Partially offsetting the above factors which negatively affected
hardware margins, the Company began shipping the Atigo product
line in the third quarter of 2002, which resulted in a positive
effect on margins. As a result of these activities, gross
margins from hardware sales for the year ended December 31,
2002 were 12%, compared to 25% for 2001. Software cost of sales
decreased from $397,094 for the year ended December 31,
2001 to $0 for the same period in 2002 as the Company had no
software sales in 2002. The lack of high-margin software sales
impacts negatively on the Companys gross margin from
product sales which decreased to 12% for the fiscal year 2002
from 27% for 2001. Cost of sales of consulting, licensing and
other revenue decreased 9%, which is relatively consistent with
the 2% decrease in consulting, license and other revenue. This
resulted in an increase in related margins to 39% in 2002 from
34% in 2001, due primarily to an increase in the mix of higher
margin contracts in 2002 when compared to 2001. The Company
recognized inventory and tooling provisions of $913,175 and
$1,829,234 in the fiscal years 2002 and 2001, respectively,
related to its wearable computer product lines which are
discussed in detail below. Total gross margins, including the
provisions for inventory and tooling, were 13% and 11%, for the
year ended December 31, 2002 and 2001, respectively.


The 2002 inventory and tooling provision
consisted of i) a $1,191,696 charge to write-down the net
carrying value of inventory associated with the MA V,
MA TC and MA IV product lines due to an estimated
general decline in their value, ii) a $53,958 charge related to
a write-down of a small number of early-production models of the
MA V product line with limited hard disk capacity received
by the Company, iii) the $631,556 reversal of an inventory
reserve recorded in 2001 related to the pomaproduct
line, a prior model of wearable computer, discussed below, iv) a
$299,077 reserve against tooling associated with the MA V
product line. The 2001 inventory and tooling provision consisted
of i) a $663,790 charge to reduce the net carrying value of
inventory associated with the MA IV product line given the
uncertainties created by the introduction of the MA V and
MA TC product lines, ii) a $141,280 inventory write-off
established for hard disk drives that were purchased for the
MA V product line but later replaced with higher-capacity
hard disk drives (during the first quarter of 2002, all of the
hard drives were sold in bulk at an amount approximating their
net carrying value and this reserve was fully utilized), iii)
the $885,019 inventory charge recorded in 2001 related to the
pomaproduct line discussed below and iv) a $139,145
charge to reduce the net carrying value of tooling associated
with the MA IV product line.

In 2001, a charge of $885,019 was recorded to
reflect managements estimate of losses to be incurred on
the total initial production run of the pomaproduct
line. The Company elected to sell the pomasystems at
prices that are less than their initial production costs to
favorably position pomain the price-sensitive
light-commercial and near-consumer markets. Although the pomainventory had not been received by the Company as of
December 31, 2001, the Company recorded the expected losses
during 2001, which was the period in which the underlying
contracts were entered into. Because the inventory had not been
received by the company as of December 31, 2001, and was
therefore not recorded as an asset, this charge was recorded as
an accrued liability which was being reclassified to an
inventory reserve as pomainventory shipments were
received during 2002. During 2002, the Company entered into an
agreement with the manufacturer of pomathrough which the
Company was relieved of its obligation to purchase additional
pomaunits. Pursuant to the terms of this agreement, the
Company made a payment of $80,000 during 2002 and reduced
certain of the royalty rates that are used to calculate the
licensing fees that the Company receives from the manufacturer
for its sales of pomaor other wearable computer
products. During 2002, the remaining accrued liability balance,
net of the $80,000 payment, was reversed, resulting in a
$631,556 reduction to the provision for inventory and tooling
reserve.

The Companys management believes that it
can sell its wearable/mobile computer inventory at amounts that
approximate current net carrying values, which have been reduced
as a result of the above charges. To

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determine the size of the charges to record,
management reviewed the carrying value of its inventory in light
of the introduction of new and competing product lines, its
ability to sell the quantities of inventory on hand as well as
the quantities expected to be received in the future and the
sales prices it ultimately expects to achieve. This analysis
took into account estimated price concessions which management
believes are likely to be necessary in disposing of this
inventory. As a result of this review, it was determined that
certain of the Companys inventory is slow-moving, risked
becoming obsolete or will likely be sold at below its historical
cost. Based upon a specific review of the carrying costs for the
inventory items, management estimated the quantity of each
inventory item that the Company was expected to be able to sell
and also quantified inventory amounts that may not be
recoverable. Management does not expect to record significant
profits or losses upon the ultimate sale of this inventory.


Sales and Marketing Expenses.Sales and marketing expenses for the
year ended December 31, 2002 were $14,941,839, a decrease
of $2,587,073, or 15%, compared to $17,528,912 for the same
period in 2001. Included in sales and marketing expenses for the
year ended December 31, 2002 is a $857,011 non-cash charge
related to the cancellation of an agreement for marketing
services and certain retail space at the Waldorf Astoria Hotel
in New York City. Non-cash expenses for outside marketing
services funded through the issuance of the Companys
equity securities, which included expenses of the marketing and
rental agreement at the Waldorf Astoria Hotel before
cancellation, were $773,976 and $265,510 for the year ended
December 31, 2002 and 2001, respectively. In addition,
decreases of approximately $347,000, $848,000, $234,000,
$409,000 and $92,000, respectively, in recruiting costs,
salaries, benefits, consulting and promotional items occurred as
a result of the cost saving measures undertaken in the last
three quarters of 2002. General expenditures for sales and
marketing expenses of the European and Asian operations also
decreased $655,000 from 2001 to 2002.

General and Administrative Expenses.General and administrative expenses
for the year ended December 31, 2002 were $5,703,402, a
decrease of $961,919, or 14%, compared to $6,665,321, for the
corresponding period in 2001. As a result of the cost saving
measures undertaken in the last three quarters of 2002, general
and administrative expenses relating to salaries and benefits,
consulting and travel decreased approximately $431,000, $284,000
and $137,000, respectively, compared to the same period in 2001.

Research and Development Expenses.The Companys research and
development expenses consist primarily of personnel costs, the
purchase of test equipment and payments to consultants and other
third-parties which provide research and development services
for general wearable technology. Research and development
expenses for the year ended December 31, 2002 were
$6,358,883, a decrease of $3,050,951, or 32%, compared to
$9,409,834 for the corresponding period in 2001. This decrease
resulted largely from a $2,600,000 decline in expenditures to
third parties and consultants for design and development of the
Companys mobile/wearable product lines. Expenditures
during the 2001 period related to the MA V and MA TC
product lines while expenditures during the 2002 period related
primarily to the Atigo product line. In addition, the research
and development expenses of the Companys European and
Asian operations decreased by $904,000 from 2001 to 2002 due to
cost saving measures undertaken in the last three quarters of
2002.

Restructuring Costs.Restructuring costs were $1,038,160
for year ended December 31, 2002. These expenses relate to
the Companys cost cutting efforts undertaken in the
second, third and fourth quarters of 2002, for which no
comparable expenses were recorded during the same periods in
2001. These expenses consist of $434,308 for severance extended
to terminated employees, a $233,504 charge related to the
reduction of facilities, a $157,307 write-off of certain
capitalized patent costs and $213,041 for the closing of the
Companys branch operations in Japan. The Companys
wholly-owned subsidiary operating in Japan, Xybernaut KK, was
not closed.

Interest and Other, Net.Other income for the year ended
December 31, 2002 was $163,257, a decrease of $177,462 or
52%, compared to $340,719 for the corresponding period in 2001.
This decrease resulted primarily from a decrease in interest
income earned from the Companys cash balances from the
fiscal year 2002 compared to the same period of 2001.

Provision for Taxes.The Company accrued $562 and $25,840
for a tax provision for the years ended December 31, 2002
and 2001, respectively, related to the operations of its foreign
subsidiaries. The Companys

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U.S. operations had a net loss for the year ended
December 30, 2002 and, therefore, no provision for U.S.
income taxes is required.


Net Loss.As a
result of the factors described above, the net loss for the year
ended December 31, 2002 was $26,580,833, a decrease of
$5,618,746, or 17%, compared to $32,199,579 for the
corresponding period in 2001.

Years Ended December 31, 2001 and
December 31, 2000

Revenue.The Company
derived its revenue from product sales of its wearable
computers, product sales of software and consulting services.
Total revenue for the year ended December 31, 2001 was
$9,819,993, an increase of $315,102, or 3%, compared to
$9,504,891 for the year ended December 31, 2000. Product
revenue for the year ended December 31, 2001 was
$5,906,402, a decrease of $195,173, or 3%, compared to
$6,101,575 for 2000. Sales from the Companys wearable
computer products increased from $4,886,565 in 2000 to
$5,227,502 in 2001, representing a $340,937, or 7%, increase.
This increase resulted from the introduction of the MA V
and MA TC product lines in the second half of 2001.
Offsetting this increase in wearable computer sales was a
decrease in software revenue from $1,215,010 in 2000 to $678,900
in 2001, representing a $536,110, or 44%, decrease. This
decrease related to a single $925,000 sale in 2000 for which no
similarly large transaction occurred in 2001. The Companys
consulting, licensing and other revenue during 2001 was
$3,913,591, an increase of $510,275, or 15%, from 2000 revenue
of $3,403,316. This increase resulted primarily from revenues
realized in 2001 from a large multi-year consulting contract.
Since this contract commenced in mid-2000, comparable billings
were only realized for approximately half of the prior year.

Cost of Sales.The
Companys cost of sales include the costs of components for
the Companys wearable computer product lines, purchased
software, direct labor and materials, amortization of tooling
costs, warranty costs, fulfillment and shipping costs, and
inventory and tooling reserves. Total cost of sales, excluding
inventory and tooling reserve charges, for the year ended
December 31, 2001 was $6,901,150, a decrease of $177,914,
or 3%, compared to $7,079,064 for the year ended
December 31, 2000. This decrease was primarily the result
of a $676,332, or 14%, decrease in product cost of sales from
$4,990,348 in 2000 to $4,314,016 in 2001. The cost of sales
related to the Companys wearable computer products
decreased $247,970, or 6%, from 2000 to 2001, due primarily to
licensing fees incurred during 2000 for software used with the
Companys earlier-generation product line, the MA IV,
which were not incurred in 2001. Additionally, the cost of sales
for software decreased $428,362, or 52%, from 2000 to 2001 which
corresponds generally to the decrease in software revenue.
Overall gross margins before reserves were 30% and 26% for 2001
and 2000, respectively. The Companys gross margin from its
product sales increased to 27% in 2001 from 18% in 2000,
resulting primarily from higher margins on sales of the
Companys new wearable computer product lines introduced in
2001, along with decreased licensing fees. Additionally,
software margins increased to 42% in 2001 from 32% in 2000. The
increase in software margins relates primarily to an increase in
software maintenance revenue in 2001 when compared to 2000. The
Companys cost of services related to consulting, licensing
and other revenue increased $498,418, or 24%, from $2,088,716 in
2000 to $2,587,134 in 2001. The Companys gross margin from
its consulting, licensing and other services decreased to 34% in
2001 from 39% in 2000. These changes resulted primarily from an
increase in labor and sub-contractor costs in 2001 when compared
with 2000. Overall gross margins, including inventory and
tooling charges, were 11% and 10% for 2001 and 2000,
respectively.

The Company recorded provisions of $1,829,234 in
2001 and $1,500,000 in 2000 related to its wearable computer
product lines. The 2001 inventory and tooling provision
consisted of i) a $663,790 charge to reduce the net
carrying value of inventory associated with the MA IV
product line given the uncertainties created by the introduction
of the MA V and MA TC product lines, ii) a
$141,280 inventory reserve established for hard disk drives that
were purchased for the MA V product line but later replaced
with higher-capacity hard disk drives (during the first quarter
of 2002, all of the hard drives were sold in bulk at an amount
approximating their net carrying value and this reserve was
fully utilized), iii) the $885,019 inventory charge
recorded in 2001 related to the pomaproduct line
discussed below and iv) a $139,145 charge to reduce the net
carrying value of tooling associated with the MA IV product
line. The 2000 provision of $1,500,000 was recorded to

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reduce the net carrying value of inventory and
tooling associated with the MA IV product line given the
uncertainties created by the introduction of the MA V and
MA TC product lines.


In 2001, a charge of $885,019 was recorded to
reflect managements estimate of losses to be incurred on
the total initial production run of the pomaproduct
line. The Company elected to sell the pomasystems at
prices that are less than their initial production costs to
favorably position pomain the price-sensitive
light-commercial and near-consumer markets. Although the
pomainventory had not been received by the Company as of
December 31, 2001, the Company recorded the expected losses
during 2001, which was the period in which the underlying
contracts were entered into. Because the inventory had not been
received by the company as of December 31, 2001, and was
therefore not recorded as an asset, this charge was recorded as
an accrued liability which was being reclassified to an
inventory reserve as pomainventory shipments were
received during 2002. During 2002, the Company entered into an
agreement with the manufacturer of pomathrough which the
Company was relieved of its obligation to purchase additional
pomaunits. Pursuant to the terms of this agreement, the
Company made a payment of $80,000 during 2002 and reduced
certain of the royalty rates that are used to calculate the
licensing fees that the Company receives from the manufacturer
for its sales of pomaor other wearable computer
products. During 2002, the remaining accrued liability balance,
net of the $80,000 payment, was reversed, resulting in a
$631,556 reduction to the provision for inventory and tooling
reserve.

The Companys management believed that it
could sell its wearable computer inventory at amounts that
approximated current net carrying values, which had been reduced
as a result of the above charges. To determine the size of the
charges to record, management reviewed the carrying value of its
inventory in light of the introduction of new product lines, its
ability to sell the quantities of inventory on hand as well as
the quantities expected to be received in the future and the
sales prices it ultimately expected to achieve. This analysis
took into account estimated price concessions which management
believed were likely to be necessary in disposing of this
inventory. As a result of this review, it was determined that
certain of the Companys inventory was slow-moving, risked
becoming obsolete or would likely be sold at below its
historical cost. Based upon a specific review of the carrying
costs for the inventory items, management estimated the quantity
of each inventory item that the Company was expected to be able
to sell and also quantified inventory amounts that may not be
recoverable. Management did not expect to record significant
profits or losses upon the ultimate sale of this inventory.

Sales and Marketing Expenses.Sales and marketing expenses for the
year ended December 31, 2001 were $17,528,912, an increase
of $6,048,100, or 53%, compared to $11,480,812 for the year
ended December 31, 2000. The increase was the result of
efforts to market and sell the Companys new wearable
computer product lines in 2001. These efforts included an
increase of approximately $3,400,000 in personnel costs related
to its sales, marketing and business development functions.
Additionally, expenditures relating to outside marketing
services, including those incurred for a new logo and collateral
literature, trade shows and conferences increased by
approximately $1,100,000 in 2001 from 2000. The Company recorded
$265,510 and $1,254,008 of non-cash expenses during 2001 and
2000, respectively, for outside marketing services which were
paid through the issuance of the Companys equity
securities.

General and Administrative Expenses.General and administrative expenses
for the year ended December 31, 2001 were $6,665,321, an
increase of $600,080, or 10%, compared to $6,065,241 for the
year ended December 31, 2000. This increase was primarily
the result of an increase in personnel costs.

Research and Development Expenses.The Companys research and
development expenses consist primarily of personnel costs, the
purchase of test equipment and payments to consultants and other
third-parties which provide research and development services.
Research and development expense for the year ended
December 31, 2001 was $9,409,834, an increase of $3,483,997
or 59%, compared to $5,925,837 for the year ended
December 31, 2000. This was principally the result of
increases of approximately $1,728,000 in third-party
expenditures made during 2001 over 2000 levels related to the
research and design of wearable computers and peripherals,
$571,000 in personnel costs and $836,000 in outside research
services related to wearable technology, including hardware and
software development, product testing and evaluation.

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Merger Costs.Merger
expenses were $621,048 for 2000. These non-recurring expenses
related to the Companys April 2000 merger with XSI, for
which no comparable expenses were recorded in 2001. These
expenses consist of $452,683 in direct costs, including fees for
investment banking, legal and accounting services, and $168,365
in charges to conform XSIs accounting policies to those of
the Company.

Interest and Other, Net.Net interest income and other income
for the year ended December 31, 2001 was $340,719, a
decrease in expense of $1,321,362, compared to expense of
$980,643 for the year ended December 31, 2000. This
increase was the result of approximately $1,267,000 of interest
expense and the amortization of note discounts related to
certain loans that the Company received during 2000. The Company
did not have significant borrowings during 2001.

Provision for Income Taxes.The provision for income taxes for the
year ended December 31, 2001 was $25,840, a decrease of
$11,628, compared to the income tax provision of $37,468 for the
year ended December 31, 2000. These amounts relate to the
operations of the Companys foreign subsidiaries. The
Companys U.S. operations had a net loss during these
periods and, therefore, no provision for U.S. income taxes was
made.

Provision for Preferred Stock Dividends.The Company accrued dividends at 5%
per year on the outstanding principal amount of its preferred
stock during the year ended December 31, 2000. As of that
date, all outstanding preferred stock had been fully converted
into common stock. Therefore, for the year ended
December 31, 2001, there was no provision for dividends, a
decrease of $10,438, or 100%, from the $10,438 recorded in 2000.

Net Loss Applicable to Holders of Common
Stock.As a result of the factors
described above, the net loss applicable to holders of common
stock for the year ended December 31, 2001 was $32,199,579,
an increase of $8,003,919 or 33%, compared to $24,195,660 for
the year ended December 31, 2000.

Other Operating Activities

For the year ended December 31, 2002, the
Companys operating activities used cash of $22,326,101,
primarily as a result of its net loss of $26,580,833, and its
investing activities used cash of $934,697. These activities
were funded through the Companys financing activities
which provided cash of $22,011,620, principally through the
issuance of common stock. As a result, the Companys cash
balance decreased to $1,967,710 at December 31, 2002 from
$3,172,609 at December 31, 2001.

For the year ended December 31, 2001, the
Companys operating activities used cash of $28,355,424,
primarily as a result of its net loss of $32,199,579, and its
investing activities used cash of $3,193,294. These activities
were funded through the Companys financing activities
which provided cash of $26,223,674, principally through the
issuance of common stock. As a result, the Companys cash
balance decreased to $3,172,609 at December 31, 2001 from
$8,848,715 at December 31, 2000.

For the year ended December 31, 2000, the
Companys operating activities used cash of $22,475,911,
primarily as a result of its net loss of $24,185,222 and the use
of cash for working capital of $3,722,120, amounts which were
offset by non-cash expenses of $5,431,431. The Companys
investing activities used cash of $2,630,434. These operating
and investing activities were funded through the Companys
financing activities which provided cash of $32,017,341,
principally through the issuance of common stock. As a result,
the Companys cash balance increased from $2,126,000 at
December 31, 1999 to $8,848,715 at December 31, 2000.

For hardware product sales, the Company generally
provides a one-year warranty on its parts and a six-month
warranty on labor. However, the Companys suppliers for the
significant components of the MA and Atigo products, including
the computing unit, flat panel and head mounted displays, and
batteries, provide the Company with similar warranties. A
provision for estimated future warranty costs is recorded at the
time of shipment as a component of cost of sales. The provision
is an estimate of internal costs to be incurred for such sales
above and beyond the warranty offered to the Company by its
suppliers. The trend in the computer hardware industry is to
provide extended warranties for up to two years beyond the
one-year base warranty.

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The Company already offers an extended warranty
on Atigo and is negotiating with the suppliers of its MA
products to offer similar warranties to the Company to back up
the extended warranties offered to the Companys customers.
In the event that the Company is not able to obtain such
warranties from its suppliers, the Company may incur warranty
expenses in the future that are significantly greater than those
incurred in the past.


The Companys consolidated financial
statements contain a provision for income tax expense related to
its operations outside the United States. Subject to
realization, the Company has generated net operating losses in
the U.S. that can be used to offset taxable operating income in
the future. The Companys future operations, if profitable,
will be subject to income tax expense not previously incurred by
the Company (see Note 10 to the Consolidated Financial
Statements). At December 31, 2002, the Company had
approximately $116,312,000 and $6,560,000 of net operating loss
carry forwards for U.S. federal and foreign income tax purposes,
respectively. The U.S. losses will begin to expire in 2010 and
the losses from foreign operations do not expire. The use of the
U.S. carryforwards may be limited in any one year under Internal
Revenue Code Section 382 if significant ownership changes
occur.

The Company is involved in routine legal and
administrative proceedings and claims of various types. While
any such proceeding or claim contains an element of uncertainty,
management does not expect that they will have a material
adverse effect on the Companys results of operations or
financial position.

Transactions With Related and Certain Other
Parties

The Company uses a member of its Board of
Directors as its patent counsel. The Company had expenditures of
$331,112, $421,333 and $174,468 during 2002, 2001 and 2000,
respectively, in legal services payable to this Director. These
amounts represent gross payments made by the Company and the
counsel is responsible for all overhead, professional,
administrative and other expenditures incurred by his law firm.
The law firm bills the Company in accordance with its
established standard billing rates used in the past with its
other clients. During 2002 and 2001, the Company represented the
law firms only significant client. During approximately
half of 2002 and all of 2001 and 2000, the Director also serves
as the Companys processing agent for payments made to
various other domestic and international law firms and agencies
used to file and maintain patents and trademarks. The director
is paid only the amount that is passed through to these other
law firms and agencies and pays administrative services related
to these services. The Company made additional payments of
$274,040, $485,827 and $266,026 during 2002, 2001 and 2000,
respectively, to this Directors law firm related to
services rendered by the Directors law firm as the
Companys processing agent for all foreign patent and
trademark filing and prosecution expenses. The Companys
management believes that the relationship with this law firm is
based on arms-length terms and conditions.

The Company uses a law firm, in which an officer
and member of its Board of Directors is a partner, for services
related to financings, litigation, SEC filings and other general
legal matters. The Company had expenditures of $464,067,
$392,524 and $446,320 during 2002, 2001 and 2000, respectively,
in legal services payable to this law firm. The law firm bills
the Company in accordance with the established billing rates
used with its other clients. As a result, the Companys
management believes that the relationship with this law firm is
based on arms-length terms and conditions.

Two of the Companys former executive
officers were members of the board of directors of a former
customer that purchased software products and consulting
services from the Company. During 2001, this customer was forced
to cease operations when its largest customer withheld payment
for ongoing services. During 2001 and 2000, the Company recorded
revenues on sales to this customer of $29,603 and $573,955,
respectively. As of December 31, 2000, the Company had a
$259,566 accounts receivable balance remaining from this
customer. During 2001, the Company collected $259,333 from this
customer and wrote off the remaining $29,836 balance. The
Company billed this customer using the established billing rates
used with its other customers. Additionally, the Company
believes that the final payment received by the Company was
commensurate with those received by other similar vendors of the
customer. As a result, the Companys management believes
that the relationship with this customer was based on
arms-length terms and conditions.

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During 2000, Xybernaut GmbH used a company to
provide configuration and technical support services and a
separate company to act as a distributor of the Companys
hardware products. The executive officers of these two companies
are the son and daughter-in-law of one of the Companys
Senior Vice Presidents and member of its Board of Directors.
During 2000, the Company incurred expenses related to the
technical support services totaling $180,456 and recognized
revenue related to distribution sales of its hardware products
totaling $313,843. During 2000, the Company terminated its
relationship with these two companies and established a reserve
of $108,856 against the accounts receivable balance owed by one
of the companies. This balance was written off in 2001. The
company providing configuration and technical support services
billed the Company using the established billing rates used with
its other clients. Additionally, management periodically
compared these billings against charges it would incur if these
services were provided by a different provider. The agreement
with the distributor was reached with similar terms and
conditions provided to other resellers of the Companys
products. As a result, the Companys management believes
that the relationship with these companies was based on
arms-length terms and conditions.

Between November 2000 and February 2001, the
Company loaned a net balance of $940,188 to the Companys
President, Chief Executive Officer and Chairman of the Board of
Directors. The proceeds were used to prevent a forced sale of a
portion of this officers personal common stock holdings of
the Company that secured a personal margin loan from an
investment bank. The loan was made pursuant to a promissory note
that was secured by shares of the officers personal common
stock holdings of the Company and accrued interest at 8% per
year. On December 31, 2001, the Companys Board of
Directors increased the number of shares securing the loan from
200,000 shares to 250,000 shares, extended the maturity date
from December 31, 2001 to December 31, 2002 and
reduced the interest rate to 6%, reflective of a general decline
in interest rates over this period. On December 17, 2002,
the $1,086,891 in outstanding principal and interest was repaid
in full through the i) transfer by the officer to the
Company of 1,108,343 shares of the Companys common stock
personally held by the officer, which amount includes the shares
that were pledged as collateral, which were valued at
$681,631,and ii) cancellation of all of the officers
742,049 options to purchase shares of the Companys common
stock that had been granted prior to the date of repayment,
which were valued at $405,260. Effective December 31, 2002,
the Company cancelled the 1,108,343 shares of common stock
transferred through this repayment. To determine the fair market
value of the transfer of shares of stock and the cancellation of
stock options, the Company used the market price of the
Companys common stock on the date of repayment and the
Black-Scholes option-pricing model, respectively. The variables
used in the Black-Scholes option-pricing model were as follows:
i) the risk free rate was 3.03%, which was the yield of
5-year Treasury Notes issued November 15, 2002,
ii) the standard deviation of stock return was 131.25%,
which was the volatility of the Companys stock calculated
using the end of the month stock price for the period from
January 1, 2000 through December 31, 2002. The
outstanding principal and interest owed by the officer to the
Company under this promissory note totaled $0 and $1,026,708 at
December 31, 2002 and 2001, respectively.

The Company has contracted with IBM to design,
develop and manufacture certain components of the MA V
product line, including the computer portion and two versions of
FPDs (the Engineering and Inventory Agreement). The
Company has also entered into agreements with IBM under which
IBM purchases MA V and Atigo products from the Company and
markets and sells the systems worldwide to its own customers
(the Sales and Marketing Agreement). During 2002,
2001 and 2000, the Company paid $2,772,457, $4,148,523 and
$2,406,020, respectively, to IBM related to design and
development services and inventory purchases. During 2002 and
2001, the Company recorded revenues of $1,109,743 and $532,675,
respectively, related to sales of MA V and Atigo products
to IBM. Before selecting IBM as its partner for the Engineering
and Inventory Agreement, the Company reviewed IBMs
proposal to provide such services, which included discussion of
the estimated costs to be incurred, IBMs track-record of
bringing new technologies to market, IBMs reputation for
quality and other customary evaluations. The Sales and Marketing
Agreement was reached with similar terms and conditions provided
to other volume resellers of the Companys products. As a
result, the Companys management believes that the
Engineering and Inventory Agreement and the Sales and Marketing
Agreement contain arms-length terms and conditions.

29



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Certain of the end-users of the Companys
wearable computer products are universities and other
not-for-profit entities (collectively, the
End-Users) that purchase these products from a Value
Added Reseller (the VAR) of Xybernaut GmbH. The
Company also contracts with certain of the End-Users to provide
research and development and sales and marketing services to the
Company. The research and development services provided to the
Company include activities such as hardware and software
development, product testing and evaluation. The sales and
marketing services include activities such as Company
participation in and sponsorship of industry trade shows, the
preparation of competitive market analysis and the use of the
End-Users as named reference accounts. During 2002, 2001 and
2000, the Company recorded revenues of approximately $950,000,
$1,700,000, and $750,000, respectively, related to sales of its
products to the VAR. During 2002, 2001 and 2000, the Company
recorded total research and development and sales and marketing
expenses of $1,250,000, $1,250,000 and $50,000, respectively,
related to services performed by the End-Users. The Company
compares the cost of the projects performed by the End-Users
against the cost it would likely incur if it were to obtain
these services from entities other than the End-Users.
Management also evaluates the cost if the Company performed
these services in-house, including expenses that would be
incurred for salary and benefits, training, travel, supplies and
equipment, and overhead. As a result, the Companys
management believes that the agreements and contracts underlying
both the sale of the products and the performance of the
services contain arms-length terms and conditions.

Liquidity and Capital Resources

From its inception until the completion of the
IPO, the Company financed its operations through the private
sale of its equity securities, vendor credit, and short-term
loans received from management, stockholders and others. During
and subsequent to the IPO, the Company has financed its
operations from public and private sales of its common and
preferred stock, borrowings from financial institutions,
management and investors, proceeds from the exercise of warrants
and stock options, and sales of its products and services. The
Companys detailed financing and borrowing activities for
2002, and summary activities for 2001 and 2000, are provided
below.

Common Stock

During 2000, the Company received net cash
proceeds of $23,163,645 through the issuance of 7,923,359 shares
of its common stock through four separate private placements.
The Company also issued warrants to purchase 3,312,437 shares of
its common stock for between $4.33 and $10.00 per share related
to these private placements.

During 2001, the Company received net cash
proceeds of $22,801,278 through the issuance of 12,018,772
shares of its common stock through three separate private
placements. The Company also issued warrants to purchase
3,409,347 shares of its common stock for between $2.55 and $5.00
per share related to these private placements.

During March 2002, the Company received gross
proceeds of $9,000,000 through a private placement of 5,625,000
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 1,406,250 shares of common stock
at an exercise price of $3.00 per share. In connection with this
placement, the Company paid $270,000 in cash to financial
advisors.

During June 2002, the Company received gross
proceeds of $4,000,000 through a private placement of 6,666,666
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 1,666,666 shares of common stock
at an exercise price of $1.50 per share. In connection with this
placement, the Company issued 740,740 shares of its common stock
to financial and business development advisors.

During August 2002, the Company received gross
proceeds of $2,000,000 through a private placement of 5,714,286
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 5,714,286 shares of common stock
at an

30



---



##### 



exercise price of $0.70 per share and callable
warrants to purchase 5,714,286 shares of common stock at an
exercise price of $1.50 per share. A portion of the proceeds
from this private placement was used to repay a $250,000 note
payable.


During November 2002, the Company received gross
proceeds of $4,100,000 through a private placement of 17,083,332
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 8,541,668 shares of common stock
at an exercise price of $1.25 per share.

The Company issues warrants to purchase shares of
its common stock, primarily in connection with the
Companys financings and borrowings. The Company received
net proceeds of $2,186,802, $3,773,405 and $8,274,975 through
the issuance of 17,350,627, 1,881,470 and 2,077,700 shares of
its common stock during 2002, 2001 and 2000, respectively,
through the exercise of certain of these warrants. Concurrently
with the exercise of such warrants in 2002, the exercise price
of 17,350,627 warrants was reduced from $1.61 per share to $0.18
per share. At December 31, 2002, the Company had warrants
outstanding to purchase 12,992,204 shares of its common stock at
prices that range from $0.50 to $5.00 per share, with a weighted
average of $1.99 per share.

Employees and consultants of the Company have
exercised stock options that had been issued pursuant to the
Companys various stock incentive plans. During 2002, 2001
and 2000, the Company issued 35,835, 57,097 and 662,724 shares,
respectively, of its common stock and received gross proceeds of
$11,048, $135,659 and $1,547,011, respectively, related to these
exercises.

Preferred Stock

From 1997 through 1999, the Company issued
certain series of convertible preferred stock. The preferred
stock issuances generally accrued interest at 5.0% per year. At
December 31, 2000, all shares of the Companys
convertible preferred stock had been converted into shares of
its common stock and no preferred stock has been issued since
that time.

During 1999, the Company issued 10,500 shares of
Series D Preferred Stock for gross proceeds of $10,000,000.
As of December 31, 2000, all of the Series D Preferred
Stock principal and interest had been converted into 8,204,596
shares of common stock. During 1999, the Company issued 2,100
shares of Series E Preferred Stock for gross proceeds of
$2,000,000. As of December 31, 2000, all of the
Series E Preferred Stock principal and interest had been
converted into 1,655,714 shares of common stock.

Borrowings

In January 2000, the Company borrowed $3,025,000
from several lenders pursuant to promissory notes which accrued
interest at 10% per annum. In connection with these borrowings,
the Company issued warrants to purchase 302,500 shares of
unregistered common stock at $0.10 per share. Based on the
relative fair values of the securities issued, these warrants
were assigned a value of $921,452, which amount was recorded as
a note discount and amortized into interest expense over the
lives of the notes. In November and December 2000, the Company
repaid the principal and unpaid interest and the remaining note
discount balance was charged to interest expense.

In June 2000, XSI entered into three capital
leases for computer equipment totaling $27,190. The leases have
interest rates between 14.0% and 19.5% and mature in three
years. At December 31, 2002, the capital lease obligation
was $8,376. During 2002, 2001 and 2000, the Company incurred
interest expense of $2,320, $3,781 and $1,057, respectively,
related to these capital leases.

In July 2000, the Company entered into a
six-month $1,400,000 term loan with IBM Global Finance. The
borrowing was secured by certain of the Companys
equipment, inventory and accounts receivable balances. The
borrowing accrued interest at the prime rate plus 1.5% and was
repaid in three equal installments in September and November
2000 and January 2001. During 2001 and 2000, the Company
incurred interest expense of $2,377 and $48,431, respectively,
related to this borrowing.

31



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##### 



During June 2002, the Company received $250,000
in cash from an investor that was recorded by the Company as a
note payable. This note bore interest at 6.0% per annum and was
due on or before June 30, 2003. This note was repaid in
August 2002 from the proceeds of a private placement.

Commitments

Inventory.At
December 31, 2001, the Company had commitments to purchase
inventory, tooling and engineering and other services from its
suppliers and manufacturers related to its current and future
hardware product lines. The Company expects that it will enter
into similar commitments in the future as it designs, develops
and procures future wearable computer product lines.

Under its original agreements with IBM, the
Company was obligated to purchase certain components of the
MA V system, including 24,000 computing units, as well as
various numbers of FPDs and other accessories. The total cost to
the Company of these purchases would have been over
approximately $40,000,000. Under the original agreements, the
Company had the right to cancel this purchase commitment by
paying a cancellation fee in an amount of approximately
$4,000,000. In March 2003, the Company entered into an agreement
with IBM under which the Company was released of its obligation
to pay the penalty or procure this inventory other than
$4,910,000 in MA V computing units, FPDs, peripherals and
component parts. The final pricing provided to the Company
represents a discount from the original contractual prices.
Under the March 2003 agreement, IBM will ship inventory monthly
from March 2003 through December 2003 and the Company will remit
payments monthly from March 2003 through January 2004. IBM
Global Finance is providing a credit facility to the Company
which will provide credit to the Company for purchases of
inventory under the March 2003 agreement. In connection with
this credit facility, IBM Global Finance was granted a security
interest in certain of the Companys assets and the Company
obtained a letter of credit from a third party lender for the
benefit of IBM Global Finance in the amount of $375,000, for
which the Company posted an equal amount of restricted cash.
This security interest does not include patents and intellectual
property.

In addition to the above obligation to IBM
related to the MA V, the Company has commitments to
purchase computing units, flat panel and head mounted displays,
miscellaneous computing components as well as engineering and
other services from its various vendors related to the
MA V, Atigo, MA TC and future product lines. The
Company believes that, if needed, the timing and amount of many
of these shipments, services and payments may be adjusted
through the payment of cancellation fees, contract negotiations
or the satisfaction of obligations through the issuance of the
Companys equity securities. However, there can be no
assurance that the Company can or will successfully modify these
contracts or commitments.

Excluding the potential impact of contract
modifications, the Company estimates that it will make total
payments of approximately $5,000,000 during 2003 related to
current inventory commitments at the time of this filing, which
amount includes the commitment to purchase the additional
MA V products from IBM monthly during 2002, discussed
above. The Company expects that it will enter into similar
inventory and engineering commitments in the future as it
designs, develops and procures future wearable computer product
lines.

Operating Leases and Other.The Company leases operating
facilities and equipment under operating leases expiring on
various dates through 2005. Future minimum payments under
noncancelable operating leases at December 31, 2002 are:

|                                 |  |   |         | 
|-------------------------------- |  | - | ------- | 
|For the Year Ending December 31, |  |  
|                                 |  |  
|2003                             |  | $ | 602,773 | 
|2004                             |  |   | 210,526 | 
|2005                             |  |   | 165,041 | 
|2006                             |  |   |        | 
|2007                             |  |   |        | 
|                                 |  |   |        
|                                 |  | $ | 978,340 | 
|                                 |  |   |        

32



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##### 



Other Liquidity and Capital Resources
Disclosures

At December 31, 2002, the Company had
accounts receivable, net of allowances, of $3,410,871, an
increase of $127,043, or 4%, from the December 31, 2001
balance of $3,283,828. This fluctuation was roughly in line with
the 2% increase in total revenues from 2001 to 2002 and
management does not believe that it was caused by qualitative
factors related to the Companys business such as changes
in credit terms, slower paying customers or the impact of a
change in economic environment. Included in the accounts
receivable at December 31, 2002 is accounts receivable of
$1,103,200 associated with a December sale for which we
collected the balance in 2003. In addition, accounts receivable
at December 31, 2002 include $1,130,206 of unbilled
accounts receivable representing amounts earned and recorded
under the percentage of completion method of accounting on a
long-term contract of XSI. The Company expects to bill this
amount in its entirety in 2003 upon reaching certain milestones
in the contract.

The deferred revenue balances at
December 31, 2002 and 2001 result primarily from billings
to customers that were in excess of revenue recognized on
service contracts. Such deferred revenue will be recognized as
revenue as the revenue recognition criteria are met.

The Company has recorded net losses since its
inception, including during the periods presented in this
Form 10-K. These losses are primarily attributable to the
operating expenses incurred by the Company to design, develop,
market and sell its wearable computer products and to provide
general and administrative support for these operating
activities. During these periods, the Companys revenues
and gross margins have not been sufficient to fund these
operating activities. As a result, the Company has consistently
recorded negative cash flows from operating activities and net
losses and had an accumulated deficit of $131,023,159 at
December 31, 2002.

The combination of the Companys operating
losses and its working capital requirements has severely
impacted the Companys financial position and liquidity. At
December 31, 2002, the Company had unrestricted cash on
hand of $1,967,710 and accounts payable and accrued expenses of
$4,481,153. Certain of these liabilities are past their stated
terms of payment, including those owed to vendors that provide
services and inventory which are required by the Company to
execute its business plan. In general, any company that does not
pay its suppliers in a timely manner is at risk of being forced
into an involuntary bankruptcy proceeding instituted by
creditors, which may provide for the liquidation of assets or
the reorganization of assets and debts. The Company generally
believes that it has a reasonably good relationship with most of
its vendors and creditors. However certain of its vendors have
filed legal actions to recover overdue accounts payables and
ceased providing services and products to the Company. There can
be no assurances that other vendors will not pursue similar
actions.

During 2002, 2001 and 2000, the Company funded
its operating and investing activities through its financing
activities, which consist primarily of private placements of
common stock, warrant and stock option exercises and borrowings.

The Companys management has taken steps
that it believes are necessary to improve the Companys
operations and raise additional capital, both of which are
needed to enhance its ability to meet its cash flow needs
through December 31, 2003 and thereafter. Beginning in
April 2002 and continuing through the date of this filing,
management has performed reviews of the Companys
operations and implemented various cost cutting programs to
significantly reduce the Companys operating expenses.

Assuming there are no significant changes to the
Companys business plan, management expects to maintain
savings of over 50% from annualized fourth quarter 2001 levels.
In the fourth quarter of 2002, management met its initial target
to reach a quarterly operating expense level of between
$4,000,000 and $5,000,000. Future significant fluctuations may
still occur as a result of non-recurring charges associated with
cost-saving initiatives as well as the Companys research
and development activities, which will vary depending on the
Companys wearable/mobile computer product development
cycle during any given period.

33



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##### 



As indicated in the chart below, through the
fourth quarter of 2002, the Company had reduced its net
operating expenses by 56% from annualized fourth quarter 2001
levels.


|                       |  |               |            |               |                |  |     |               |  |  |     |   
|---------------------- |  | ------------- | ---------- | ------------- | -------------- |  | --- | ------------- |  |  | --- | --
|                       |  |               |            | % Change from |                |  |    
|                       |  | Net Operating |            |               | Fourth Quarter |  |     | % Change from | 
|                       |  | Expenses(1)   |            |               | of 2001        |  |     | Prior Quarter | 
|                       |  |               |            |               |                |  |     |               | 
|Fourth Quarter of 2001 |  | $             | 10,114,109 |               |                |  |    |               |  |  |    |   
|First Quarter of 2002  |  | $             | 8,745,553  |               |                |  | (14 | )%            |  |  | (14 | )%
|Second Quarter of 2002 |  | $             | 6,947,240  |               |                |  | (31 | )%            |  |  | (21 | )%
|Third Quarter of 2002  |  | $             | 5,995,627  |               |                |  | (41 | )%            |  |  | (14 | )%
|Fourth Quarter of 2002 |  | $             | 4,458,693  |               |                |  | (56 | )%            |  |  | (26 | )%



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The Companys management uses the
    measurement of net operating expenses in reviewing the results
    of its operations as well as in analyzing the impact of the
    various cost-saving initiatives it has implemented or plans to
    implement in the future. When used herein, net operating
    expenses represents total operating expenses as reported on the
    Companys consolidated statements of operations (as
    reported in accordance with U.S. GAAP) as adjusted for
    restructuring charges (as reported in accordance with U.S. GAAP)
    as well as certain other non-recurring transactions (that do not
    meet the criteria for recordation as restructuring charges).
    Management believes that by reviewing net operating expenses, it
    is better able to focus on the Companys recurring
    operations than it would be if it reviewed total operating
    expenses, which include charges such as severance payments to
    terminated employees, charges related to reductions in
    facilities and other large charges related to non-recurring
    activities. The net operating expense balances presented above
    reconcile to the amounts included on the Companys
    consolidated statements of operations as follows:

|                                                           |  |                |            |  |               |   |           |                |  |   |               |   |  |                |            |   |  |   |           |  
|---------------------------------------------------------- |  | -------------- | ---------- |  | ------------- | - | --------- | -------------- |  | - | ------------- | - |  | -------------- | ---------- | - |  | - | --------- | -
|                                                           |  | Fourth quarter |            |  | First quarter |   |           | Second quarter |  |   | Third quarter |   |  | Fourth quarter |           
|                                                           |  | of 2001        |            |  | of 2002       |   |           | of 2002        |  |   | of 2002       |   |  | of 2002        |           
|                                                           |  |                |            |  |               |   |           |                |  |   |               |   |  |                |           
|Total operating expenses                                   |  | $              | 10,114,109 |  |               | $ | 8,745,553 |                |  | $ | 7,102,474     |   |  | $              | 8,101,940  |   |  | $ | 4,092,317 |  
|Restructuring charges                                      |  |                |           |  |               |   |          |                |  |   | (155,234      | ) |  |                | (361,227   | ) |  |   | (521,699  | )
|Charges for cancellation of Waldorf Astoria
    agreement  |  |                |           |  |               |   |          |                |  |   |              |   |  |                | (729,511   | ) |  |   | (127,500  | )
|(Reserve), and subsequent reversal, of note
    receivable |  |                |           |  |               |   |          |                |  |   |              |   |  |                | (1,015,575 | ) |  |   | 1,015,575 |  
|                                                           |  |                |            |  |               |   |           |                |  |   |               |   |  |                |           
|Net operating expenses                                     |  | $              | 10,114,109 |  |               | $ | 8,745,553 |                |  | $ | 6,947,240     |   |  | $              | 5,995,627  |   |  | $ | 4,458,693 |  
|                                                           |  |                |            |  |               |   |           |                |  |   |               |   |  |                |           

The key cash saving initiatives that have been,
and will continue to be, implemented are listed below:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Worldwide headcount will have been reduced by 45%
    from approximately 145 full-time equivalent employees to
    approximately 80 full-time employees.                                                                                                                                                                                                                                                                                                                        
|
| |  | The Companys worldwide engineering and
    product functions have been consolidated.                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | Operations in Asia were significantly reduced,
    especially related to direct sales, marketing and product
    efforts. Future Asian operations will focus primarily on channel
    sales, potential business combinations and business development.
    The Companys branch operations in Japan, which focused
    primarily on product efforts, were closed. The Companys
    subsidiary Xybernaut KK, which focuses primarily on sales and
    marketing, was not closed.
|
| |  | Operations in Europe were significantly reduced,
    especially related to direct sales and marketing efforts. Future
    European operations will focus primarily on channel sales, sales
    and marketing relationships with strategic partners, business
    development and research and development.                                                                                                                                                                      
|
| |  | Participation in trade shows has been reduced.                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | An agreement was reached with the manufacturer of
    the pomaproduct line through which the Company
    eliminated its obligation to purchase approximately $1,500,000
    in additional systems.                                                                                                                                                                                                                                                                              

34



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##### 





| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | An agreement was reached with the manufacturer of
    the MA V product line through which the Company received a
    discount on certain inventory commitments originally scheduled
    for purchase during 2003 and 2004 and eliminated over
    approximately $40,000,000 in obligations to purchase additional
    systems as well as a potential cancellation fee of approximately
    $4,000,000. Under this agreement, the Company is required to
    purchase $4,910,000 in additional MA V systems, primarily
    during 2003.
|
| |  | An agreement with a vendor to provide the Company
    with marketing services and certain retail space at the Waldorf
    Astoria Hotel in New York City was canceled.                                                                                                                                                                                                                                                                                                                                                                
|
| |  | Management expects to not invest significant
    future time or capital resources pursuing certain of its foreign
    patent applications.                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | Agreements with certain consultants, vendors and
    partners have been, and will continue to be, cancelled or
    renegotiated in order to minimize cash expenditures through the
    issuance of the Companys equity securities, the
    renegotiation of terms and a reduction or elimination of
    services.                                                                                                                                                                                                                    
|
| |  | Other various reductions in discretionary costs
    have been, and will continue to be, implemented.                                                                                                                                                                                                                                                                                                                                                                                                                                  

Subsequent to these changes, management believes
that the Companys staffing and resources will be
sufficient to carry out its business plan for the foreseeable
future.

In addition to the cost cutting initiatives
detailed above, management continues to review all aspects of
the Companys operations and may take additional actions to
reduce operating expenses further.

At the forecasted levels discussed above,
management expects that the Company will incur operating
expenses of between $16,000,000 and $20,000,000 during 2003. The
Company will also be required to fund inventory procurement and
other expenditures. While management expects to fund a portion
of these activities through gross profits resulting from
revenues, the Company will be required to obtain most of such
amounts through outside financings. Potential sources of
additional financing include private equity offerings, warrant
exercises, strategic investments and various forms of debt
financing. In certain instances, concurrently with the exercise
of certain of these warrants the exercise prices were reduced.
Such reduction has resulted in the issuance of substantially
more shares of common stock than would have occurred had the
warrants been exercised at their original exercise prices. The
Company may reduce the exercise price of additional warrants in
the future. If additional funds are raised through the issuance
of equity securities, the percentage of ownership of current
stockholders of the Company will be reduced and if additional
funds are raised at current prices for the Companys stock,
such dilution could be significant. If additional funds are
raised through borrowings, the Company will be subject to
interest charges and principal repayments, will likely be
required to comply with financial covenants or other
restrictions, and will likely have to collateralize such
borrowings with its assets, which could be taken by the lender
in the event of default.

During 2002, the Company raised $22,011,620 in
cash through sales of its common stock to institutional
investors, through warrant and stock option exercises and
through borrowings that were repaid through the issuance of
common stock. Subsequent to December 31, 2002, the Company
raised over approximately $6,100,000 in additional funds through
warrant exercises, sales of its common stock to institutional
investors and borrowings. Management anticipates that additional
funds will be needed from additional private placements later in
2003. Due in large part to the Companys current stock
price, the depressed general capital markets and cost-cutting
efforts described above, the individual equity financings that
the Company has completed in recent quarters have been of a
smaller size when compared to those transacted in previous
periods. The equity markets, especially for small capitalization
technology stocks, have remained depressed, and the U.S. and
world economies have generally been in a decline or recession.
If a sustained decline in the general equity markets, the price
of the Companys common stock, or the U.S. or world economy
were to occur, the Company could face difficulties in its
ability to raise additional capital. Additionally, the Company
has historically made several private placements of its common
stock per year, primarily to a limited number of institutional
investors who specialize in making similar types of investments.
If these institutional investors were to choose to not
participate in future private placements, the Company could face
difficulties in its ability to raise additional capital.

35



---



##### 



On July 22, 2002, the Company received
notice from Nasdaq that the Companys common stock had
closed below $1 per share for 30 consecutive trading days.
Effective October 29, 2002, the Company was granted a
transfer to the Nasdaq SmallCap® Market. Effective
January 22, 2003, the Company was provided an extension
until July 17, 2003 for the stock price to close above $1
for ten consecutive trading days.

On January 30, 2003, Nasdaq issued a press
release in which it announced plans to extend a pilot
program governing bid price rules for all Nasdaq National
Market® and Nasdaq Small Cap issuers. The proposal will
allow issuers that meet heightened financial requirements to
benefit from extended compliance periods for satisfying minimum
bid price requirements. The proposed rule changes would [amongst
other changes] extend the bid price grace period for SmallCap
issuers demonstrating compliance with the core SmallCap initial
listing criteria from 180 to up to 540 days (approximately
18 months). Compliance with this standard will be verified
every 180 days. NASDAQ will present the overall plan to the
Securities and Exchange Commission for approval prior to
implementing the proposed changes.

The Company is currently in compliance with all
such listing criteria and management anticipates it will remain
in compliance in the future. However, there can be no assurances
that the Company will be able to remain in compliance in the
future or that the SEC will grant the Nasdaq the requisite
approval to adopt this proposal. Prior to the delisting of the
Companys common stock, the Company can appeal Nasdaq for
an extension or for other remedies. If necessary, management
intends to fully exercise all of its rights and options to
maintain its listing. If the Company is unable to remain on the
SmallCap Market, it may be forced to trade on the Over the
Counter Bulletin Board or Pink Sheets markets, which would
significantly reduce the liquidity in the stock and interest of
potential investors in purchasing the stock.

The Companys management believes that under
this Nasdaq proposal, the Company would be eligible to obtain an
extension throughout 2003 and potentially thereafter for its
stock price to close above $1 for ten consecutive trading days.

The Companys management believes that the
combination of cash on hand, cash flows from operations and
outside funding will provide sufficient liquidity to meet the
Companys ongoing cash requirements. This is based both on
the Companys historical ability to raise capital and on
debt and equity financings currently available to the Company.
However, there can be no assurance that the Company can or will
obtain sufficient funds from operations or from additional
financings on terms acceptable to the Company.

If the Company is unable to obtain sufficient
additional financing, it will be required to reduce spending in
order to maintain its operations at a reduced level. Management
believes that it will be able to reduce spending if required.
However, such reduction would negatively impact progress on
implementing the Companys business plan, and may require
substantial reductions in the purchase commitments previously
disclosed herein.

Contractual Obligations and Commercial
Commitments

The Companys significant contractual
obligations as of December 31, 2002 are for lease payments
related to a reduction in facilities classified as restructuring
in 2002, operating leases (primarily for office space) and
inventory commitments. The Company expects to receive $22,482 in
sublease income through fiscal 2003, which is equivalent to the
adjusted cost of the lease to the Company after restructuring
charges of $10,199 recorded in 2002.

Contractual Obligations

|                        |  |                         |           |  |      |   |           |      |  |   |         |  |  |      |         |      |  |   |   |  |  |   |   | 
|----------------------- |  | ----------------------- | --------- |  | ---- | - | --------- | ---- |  | - | ------- |  |  | ---- | ------- | ---- |  | - | - |  |  | - | - | 
|                        |  |                        
|                        |  | Payments Due by Periods
|                        |  |                        
|                        |  | Total                   |           |  | 2003 |   |           | 2004 |  |   | 2005    |  |  | 2006 |         | 2007
|                        |  |                         |           |  |      |   |           |      |  |   |         |  |  |      |         |     
|Restructuring Liability |  | $                       | 197,739   |  |      | $ | 78,444    |      |  | $ | 62,330  |  |  | $    | 56,965  |      |  | $ |  |  |  | $ |  | 
|Operating Lease         |  |                         | 978,340   |  |      |   | 602,773   |      |  |   | 210,526 |  |  |      | 165,041 |      |  |   |  |  |  |   |  | 
|Inventory Commitments   |  |                         | 5,400,000 |  |      |   | 5,000,000 |      |  |   | 400,000 |  |  |      |        |      |  |   |  |  |  |   |  | 
|                        |  |                         |           |  |      |   |           |      |  |   |         |  |  |      |         |      |  |  
|                        |  | $                       | 6,576,079 |  |      | $ | 5,681,217 |      |  | $ | 672,856 |  |  | $    | 222,006 |      |  | $ |  |  |  | $ |  | 
|                        |  |                         |           |  |      |   |           |      |  |   |         |  |  |      |         |      |  |  

36



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##### 





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

The Company is exposed to market risk related to
changes in foreign currency exchange rates and changes in
interest rates. The Company does not hold investments or use
derivative financial instruments for speculative or trading
purposes. All of the potential changes noted below are based on
sensitivity analyses performed on the Companys financial
position at December 31, 2002. Actual results may differ
materially.

Foreign Currency Exchange Risk

The majority of the Companys revenue,
expense, and capital purchasing activities are transacted in
U.S. dollars. However, as a result of the Companys
international manufacturing, research and development, sales and
marketing, inventory procurement, and other activities, the
Company enters into transactions denominated in other
currencies, primarily the Japanese Yen and the European Euro or
in which the U.S. Dollar equivalent is determined by the values
of such currencies. Prior to the adoption of the Euro, the
Company also regularly entered into transactions denominated in
the German Deutsche Mark. As of January 1, 2001, Xybernaut
GmbH converted its functional currency from the German Deutsche
Mark to the European Euro. The effect of this conversion was an
increase of $151,123 on beginning accumulated deficit, which is
included in the foreign currency translation balance.
Historically, the Company has not realized significant gains or
losses in transactions denominated in, or determined by, foreign
currencies. To date, the Company has not entered into foreign
exchange forward or option contracts to hedge its exposure to
future movements in foreign exchange rates because the
Companys management believes that the potential impact of
these movements does not justify the costs of entering into such
contracts or the use of capital to collateralize these
contracts. As international sales and operations increase in the
future, the Company may enter into foreign exchange forward and
option contracts to hedge transactions denominated in a foreign
currency. During 2002, the Companys operations in Europe
and Asia comprised 13.2% and 4.6% of its total revenue and 16.4%
and 1.3% of its net loss, respectively. At December 31,
2002, the Companys assets in Europe and Asia comprised
11.4% and 3.8% of its total assets, respectively. During 2001,
the Companys operations in Europe and Asia comprised 22.0%
and 5.7% of its total revenue and 13.8% and 5.8% of its net
loss, respectively. At December 31, 2001, the
Companys assets in Europe and Asia comprised 19.7% and
4.0% of its total assets, respectively. During 2000, the
Companys operations in Europe and Asia comprised 16.8% and
7.7% of its total revenue and 6.6% and 6.3% of its net loss,
respectively. At December 31, 2000, the Companys
assets in Europe and Asia comprised 8.2% and 10.6% of its total
assets, respectively. According to published sources, the
average fluctuation of the European Euro during 2002 and 2001
and the German Deutsche Mark during 2000 was 5.5%, -4.9% and
-8.8%, respectively, and the average fluctuation of the Japanese
Yen during 2002, 2001 and 2000 was 4.5%, -6.4% and -5.3%,
respectively. Management believes that these fluctuations did
not have a material impact on the Companys results of
operations or financial position for 2002, 2001 and 2000.

Interest Rate Sensitivity

As discussed in the Liquidity and Capital
Resources section, the Company has historically entered
into debt financings, has entered into a loan agreement in March
2003 and continues to explore various new financing
alternatives, including debt financing. If additional funds are
raised through borrowings, the Company will be subject to
additional interest charges and will most likely be required to
comply with financial covenants or other restrictions. Interest
rate increases may materially increase the Companys
interest expense, hinder the Companys ability to borrow
additional funds or have a negative effect on the ability of the
Companys customers to purchase its products. Required
financial covenants may also hinder the Companys ability
to expand or change its business operations. To date, the
Company has not entered into interest rate forward or option
contracts to hedge its exposure to future movements in interest
rates because the Companys management believes that the
potential impact of these movements does not justify the costs
of entering into such contracts or the use of capital to
collateralize these contracts. As the Companys exposure to
interest rate fluctuations becomes more significant, it may
enter into interest rate forward and option contracts to hedge
against such fluctuations. According to published sources, the
average prime interest rate during 2002, 2001 and 2000 was
4.75%, 7.1% and 9.2%, respectively, or a prime interest rate
fluctuation at December 31 compared to the rate at the
beginning of the fiscal year in 2002, 2001 and 2000 of 0%, -4.5%

37



---



##### 



and 1.0%, respectively. Management believes that
these fluctuations did not have a material impact on the
Companys results of operations or financial position for
2002, 2001 and 2000.


Euro Conversion

On January 1, 1999, certain member countries
of the European Union established fixed conversion rates between
their existing currencies and the Euro. The transition period
for the introduction of the Euro ended June 30, 2002. As of
January 1, 2001, Xybernaut GmbH converted its functional
currency from the German Deutsche Mark to the European Euro. The
effects of this conversion on beginning accumulated deficit was
an increase of $151,123, which is included in the foreign
currency translation balance. Issues that were addressed by the
Company as a result of the introduction of the Euro include the
conversion of information technology systems, reassessment of
foreign currency exchange risk, negotiation and amendment of
existing agreements and contracts, and processing of tax and
accounting records. At December 31, 2002, the Company did
not experience significant issues with the Euro conversion and
the conversion did not have a material impact on the
Companys results of operations or financial position.

38



---



##### 



Item 8.     Financial
Statements and Supplementary Data

Index to Financial Statements

|                                                                                                       |  |     
|------------------------------------------------------------------------------------------------------ |  | ----
|Report of Independent Accountants                                                                      |  | F-1 
|Consolidated Balance Sheets 
    December 31, 2002 and 2001                                           |  | F-2 
|Consolidated Statements of Operations 
    Years ended December 31, 2002, 2001 and 2000               |  | F-3 
|Consolidated Statements of Stockholders
    Equity  Years ended December 31, 2002, 2001 and
    2000 |  | F-4 
|Consolidated Statements of Cash Flows 
    Years ended December 31, 2002, 2001 and 2000               |  | F-5 
|Notes to Consolidated Financial Statements                                                             |  | F-6 
|Supplemental Financial Information                                                                     |  | F-29

39



---



##### 



REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and

Stockholders of Xybernaut Corporation


We have audited the accompanying consolidated
balance sheets of Xybernaut Corporation (a Delaware corporation)
as of December 31, 2002 and 2001, and the related
consolidated statements of operations, stockholders
equity, and cash flows for the three years then ended. These
financial statements are the responsibility of the
Companys management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial
position of Xybernaut Corporation as of December 31, 2002
and 2001, and the results of its operations and its cash flows
for the three years then ended in conformity with accounting
principles generally accepted in the United States of America.

/s/ Grant Thornton LLP

Vienna, VA

February 13, 2003


(except for Notes 3 and 14 as to which the
date is March 26, 2003)


F-1



---



##### 



XYBERNAUT CORPORATION

CONSOLIDATED BALANCE SHEETS

|                                                 |                                   |                                                                                                                                               |                                            |         |              |            |           |   |              |            | 
|------------------------------------------------ | --------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------- | ------------ | ---------- | --------- | - | ------------ | ---------- | 
|                                                 |                                   |                                                                                                                                              
|                                                 |                                   | December 31,                                                                                                                                  |                                           
|                                                 |                                   |                                                                                                                                               |                                           
|                                                 |                                   | 2002                                                                                                                                          |                                            |         | 2001         |           
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|ASSETS                                          
|Current assets:                                  |                                   |                                                                                                                                               |                                            |         |              |            |           |  
|                                                 |                                   | Cash and cash equivalents                                                                                                                     |                                            | $       | 1,967,710    |            |           | $ | 3,172,609    |           
|                                                 |                                   | Restricted cash                                                                                                                               |                                            |         | 500,000      |            |           |   | 500,000      |           
|                                                 |                                   | Accounts receivable, net of allowances of
    $202,911 and $213,434                                                                           |                                            |         | 3,410,871    |            |           |   | 3,283,828    |           
|                                                 |                                   | Inventory, net of reserves of $0 and $141,280                                                                                                 |                                            |         | 2,393,465    |            |           |   | 4,621,019    |           
|                                                 |                                   | Prepaid and other current assets                                                                                                              |                                            |         | 804,102      |            |           |   | 815,619      |           
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 |                                   |                                                                                                                                               | Total current assets                       |         |              | 9,076,148  |           |   |              | 12,393,075 | 
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|Property, equipment and demonstration units, net |                                   |                                                                                                                                               | 590,387                                    |         |              |            | 1,083,411 |  
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|Other assets:                                    |                                   |                                                                                                                                               |                                            |         |              |            |           |  
|                                                 |                                   | Patent costs, net of accumulated amortization of
    $1,516,758 and $1,115,910                                                                |                                            |         | 1,052,518    |            |           |   | 1,235,017    |           
|                                                 |                                   | Tooling costs, net of accumulated amortization of
    $141,122 and $97,996, and reserves of $250,000 and $0                                   |                                            |         | 776,699      |            |           |   | 1,108,869    |           
|                                                 |                                   | Other                                                                                                                                         |                                            |         | 639,619      |            |           |   | 843,946      |           
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 |                                   |                                                                                                                                               | Total other assets                         |         |              | 2,468,836  |           |   |              | 3,187,832  | 
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 |                                   |                                                                                                                                               | Total assets                               |         | $            | 12,135,371 |           |   | $            | 16,664,318 | 
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|LIABILITIES AND STOCKHOLDERS
    EQUITY        
|Liabilities:                                     |                                   |                                                                                                                                               |                                            |         |              |            |           |  
|                                                 | Current liabilities:              |                                                                                                                                               |                                            |         |              |            |           |   |             
|                                                 |                                   | Accounts payable                                                                                                                              |                                            | $       | 3,007,647    |            |           | $ | 4,303,078    |           
|                                                 |                                   | Accrued expenses and other                                                                                                                    |                                            |         | 1,473,506    |            |           |   | 2,943,843    |           
|                                                 |                                   | Deferred revenue                                                                                                                              |                                            |         | 88,460       |            |           |   | 40,288       |           
|                                                 |                                   | Notes and loans payable                                                                                                                       |                                            |         | 8,376        |            |           |   | 17,717       |           
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 |                                   |                                                                                                                                               | Total current liabilities                  |         |              | 4,577,989  |           |   |              | 7,304,926  | 
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 | Long-term restructuring liability |                                                                                                                                               |                                            | 119,295 |              |            |           |  |             
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 |                                   |                                                                                                                                               | Total liabilities                          |         | $            | 4,697,284  |           |   | $            | 7,304,926  | 
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|Commitments and contingencies                    |                                   |                                                                                                                                               |                                            |         |              |            |           |  
|Stockholders equity:                            |                                   |                                                                                                                                               |                                            |         |              |            |           |  
|                                                 |                                   | Note receivable from officer                                                                                                                  |                                            | $       |             |            |           | $ | (1,026,708   | )         
|                                                 |                                   | Common stock, $0.01 par value, 200,000,000 and
    80,000,000 shares authorized, 113,615,722 and 59,528,113 shares
    issued and outstanding |                                            |         | 1,136,157    |            |           |   | 595,281      |           
|                                                 |                                   | Additional paid-in capital                                                                                                                    |                                            |         | 137,181,587  |            |           |   | 114,523,028  |           
|                                                 |                                   | Foreign currency translation                                                                                                                  |                                            |         | 143,502      |            |           |   | (289,883     | )         
|                                                 |                                   | Accumulated deficit                                                                                                                           |                                            |         | (131,023,159 | )          |           |   | (104,442,326 | )         
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 |                                   |                                                                                                                                               | Total stockholders equity                 |         | $            | 7,438,087  |           |   | $            | 9,359,392  | 
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           
|                                                 |                                   |                                                                                                                                               | Total liabilities and stockholders equity |         | $            | 12,135,371 |           |   | $            | 16,664,318 | 
|                                                 |                                   |                                                                                                                                               |                                            |         |              |           

The accompanying notes are an integral part of
these

consolidated financial statements


F-2



---



##### 



XYBERNAUT CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                          |                                                                                  |                         |                          |             |           |             |         |             |           |             |          |             |           |             |  
|----------------------------------------- | -------------------------------------------------------------------------------- | ----------------------- | ------------------------ | ----------- | --------- | ----------- | ------- | ----------- | --------- | ----------- | -------- | ----------- | --------- | ----------- | -
|                                          |                                                                                  |                        
|                                          |                                                                                  | Year Ended December 31, |                         
|                                          |                                                                                  |                         |                         
|                                          |                                                                                  | 2002                    |                          |             | 2001      |             |         | 2000        |          
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|Revenue:                                  |                                                                                  |                         |                          |             |           |             |         |             |           |             |          |            
|                                          |                                                                                  | Hardware                |                          | $           | 6,131,759 |             |         | $           | 5,227,502 |             |          | $           | 4,886,565 |            
|                                          |                                                                                  | Software                |                          |             |          |             |         |             | 678,900   |             |          |             | 1,215,010 |            
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          | Total product                                                                    |                         |                          | 6,131,759   |           |             |         | 5,906,402   |           |             |          | 6,101,575   |          
|                                          | Consulting, licensing and other                                                  |                         |                          | 3,841,802   |           |             |         | 3,913,591   |           |             |          | 3,403,316   |          
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          |                                                                                  |                         | Total revenue            |             |           | 9,973,561   |         |             |           | 9,819,993   |          |             |           | 9,504,891   |  
|Cost of sales:                            |                                                                                  |                         |                          |             |           |             |         |             |           |             |          |            
|                                          |                                                                                  | Hardware                |                          |             | 5,399,265 |             |         |             | 3,916,922 |             |          |             | 4,164,892 |            
|                                          |                                                                                  | Software                |                          |             |          |             |         |             | 397,094   |             |          |             | 825,456   |            
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          | Total product                                                                    |                         |                          | 5,399,265   |           |             |         | 4,314,016   |           |             |          | 4,990,348   |          
|                                          | Consulting, licensing and other                                                  |                         |                          | 2,362,365   |           |             |         | 2,587,134   |           |             |          | 2,088,716   |          
|                                          | Provision for inventory and tooling                                              |                         |                          | 913,175     |           |             |         | 1,829,234   |           |             |          | 1,500,000   |          
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          |                                                                                  |                         | Gross income             |             |           | 1,298,756   |         |             |           | 1,089,609   |          |             |           | 925,827     |  
|Operating expenses:                       |                                                                                  |                         |                          |             |           |             |         |             |           |             |          |            
|                                          | Sales and marketing                                                              |                         |                          | 14,941,839  |           |             |         | 17,528,912  |           |             |          | 11,480,812  |          
|                                          | General and administrative                                                       |                         |                          | 5,703,402   |           |             |         | 6,665,321   |           |             |          | 6,065,241   |          
|                                          | Research and development                                                         |                         |                          | 6,358,883   |           |             |         | 9,409,834   |           |             |          | 5,925,837   |          
|                                          | Restructuring charges                                                            |                         |                          | 1,038,160   |           |             |         |            |           |             |          |            |          
|                                          | Merger costs                                                                     |                         |                          |            |           |             |         |            |           |             |          | 621,048     |          
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          |                                                                                  |                         | Total operating expenses |             |           | 28,042,284  |         |             |           | 33,604,067  |          |             |           | 24,092,938  |  
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          |                                                                                  |                         | Operating loss           |             |           | (26,743,528 | )       |             |           | (32,514,458 | )        |             |           | (23,167,111 | )
|Interest and other income (expenses), net |                                                                                  |                         | 163,257                  |             |           |             | 340,719 |             |           |             | (980,643 | )          
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          | Loss before provision for income taxes                                           |                         |                          | (26,580,271 | )         |             |         | (32,173,739 | )         |             |          | (24,147,754 | )        
|Provision for income taxes                |                                                                                  |                         | 562                      |             |           |             | 25,840  |             |           |             | 37,468   |            
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          | Net loss                                                                         |                         | $                        | (26,580,833 | )         |             | $       | (32,199,579 | )         |             | $        | (24,185,222 | )        
|Provision for preferred stock dividends   |                                                                                  |                         |                         |             |           |             |        |             |           |             | 10,438   |            
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          | Net loss applicable to holders of common stock                                   |                         | $                        | (26,580,833 | )         |             | $       | (32,199,579 | )         |             | $        | (24,195,660 | )        
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          | Net loss per share applicable to holders of
    common stock (basic and diluted) |                         | $                        | (0.37       | )         |             | $       | (0.63       | )         |             | $        | (0.63       | )        
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          
|                                          | Weighted average number of common shares
    outstanding (basic and diluted)     |                         |                          | 71,963,440  |           |             |         | 50,827,020  |           |             |          | 38,592,282  |          
|                                          |                                                                                  |                         |                          |             |           |             |         |             |          

The accompanying notes are an integral part of
these

consolidated financial statements


F-3



---



##### 



XYBERNAUT CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |          |   |  |   |              |   |  |   |             |  
|------------------------------------------------------------------------- |  | ---------------- | ------ | - | --------------- |  | ----------- | --------------- |  | - | ---------- | - |  | ------------- | --------- | - | ----------- | - | ---------- | ------------ |  | - | ----------- | - |  | ------ | -------- | - |  | - | ------------ | - |  | - | ----------- | -
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |              
|                                                                          |  | Number of Shares |        |   | Value of Shares |  |             | Note Receivable |  |   | Additional |   |  | Accumulated   |           |   |             |   | Total      |             
|                                                                          |  |                  |        |   |                 |  |             | From            |  |   | Paid-in    |   |  | Comprehensive |           |   | Accumulated |   |            | Shareholders | 
|                                                                          |  | Preferred        |        |   | Common          |  |             | Preferred       |  |   | Common     |   |  | Officer       |           |   | Capital     |   |            | Income       |  |   | Deficit     |   |  | Equity |         
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Balance, January 1, 2000                                                  |  |                  | 4,600  |   |                 |  | 30,373,734  |                 |  | $ | 3,996,588  |   |  | $             | 303,737   |   |             | $ |           |              |  | $ | 47,746,424  |   |  | $      | 58,541   |   |  | $ | (48,057,525  | ) |  | $ | 4,047,765   |  
|Issuance of common stock                                                  |  |                  |       |   |                 |  | 7,923,359   |                 |  |   |           |   |  |               | 79,234    |   |             |   |           |              |  |   | 22,992,004  |   |  |        |         |   |  |   |             |   |  |   | 23,071,238  |  
|Conversion of preferred stock into common stock                           |  |                  | (4,600 | ) |                 |  | 4,173,430   |                 |  |   | (3,996,588 | ) |  |               | 41,734    |   |             |   |           |              |  |   | 4,098,320   |   |  |        |         |   |  |   |             |   |  |   | 143,466     |  
|Exercise of warrants                                                      |  |                  |       |   |                 |  | 2,077,700   |                 |  |   |           |   |  |               | 20,777    |   |             |   |           |              |  |   | 9,175,650   |   |  |        |         |   |  |   |             |   |  |   | 9,196,427   |  
|Exercise of stock options                                                 |  |                  |       |   |                 |  | 662,724     |                 |  |   |           |   |  |               | 6,627     |   |             |   |           |              |  |   | 1,540,384   |   |  |        |         |   |  |   |             |   |  |   | 1,547,011   |  
|Equity securities issued for services and payment
    of accounts payable |  |                  |       |   |                 |  | 184,871     |                 |  |   |           |   |  |               | 1,849     |   |             |   |           |              |  |   | 1,748,592   |   |  |        |         |   |  |   |             |   |  |   | 1,750,441   |  
|Loans and accrued interest                                                |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   | (997,981   | )            |  |   |            |   |  |        |         |   |  |   |             |   |  |   | (997,981    | )
|Foreign currency translation                                              |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        | (244,524 | ) |  |   |              |   |  |   | (244,524    | )
|Net loss                                                                  |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        |         |   |  |   | (24,185,222  | ) |  |   | (24,185,222 | )
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Total comprehensive loss                                                  |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        |         |   |  |   |             |   |  |   | (24,429,746 | )
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Balance, December 31, 2000                                                |  |                  |       |   |                 |  | 45,395,818  |                 |  | $ |           |   |  | $             | 453,958   |   |             | $ | (997,981   | )            |  | $ | 87,301,374  |   |  | $      | (185,983 | ) |  | $ | (72,242,747  | ) |  | $ | 14,328,621  |  
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Issuance of common stock                                                  |  |                  |       |   |                 |  | 12,018,772  |                 |  |   |           |   |  |               | 120,187   |   |             |   |           |              |  |   | 22,407,342  |   |  |        |         |   |  |   |             |   |  |   | 22,527,529  |  
|Exercise of warrants                                                      |  |                  |       |   |                 |  | 1,881,470   |                 |  |   |           |   |  |               | 18,815    |   |             |   |           |              |  |   | 3,754,592   |   |  |        |         |   |  |   |             |   |  |   | 3,773,407   |  
|Exercise of stock options                                                 |  |                  |       |   |                 |  | 57,097      |                 |  |   |           |   |  |               | 571       |   |             |   |           |              |  |   | 135,088     |   |  |        |         |   |  |   |             |   |  |   | 135,659     |  
|Equity securities issued for services and payment
    of accounts payable |  |                  |       |   |                 |  | 174,956     |                 |  |   |           |   |  |               | 1,750     |   |             |   |           |              |  |   | 924,632     |   |  |        |         |   |  |   |             |   |  |   | 926,382     |  
|Accrued interest, net of repayment                                        |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   | (28,727    | )            |  |   |            |   |  |        |         |   |  |   |             |   |  |   | (28,727     | )
|Foreign currency translation                                              |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        | (103,900 | ) |  |   |              |   |  |   | (103,900    | )
|Net loss                                                                  |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        |         |   |  |   | (32,199,579  | ) |  |   | (32,199,579 | )
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Total comprehensive loss                                                  |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        |         |   |  |   |             |   |  |   | (32,303,479 | )
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Balance, December 31, 2001                                                |  |                  |       |   |                 |  | 59,528,113  |                 |  | $ |           |   |  | $             | 595,281   |   |             | $ | (1,026,708 | )            |  | $ | 114,523,028 |   |  | $      | (289,883 | ) |  | $ | (104,442,326 | ) |  | $ | 9,359,392   |  
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Issuance of common stock                                                  |  |                  |       |   |                 |  | 35,830,024  |                 |  |   |           |   |  |               | 358,299   |   |             |   |           |              |  |   | 18,375,806  |   |  |        |         |   |  |   |             |   |  |   | 18,734,105  |  
|Exercise of warrants                                                      |  |                  |       |   |                 |  | 17,350,627  |                 |  |   |           |   |  |               | 173,506   |   |             |   |           |              |  |   | 2,972,677   |   |  |        |         |   |  |   |             |   |  |   | 3,146,183   |  
|Exercise of stock options                                                 |  |                  |       |   |                 |  | 35,835      |                 |  |   |           |   |  |               | 359       |   |             |   |           |              |  |   | 10,689      |   |  |        |         |   |  |   |             |   |  |   | 11,048      |  
|Equity securities issued for services and payment
    of accounts payable |  |                  |       |   |                 |  | 1,542,833   |                 |  |   |           |   |  |               | 15,429    |   |             |   |           |              |  |   | 2,178,179   |   |  |        |         |   |  |   |             |   |  |   | 2,193,608   |  
|Equity securities issued in restructuring                                 |  |                  |       |   |                 |  | 436,633     |                 |  |   |           |   |  |               | 4,366     |   |             |   |           |              |  |   | 197,016     |   |  |        |         |   |  |   |             |   |  |   | 201,382     |  
|Repayment of principal and interest                                       |  |                  |       |   |                 |  | (1,108,343  | )               |  |   |           |   |  |               | (11,083   | ) |             |   | 1,026,708  |              |  |   | (1,075,808  | ) |  |        |         |   |  |   |             |   |  |   | (60,183     | )
|Foreign currency translation                                              |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        | 433,385  |   |  |   |              |   |  |   | 433,385     |  
|Net loss                                                                  |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        |         |   |  |   | (26,580,833  | ) |  |   | (26,580,833 | )
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Total comprehensive loss                                                  |  |                  |       |   |                 |  |            |                 |  |   |           |   |  |               |          |   |             |   |           |              |  |   |            |   |  |        |         |   |  |   |             |   |  |   | (26,147,448 | )
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         
|Balance, December 31, 2002                                                |  |                  |       |   |                 |  | 113,615,722 |                 |  | $ |           |   |  | $             | 1,136,157 |   |             | $ |           |              |  | $ | 137,181,587 |   |  | $      | 143,502  |   |  | $ | (131,023,159 | ) |  | $ | 7,438,087   |  
|                                                                          |  |                  |        |   |                 |  |             |                 |  |   |            |   |  |               |           |   |             |   |            |              |  |   |             |   |  |        |         

The accompanying notes are an integral part of
these

consolidated financial statements


F-4



---



##### 



XYBERNAUT CORPORATION

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |             |            |           |             |             |            |  
|----------------------------------------------------------------- | ------------------------------------------------------------------------------- | -------------------------------------------------------------- | ------------------------------------------------------------------------------------------ | ----------- | ----------- | ---------- | ---------- | ----------- | ----------- | ---------- | --------- | ----------- | ----------- | ---------- | -
|                                                                  |                                                                                 |                                                               
|                                                                  |                                                                                 | Year Ended December 31,                                        |                                                                                           
|                                                                  |                                                                                 |                                                                |                                                                                           
|                                                                  |                                                                                 | 2002                                                           |                                                                                            |             | 2001        |            |            | 2000        |            
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Cash flows from operating activities:                             |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |             |            |           |            
|                                                                  | Net loss                                                                        |                                                                | $                                                                                          | (26,580,833 | )           |            | $          | (32,199,579 | )           |            | $         | (24,185,222 | )          
|                                                                  | Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                                |                                                                                            |             |             |            |            |             |             |            |           |             |            
|                                                                  |                                                                                 | Depreciation and amortization                                  |                                                                                            |             | 1,815,993   |            |            |             | 1,518,833   |            |           |             | 1,617,729   |           
|                                                                  |                                                                                 | Provision for inventory and tooling                            |                                                                                            |             | 913,175     |            |            |             | 1,829,234   |            |           |             | 1,500,000   |           
|                                                                  |                                                                                 | Provision for bad debts                                        |                                                                                            |             | 100,000     |            |            |             |            |            |           |             | 79,620      |           
|                                                                  |                                                                                 | Non-cash restructuring charges                                 |                                                                                            |             | 792,614     |            |            |             |            |            |           |             |            |           
|                                                                  |                                                                                 | Non-cash charges for equity securities issued for
    services |                                                                                            |             | 1,894,836   |            |            |             | 606,406     |            |           |             | 1,312,630   |           
|                                                                  |                                                                                 | Amortization of note discount                                  |                                                                                            |             |            |            |            |             |            |            |           |             | 921,452     |           
|                                                                  |                                                                                 | Changes in assets and liabilities:                             |                                                                                            |             |             |            |            |             |             |            |           |             |             |           
|                                                                  |                                                                                 |                                                                | Inventory                                                                                  |             |             | 1,302,306  |            |             |             | (1,905,917 | )         |             |             | 1,051,244  |  
|                                                                  |                                                                                 |                                                                | Accounts receivable                                                                        |             |             | (139,336   | )          |             |             | 127,705    |           |             |             | (1,765,736 | )
|                                                                  |                                                                                 |                                                                | Prepaid and other current assets                                                           |             |             | 85,051     |            |             |             | (212,533   | )         |             |             | (59,297    | )
|                                                                  |                                                                                 |                                                                | Other assets                                                                               |             |             | 921        |            |             |             | (132,575   | )         |             |             | (299,995   | )
|                                                                  |                                                                                 |                                                                | Accounts payable                                                                           |             |             | (1,165,609 | )          |             |             | 2,425,693  |           |             |             | (2,664,175 | )
|                                                                  |                                                                                 |                                                                | Accrued expenses and other                                                                 |             |             | (1,512,686 | )          |             |             | 15,555     |           |             |             | (412,432   | )
|                                                                  |                                                                                 |                                                                | Long-term restructuring liability                                                          |             |             | 119,295    |            |             |             |           |           |             |             |           |  
|                                                                  |                                                                                 |                                                                | Deferred revenue                                                                           |             |             | 48,172     |            |             |             | (428,246   | )         |             |             | 428,271    |  
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|                                                                  |                                                                                 | Net cash used in operating activities                          |                                                                                            | $           | (22,326,101 | )          |            | $           | (28,355,424 | )          |           | $           | (22,475,911 | )         
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Cash flows from investing activities:                             |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |             |            |           |            
|                                                                  |                                                                                 |                                                                | Note receivable from officers, net                                                         |             |             | (37,961    | )          |             |             | 50,949     |           |             |             | (949,628   | )
|                                                                  |                                                                                 |                                                                | Acquisition of property, equipment and
    demonstration units                             |             |             | (626,719   | )          |             |             | (1,100,696 | )         |             |             | (673,485   | )
|                                                                  |                                                                                 |                                                                | Acquisition of patents and trademarks                                                      |             |             | (270,017   | )          |             |             | (858,861   | )         |             |             | (364,859   | )
|                                                                  |                                                                                 |                                                                | Decrease in restricted cash                                                                |             |             |           |            |             |             | (85,384    | )         |             |             | (424,917   | )
|                                                                  |                                                                                 |                                                                | Capitalization of tooling costs                                                            |             |             |           |            |             |             | (1,199,302 | )         |             |             | (217,545   | )
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|                                                                  |                                                                                 | Net cash used in investing activities                          |                                                                                            | $           | (934,697    | )          |            | $           | (3,193,294  | )          |           | $           | (2,630,434  | )         
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Cash flows from financing activities:                             |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |             |            |           |            
|                                                                  |                                                                                 | Proceeds from:                                                 |                                                                                            |             |             |            |            |             |             |            |           |             |             |           
|                                                                  |                                                                                 |                                                                | Common stock offerings, net                                                                |             |             | 19,833,486 |            |             |             | 22,801,278 |           |             |             | 23,163,645 |  
|                                                                  |                                                                                 |                                                                | Exercise of warrants                                                                       |             |             | 2,186,802  |            |             |             | 3,773,405  |           |             |             | 8,274,975  |  
|                                                                  |                                                                                 |                                                                | Exercise of stock options                                                                  |             |             | 11,048     |            |             |             | 135,659    |           |             |             | 1,547,011  |  
|                                                                  |                                                                                 |                                                                | Notes and loans                                                                            |             |             | 250,000    |            |             |             |           |           |             |             | 4,425,000  |  
|                                                                  |                                                                                 | Payments for:                                                  |                                                                                            |             |             |            |            |             |             |            |           |             |             |           
|                                                                  |                                                                                 |                                                                | Notes and loans                                                                            |             |             | (250,000   | )          |             |             | (466,668   | )         |             |             | (5,368,290 | )
|                                                                  |                                                                                 |                                                                | Capitalization of loan costs                                                               |             |             | (19,716    | )          |             |             | (20,000    | )         |             |             | (25,000    | )
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|                                                                  |                                                                                 |                                                                | Net cash provided by financing activities                                                  |             | $           | 22,011,620 |            |             | $           | 26,223,674 |           |             | $           | 32,017,341 |  
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Effect of exchange rate changes on cash and cash
    equivalents  |                                                                                 |                                                                | 44,279                                                                                     |             |             |            | (351,062   | )           |             |            | (188,281  | )          
|Net decrease in cash and cash equivalents                         |                                                                                 |                                                                | (1,204,899                                                                                 | )           |             |            | (5,676,106 | )           |             |            | 6,722,715 |            
|Cash and cash equivalents, beginning of period                    |                                                                                 |                                                                | 3,172,609                                                                                  |             |             |            | 8,848,715  |             |             |            | 2,126,000 |            
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Cash and cash equivalents, end of period                          |                                                                                 | $                                                              | 1,967,710                                                                                  |             |             | $          | 3,172,609  |             |             | $          | 8,848,715 |            
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Supplemental disclosure of cash flow information:                 |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |             |            |           |            
|                                                                  |                                                                                 |                                                                | Cash paid for interest                                                                     |             | $           | 2,402      |            |             | $           | 6,175      |           |             | $           | 368,601    |  
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|                                                                  |                                                                                 |                                                                | Cash paid for taxes                                                                        |             | $           | 23,050     |            |             | $           | 40,109     |           |             | $           | 44,946     |  
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Supplemental disclosure of non-cash financing
    activities:     |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |             |            |           |            
|                                                                  |                                                                                 |                                                                | Equity securities issued for future services,
    recorded as prepaid expenses when issued |             | $           | 1,929,498  |            |             | $           | 507,917    |           |             | $           | 725,390    |  
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|                                                                  |                                                                                 |                                                                | Equity securities issued for services rendered,
    expensed in periods issued             |             | $           | 373,027    |            |             | $           | 129,549    |           |             | $           | 637,907    |  
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|                                                                  |                                                                                 |                                                                | Equity securities issued for settlement of
    accounts payable and accrued expenses       |             | $           | 509,547    |            |             | $           | 337,666    |           |             | $           | 202,879    |  
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Equity retired for repayment of note receivable
    from officer  |                                                                                 | $                                                              | 1,026,708                                                                                  |             |             | $          |           |             |             | $          |          |            
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Provision for preferred stock dividend
    requirements           |                                                                                 | $                                                              |                                                                                           |             |             | $          |           |             |             | $          | 10,438    |            
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Common stock issued for preferred stock dividend
    requirements |                                                                                 | $                                                              |                                                                                           |             |             | $          |           |             |             | $          | 153,904   |            
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            
|Charges to conform accounting policies during
    merger          |                                                                                 | $                                                              |                                                                                           |             |             | $          |           |             |             | $          | 168,365   |            
|                                                                  |                                                                                 |                                                                |                                                                                            |             |             |            |            |             |            

The accompanying notes are an integral part of
these

consolidated financial statements.


F-5



---



##### 



XYBERNAUT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

1. The Company and Financing
Requirements

Xybernaut Corporation, a Delaware corporation
(Xybernaut or the Company), is engaged
in the research, development, manufacture, marketing and sales
of mobile, wearable computing and communication systems as well
as software and service solutions designed to enhance
productivity and improve product management, asset management,
and the accuracy, timeliness and utilization of captured data.
The Company offers solutions with a software and services focus
through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(U.S.). The Company offers solutions with a hardware focus
through its U.S. operations and through its wholly-owned
subsidiaries Xybernaut K.K. (Japan) and Xybernaut GmbH
(Germany). The Mobile Assistant® (MA®)
series is the Companys primary line of hardware products,
the current versions of which are the Mobile Assistant V
(MA V) and MA TC. Since its commercial
introduction in 1995, the Company has realized revenue of over
$19,500,000 on sales of approximately 4,000 units of the MA
series. During 2002, the Company introduced the Atigo
product line, a family of wireless web panels that can be used
either as stand-alone handheld personal computers
(PCs) or as displays for an MA system, a laptop
or a conventional PC.

The Company was originally incorporated in 1990
and completed its initial public offering on July 18, 1996.
On April 7, 2000, Xybernaut acquired Selfware, Inc, which
subsequently changed its name to Xybernaut Solutions, Inc.
(XSI). The merger was accounted for as a pooling of
interests. All financial data of the Company, including
Xybernauts previously issued financial statements for the
periods presented in this Form 10-K, have been restated to
include the historical financial information of XSI.

The Company has recorded significant net losses
since its inception and will require additional capital to fund
its business plan and meet its ongoing obligations for 2003 and
potentially beyond. Management believes the Company will be
successful in its efforts to obtain such capital, having raised
approximately $6,100,000 in early 2003, and based on debt and
equity financings currently available to the Company. However,
there can be no assurance that the Company will not incur
additional losses or will not require significant amounts of
additional capital. In addition, the Company has reduced its
operating expenses by significant amounts through an ongoing
restructuring program. If the Company is unable to obtain
sufficient additional financing, it will be required to reduce
spending in order to maintain its operations at a reduced level.
Management believes that it will be able to reduce spending if
required.

2. Summary of Significant Accounting
Policies

Principles of
Consolidation

The consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries: XSI
(Virginia, U.S.), Xybernaut GmbH (Böblingen, Germany),
Xybernaut K.K. (Yokohama, Japan) and Xybernaut Development
Corporation (Virginia, U.S.). All significant intercompany
accounts and transactions have been eliminated in the
consolidation. Net gains and losses resulting from foreign
currency transactions have not been material.

Use of Estimates in the
Preparation of Financial Statements

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

F-6



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##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

2. Summary of Significant Accounting
Policies, continued:

Cash, Cash Equivalents and
Restricted Cash

The Company considers all highly liquid
investments purchased with an original maturity of three months
or less to be cash equivalents. At December 31, 2002 and
2001, the Company had $500,000 in restricted cash consisted of a
cash deposit made to secure a long term contract. The Company
expects the restriction on this cash deposit will lapse in 2003
upon completion of the related contract.

Inventory

At December 31, 2002, inventory consisted
primarily of wearable computer component parts held for resale
and allocated tooling costs, and is comprised primarily of
finished goods. Inventory is stated at the lower of cost or
market, with cost being determined on a first-in, first-out
basis. Management periodically assesses the need to provide for
obsolescence of inventory and adjusts the carrying value of
inventory to its net realizable value when required.

The Company recorded inventory provisions related
to its wearable computer product lines of $614,098 in 2002,
$1,690,089 in 2001 and $1,250,000 in 2000. The 2002 provision
consisted of i) a $1,191,696 charge to write-down the net
carrying value of inventory associated with the MA V,
MA TC and MA IV product lines due to an estimated
decline in their value, ii) a $53,958 charge related to a
write-down of a small number of early-production models of the
MA V product line with limited hard disk capacity received by
the Company and iii) the $631,556 reversal of a reserve recorded
in 2001 related to the pomaproduct line discussed below.

The 2001 provision consisted of i) a
$663,790 charge to reduce the net carrying value of inventory
associated with the MA IV product line given the
uncertainties created by the introduction of the MA V and
MA TC product lines, ii) a $141,280 reserve
established for hard disk drives that were purchased for the
MA V product line but later replaced with higher-capacity
hard disk drives (during the first quarter of 2002, all of the
hard drives were sold in bulk at an amount approximating their
net carrying value and this reserve was fully utilized) and
iii) the $885,019 charge recorded in 2001 related to the
pomaproduct line discussed below. The 2000 provision
consisted of a $1,250,000 charge to reduce the net carrying
value of inventory associated with the MA IV product line
given the uncertainties created by the introduction of the
MA V and MA TC product lines.

In 2001, a charge of $885,019 was recorded to
reflect managements estimate of losses to be incurred on
the total initial production run of the pomaproduct
line. The Company elected to sell the pomasystems at
prices that are less than their initial production costs to
favorably position pomain the price-sensitive
light-commercial and near-consumer markets. Although the
poma inventory had not been received by the Company as of
December 31, 2001, the Company recorded the expected losses
during 2001, which was the period in which the underlying
contracts were entered into. Because the inventory had not been
received by the company as of December 31, 2001, and was
therefore not recorded as an asset, this charge was recorded as
an accrued liability which was being reclassified to an
inventory reserve as pomainventory shipments were
received during 2002. During 2002, the Company entered into an
agreement with the manufacturer of pomathrough which the
Company was relieved of its obligation to purchase additional
pomaunits. Pursuant to the terms of this agreement, the
Company made a payment of $80,000 during 2002 and reduced
certain of the royalty rates that are used to calculate the
licensing fees that the Company receives from the manufacturer
for its sales of pomaor other wearable computer
products. During 2002, the remaining accrued liability balance,
net of the $80,000 payment, was reversed, resulting in a
$631,556 reduction to the provision for inventory and tooling
reserve.

F-7



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

2. Summary of Significant Accounting
Policies, continued:

The Companys inventory reserves at
December 31, 2002 and 2001 were $0 and $141,280,
respectively. This amount consisted of the $141,280 reserve
established in 2001 for hard disk drives, which was fully
utilized in 2002 upon the sale of the hard drives at an amount
approximating their net carrying value.

The Companys management believes that it
can sell its wearable/mobile computer inventory at amounts that
approximate current net carrying values, which have been reduced
as a result of the above charges. To determine the size of the
charges to record, management reviewed the carrying value of its
inventory in light of the introduction of new product lines, its
ability to sell the quantities of inventory on hand as well as
the quantities expected to be received in the future and the
sales prices it ultimately expects to achieve. This analysis
took into account estimated price concessions which management
believes are likely to be necessary in disposing of this
inventory. As a result of this review, it was determined that
certain of the Companys inventory is slow-moving, risked
becoming obsolete or will likely be sold at below its historical
cost. Based upon a specific review of the carrying costs for the
inventory items, management estimated the quantity of each
inventory item that the Company was expected to be able to sell
and also quantified inventory amounts that may not be
recoverable. Management does not expect to record significant
profits or losses upon the ultimate sale of this inventory.

As of December 31, 2002, net of the effect
of write-offs, the Companys inventory consisted of
$1,654,505 in MA V systems, $668,224 in MA TC systems,
$39,296 in Atigo systems and $31,440 in pomasystems.

Property and
Equipment

Property and equipment are stated at cost and are
depreciated on a straight-line basis over the estimated useful
lives of the assets, as follows:

|                       |  |                                            
|---------------------- |  | -------------------------------------------
|Furniture and fixtures |  | 3-7 years                                  
|Equipment              |  | 3-7 years                                  
|Leasehold Improvements |  | 3 years or life of lease, whichever is less
|Demonstration units    |  | 1 year                                     

Expenditures for maintenance and repairs are
expensed directly to the appropriate operating account as
incurred. Expenditures determined to represent additions and
improvements are capitalized.

Tooling Costs

Capitalized tooling costs consist of payments
made to third-party vendors for their products and services that
are used in the manufacture of the Companys proprietary
hardware products. Tooling costs are allocated to inventory or
property and equipment and are amortized as a component of cost
of sales or depreciation based upon the number of units sold or
used as demonstration units in a given period compared to the
total number of units expected in a products production
run.

Management periodically assesses the need to
provide for obsolescence of tooling costs and adjusts the
carrying values to their net realizable value when required
through a process similar to that discussed in the Inventory
section above. During 2002, 2001 and 2000, the Company
recognized charges of $299,077, $139,145 and $250,000,
respectively, related to its capitalized tooling assets. The
2002 charge consisted of a $250,000 reserve against the MA V
product line to provide for an estimated decline in value of
this inventory and a $49,077 write-off against the MA TC product
line. The 2001 and 2000 charges were recorded to reduce the net
carrying value of tooling associated with the MA IV product line
given the uncertainties created by the introduction of the MA V
and MA TC product lines. In the event that the anticipated
production run size or sales of a product do not materialize,
additional adjustment may be necessary to write down the
carrying value of the Companys tooling costs.

F-8



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##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


The capitalized tooling asset is systematically
allocated to inventory and property and equipment and is
amortized as a component of cost of sales or depreciation based
upon the number of units sold or used as demonstration units in
a given period compared to the total number of units management
expects to make in a products production run.
Managements expectation of the number of units to be made
during a given products production run is based on a
number of assumptions and estimates, including but not limited
to those related to the introduction of new product lines, the
Companys ability to procure and sell the quantities of
inventory, the introduction of competing products, customer
demand and general economic conditions. In 2002, the total
number of units management expects to make in the MA V
production run was revised downward based on negotiations with
the vendor, which negotiations were finalized in March 2003.

As of December 31, 2002, net of the effects
of reserves and write-offs, the Companys tooling asset
consisted of $745,045 for MA V systems and $31,654 for
MA TC systems. Capitalized tooling costs during 2002, 2001
and 2000 were $0, $1,199,302 and $266,217, respectively.
Amortization to cost of goods sold or depreciation, depending on
classification of tooling costs as inventory or property and
equipment, was $43,126, $148,866 and $105,095 in 2002, 2001, and
2000, respectively.

Software Development
Costs

The Company records software development costs in
accordance with Statement of Financial Accounting Standards
(SFAS) No. 86, Accounting for the Costs
of Computer Software to be Sold, Leased, or Otherwise
Marketed, which requires the capitalization of certain
software development costs once technological feasibility is
established, which the Company defines as the completion of a
working model. Capitalized software costs are amortized either
on a straight-line basis over the estimated product life or
based on the ratio of current revenues to total projected
product revenues. The Company has not historically capitalized
software development costs because the projects have not reached
the point of technological feasibility. At December 31,
2002, 2001 and 2000, there are no capitalized software
development costs or related amortization in the financial
statements. Software development costs incurred on projects that
have not reached technological feasibility are included as a
component of research and development expense and are recorded
during the period in which they are incurred.

Retainage

Certain government contracts of XSI require that
five to twenty percent of direct labor reimbursements per
contract be withheld from payments remitted to the Company until
such time as the contract is completed and a final accounting
and approval has been made. Since the amounts billed will not be
collected within one year of the financial statements date, the
balance is included in long-term other assets. Retainage at
December 31, 2002 and 2001 was $384,359 and $316,839,
respectively.

Patent Costs

The Company capitalizes legal fees, filing fees
and other direct costs incurred to obtain patents and
trademarks. These costs are amortized on a straight-line basis
over a five-year period and are included in general and
administrative expenses. Patent and trademark amortization
expense was $426,751, $350,110, and $258,732 during 2002, 2001
and 2000, respectively. Costs associated with the maintenance
and upkeep of existing patents are expensed as incurred as part
of general and administrative expenses.

As part of the Companys cost cutting
efforts undertaken during 2002 and 2003, management performed an
extensive cost-benefit analysis of its patent portfolio. As a
result of this review, the Company decided to maintain all
patents that have already been granted as well as all those
pending that management considers its key patents,
including those related to wearable computers, the transferable
core, way point and the dual

F-9



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##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


purpose flat panel. However, the Company
concluded that by not further pursuing certain of its patent
applications, it could achieve significant cost savings while
not materially negatively impacting its business plan. The
patents that the Company expects to not pursue are often those
that are not significantly through the patent application
process. This is due to the fact that the process of getting a
patent granted is expensive while the process of maintaining a
patent subsequent to grant is relatively inexpensive.
Additionally, due to the concentration of revenues, the
strategic importance of the Companys U.S. operations, and
the lower cost of obtaining a patent in the U.S., the Company
expects to continue to pursue all domestic patents, whether
granted or pending. Additionally, the Company has determined to
not pursue patents pending in other instances, including those
in which it determined that it had filed for patents for which
it has similar or better protection through other patents in its
portfolio, in countries that do not play a strategic role in the
Companys current business plan or that it has otherwise
determined will likely not meet the internal criteria management
deems necessary to justify the continued cost to complete the
patent application process. The Company recorded a $157,307
restructuring charge in 2002 related to the write-off of
capitalized patent costs related to this review.

Impairment of Long-Lived
Assets

The Companys management monitors the
carrying value of long-lived assets for potential impairment on
an on-going basis. Potential impairment is determined by
comparing the carrying value of these assets with their related,
expected future net cash flows. Should the sum of the related,
expected future net cash flows be less than the carrying value,
management would determine whether an impairment loss should be
recognized. An impairment loss would be measured by the amount
by which the carrying value of the asset exceeds the future
discounted cash flows. No such impairment losses were recorded
during 2002, 2001 or 2000.

Revenue Recognition and
Warranties

The Companys revenues are principally
derived from sales of its hardware and software products and
from consulting services. Revenue from hardware product sales is
recognized upon shipment of the Companys products to
end-users pursuant to binding customer purchase orders. When
shipments are made to distributors, revenue is recognized upon
ultimate sale by the distributors to end-users, when the
distributors purchase product for their own use pursuant to
separate binding purchase orders, or when returns can be
reasonably estimated. For hardware product sales, the Company
generally provides a one-year warranty on its parts and a
six-month warranty on labor. A provision for estimated future
warranty costs is recorded at the time of shipment as a
component of cost of sales. However, the Companys
suppliers for the significant components of its hardware
products, including the computing unit, flat panel and head
mounted displays, and batteries, provide the Company with
similar warranties. The Company recorded warranty expense for
the net of estimated expenses less warranty coverage from
suppliers of $553,310, $229,413, and $0 during 2002, 2001 and
2000, respectively, and had a warranty reserve of $81,552 and
$86,915 at December 31, 2002 and 2001, respectively.

The Company recognizes software revenue in
accordance with Statement of Position (SOP)
No. 97-2, Software Revenue Recognition and SOP
No. 98-9, Modification of SOP 97-2, Software
Revenue Recognition, With Respect to Certain Transactions.
If a contract requires significant production, modification, or
customization of the software, the arrangement is accounted for
as a long-term service contract. If it does not, software
revenue is realizable when the following criteria are met:
persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the sellers price
to the buyer is fixed or determinable, and collectibility is
reasonably assured. Other criteria that must be met include the
determination of whether the revenue in multiple-element
arrangements can be recognized separately for each element as
performance occurs and the determination of the fee based on
vendor-specific objective evidence

F-10



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##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


(VSOE) of fair value for each
element. The Company determines VSOE of fair value of each
element by the price charged when the same element is sold
separately or based on Managements established prices for
elements such as consulting rates on comparable service
contracts or the price of software with the same functionality
available in the industry. If management is unable to determine
the VSOE of a delivered element, the revenue is recognized by
the residual method. As performance occurs, the fee for the
delivered item is determined by the total fee of the arrangement
less the total fair value of the undelivered elements. The total
fair value of the undelivered elements is deferred and
subsequently recognized as performance occurs. If management is
unable to determine the VSOE of an undelivered element, all
revenue from the contract is deferred until the VSOE is
established or all performance has occurred. If the only
undelivered element without VSOE of fair value is services that
can be accounted for separately, the entire fee is recognized
over the service period.

The Company recognizes revenue from long-term
service contracts in accordance with Accounting Research
Bulletin (ARB) No. 45, Long-Term
Construction Type Contracts, using the relevant guidance
in SOP 81-1, Accounting for Performance of
Construction-Type and Certain Production-Type Contracts,
as determined by the terms and conditions of the Companys
various consulting contracts with its customers. Revenue is
typically recognized ratably over the contractual periods or as
the services are provided. In time and materials contracts,
revenue is recognized as the Company incurs billable costs. In
fixed price contracts, revenue is recognized based on the
percentage of completion method by calculating the ratio of
costs incurred over total estimated costs to complete. Revenue
in excess of billings on service contracts is recorded as
unbilled receivables. At December 31, 2002 and 2001,
unbilled receivables of $1,130,206 and $365,763, respectively,
were included in trade accounts receivable. Billings in excess
of revenue recognized on service contracts are recorded as
deferred revenue until revenue recognition criteria are met. At
December 31, 2002 and 2001, $88,460 and $40,288,
respectively, were recorded as deferred revenue.

Income Taxes

Deferred income tax assets and liabilities are
computed annually for differences between the financial
statement and income tax bases of assets and liabilities that
will result in taxable or deductible amounts in the future. Such
deferred income tax asset and liability computations are based
on enacted tax laws and rates applicable to periods in which the
differences are expected to affect taxable income. Income tax
expense is the tax payable or refundable for the period plus or
minus the change during the period in deferred income tax assets
and liabilities. The provision for income taxes in 2002, 2001
and 2000 is the result of operations of the Companys
international subsidiaries.

Comprehensive
Loss

The Company separately reports net loss and other
comprehensive income or loss pursuant to SFAS No. 130,
Reporting Comprehensive Income. Other comprehensive
income or loss refers to revenues, expenses, gains and losses
that under generally accepted accounting principles are recorded
as an element of stockholders equity and are excluded from
net income. The Companys other comprehensive income or
loss is comprised primarily of gains and losses related to
foreign currency translation and investments.

Net Loss Per
Share

Basic earnings (or loss) per share is calculated
using the weighted average number of shares of common stock
outstanding during a reporting period. Diluted loss per share
adjusts the weighted average number of outstanding shares for
the potential dilution that could occur if stock options,
warrants or other convertible securities were exercised or
converted into common stock. For all periods presented herein,
the Companys

F-11



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##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

2. Summary of Significant Accounting
Policies, continued:

diluted loss per share is equal to its basic loss
per share because the effects of exercise were anti-dilutive
given the losses the Company incurred during such periods.

Stock-Based
Compensation.

In December 2002 the FASB issued SFAS
No. 148, Accounting for Stock Based
Compensation-Transition and Disclosure an amendment to
FASB Statement No. 123, Accounting for Stock-Based
Compensation. SFAS No. 148 amends the disclosure
provisions to require prominent disclosure about the effects on
reported net income of an entitys accounting policy
decisions with respect to stock-based compensation. Stock
options are accounted for using the intrinsic method in
accordance with APB No. 25, Accounting for Stock
Issued to Employees, as interpreted, whereby if options
are priced at fair market value or above at the date of grant,
no compensation expense is recognized. The pro forma information
is as follows:

|                                                                                       |  |      |             |   |      |   |             |      |  |   |             |  
|-------------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | -
|                                                                                       |  | 2002 |             |   | 2001 |   |             | 2000 | 
|                                                                                       |  |      |             |   |      |   |             |      | 
|Net loss as reported                                                                   |  | $    | (26,580,833 | ) |      | $ | (32,199,579 | )    |  | $ | (24,185,222 | )
|Stock-based employee compensation cost included
    in net loss as reported            |  | $    |            |   |      | $ |            |      |  | $ |            |  
|Stock-based employee compensation cost under the
    fair value method of SFAS No. 123 |  | $    | (4,458,397  | ) |      | $ | (6,565,666  | )    |  | $ | (5,114,852  | )
|Net loss pro forma                                                                     |  | $    | (31,039,230 | ) |      | $ | (38,765,245 | )    |  | $ | (29,300,074 | )
|Net loss per share basic and diluted 
    as reported                                 |  | $    | (0.37       | ) |      | $ | (0.63       | )    |  | $ | (0.63       | )
|Net loss per share basic and diluted 
    pro forma                                   |  | $    | (0.43       | ) |      | $ | (0.76       | )    |  | $ | (0.76       | )

Issuance of Equity Securities
for Services

The Company periodically issues equity securities
to certain employees, consultants and companies for services
provided to, or goods received by, the Company. These securities
include shares of common stock and warrants and options to
purchase shares of common stock. These transactions were
individually valued based upon the fair value of the securities
issued or the services or goods provided, whichever was more
reliably measured. In 2002, the Company recorded prepaid assets
for future services or goods to be provided of $1,929,498, of
which, $143,846 is expected to be expensed in 2003. In 2001,
$507,917 was recorded as prepaid assets for future services or
goods to be provided, which was expensed in 2001 and 2002. In
2000, $725,390 was recorded as prepaid assets for future
services or goods to be provided, which was expensed in 2000 and
2001. Included in prepaid and other assets at December 31,
2002 and 2001 are equity securities issued for payment of future
services of $143,846 and $253,958, respectively.

Restructuring

The Company recorded restructuring charges in
accordance with Emerging Issues Task Force (EITF)
Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a
Restructuring), and Staff Accounting Bulleting
(SAB) No. 100, Restructuring and
Impairment Charges. During the second, third and fourth
quarters of 2002, management adopted various restructuring plans
which established the plans of termination, the benefits
available to terminated employees and communicated these
benefits to the terminated employees. The employee severance
costs and outplacement services according to these plans were
recorded as restructuring charges and totaled $434,308. As part
of the restructuring plans, office space was reduced by moving
XSI employees to the Companys headquarters and preparing
the vacated space for sublease. The present value of the future
cash flows of the office rent for the life of the contract less
an estimate that the space can be subleased at 50% of total rent
totaled $223,305. Further consolidation and subleasing of office
space at headquarters resulted in an additional restructuring
charge of $10,199. In the fourth quarter, the Company

F-12



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##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


closed its branch operations in Japan, resulting
in a $213,041 restructuring charge (the Companys
wholly-owned subsidiary operating in Japan, Xybernaut KK, was
not closed). Also, in the fourth quarter, management performed
an extensive cost-benefit analysis of its patent portfolio and
recorded a $157,307 charge related to the write-off of certain
patent costs. Of these 2002 restructuring charges, $245,546 was
or will be paid in cash and $188,762 was paid by the issuance of
equity securities during the last three quarters of 2002. At
December 31, 2002, of the remaining unpaid balance of
$197,739, $78,444 is included in accrued expenses and will be
paid in 2003. The remaining balance $119,295 is classified as a
long-term liability on the balance sheet and will be paid in
2004 and 2005. The original charge for outplacement services
extended to severed employees was reduced by $4,536 in 2002 as
outplacement services expired resulting in no expense to the
Company. Management expects to establish and implement
additional restructuring plans into 2003 depending on business
conditions.

The components of the restructuring charge in
2002 are as follows:

|                                    |  |   |           | 
|----------------------------------- |  | - | --------- | 
|Severance and outplacement services |  | $ | 434,308   | 
|Lease obligations                   |  |   | 233,504   | 
|Closing of branch operations        |  |   | 213,041   | 
|Write-down of certain patent costs  |  |   | 157,307   | 
|                                    |  |   |          
|                                    |  | $ | 1,038,160 | 

Fair Value of Financial
Instruments

The carrying amounts of financial instruments
including cash and cash equivalents, accounts receivable and
accounts payable approximated fair value as of December 31,
2002 and 2001 because of the relatively short maturity of these
instruments. The carrying value of the notes and loans
receivable or payable approximated fair value as of
December 31, 2002 and 2001 based upon market prices for the
same or similar issues.

Foreign Currency
Translation

Assets and liabilities of the Companys
foreign subsidiaries are translated at the exchange rate on the
balance sheet date. Translation adjustments resulting from this
process are charged or credited to equity. Revenues and expenses
are translated at the average exchange rate for the year. Gains
and losses on foreign currency transactions are immaterial for
the years ended December 31, 2002, 2001 and 2000.

Recent Accounting
Pronouncements

In July 2001, the Financial Accounting Standards
Board (FASB) issued SFAS No. 143,
Accounting for Asset Retirement Obligations. The
statement provides accounting standards for retirement
obligations associated with tangible long-lived assets, with
adoption required by January 1, 2003. SFAS No. 143
requires that the fair value of a liability for an asset
retirement obligation be recorded in the period in which it is
incurred. The associated asset retirement cost is capitalized as
part of the carrying amount of the long-lived asset. Over time
the capitalized costs are depreciated and the present value of
the asset retirement liability increases, resulting in a period
expense. Upon retirement, a gain or loss will be recorded if the
cost to settle the retirement obligation differs from the
carrying amount. The Company does not believe there will be a
material effect from the adoption of this standard.

In August 2001, the FASB issued SFAS
No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets, effective for fiscal years beginning
after December 15, 2001. The new rule addresses the
accounting and reporting for the impairment or disposal of
long-lived assets. SFAS No. 144 supersedes SFAS
No. 121, Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed

F-13



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##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


Of but retains many of the fundamental
provisions of SFAS No. 121. SFAS No. 144 also
supercedes the accounting and reporting provisions of Accounting
Principles Board Opinion (APB) 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 for the disposal of a segment of a business.
However, SFAS No. 144 retains the requirements of APB
No. 30 to report discontinued operations separately and
extends that reporting requirement to components of an entity
that has either been disposed of or is classified as held for
sale. SFAS No. 144 excludes goodwill and other intangibles
that are not amortized from its scope. For assets to be held and
used, SFAS No. 144 addresses how cash flows should be
estimated to test the recoverability of an asset or group of
assets, clarifies how an impairment loss should be allocated,
and creates a requirement to use an expected present value
technique to estimate fair value if market prices are not
available and uncertainties exist about the timing and amount of
future cash flows. For long-lived assets to be disposed of by
sale, SFAS No. 144 establishes the criteria to be met to
qualify for this classification, defines the timing of when the
related sale must be consummated, eliminates the net realizable
value measurement approach for segments of a business and
certain acquired assets in a business combination, and defines
costs to sell the asset. The Company does not believe there will
be a material effect from the adoption of this standard.

In April 2002, the FASB issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44, and 64,
Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 rescinds SFAS No. 4
and SFAS No. 64, which addressed the accounting for gains
and losses from extinguishment of debt, rescinds SFAS
No. 44 which set forth industry-specific transitional
guidance, amends SFAS No. 13 to require that certain lease
modifications that have economic effects similar to
sale-leaseback transactions be accounted for in the same manner
as sale-leaseback transactions and makes technical corrections
to certain existing pronouncements that are not substantive in
nature. The Company does not believe there will be a material
effect from the adoption of this standard.

In July 2002, the FASB issued SFAS No. 146,
Accounting for Exit or Disposal Activities. SFAS
No. 146 addresses the recognition, measurement and
reporting of costs associated with exit and disposal activities,
including restructuring activities that are currently accounted
for pursuant to the guidance set forth in EITF Issue
No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). The
scope of SFAS No. 146 includes costs related to terminating
a contract that is not a capital lease, costs to consolidate
facilities or relocate employees, and certain termination
benefits provided to employees who are involuntarily terminated.
SFAS No. 146 is effective for exit or disposal activities
initiated after December 31, 2002. The Company does not
believe there will be a material effect from the adoption of
this standard.

Reclassifications

Certain 2000 and 2001 balances and disclosures
have been reclassified to conform to the 2002 presentation.

3. Liquidity and Operations



The Company has recorded net losses since its
inception, including during the periods presented in this
Form 10-K. These losses are primarily attributable to the
operating expenses incurred by the Company to design, develop,
market and sell its wearable computer products and to provide
general and administrative support for these operating
activities. During these periods, the Companys revenues
and gross margins have not been sufficient to fund these
operating activities. As a result, the Company has consistently
recorded negative cash flows from operating activities and net
losses and had an accumulated deficit of $131,023,159 at
December 31, 2002.

F-14



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



3. Liquidity and Operations,
continued:


The combination of the Companys operating
losses and its working capital requirements has severely
impacted the Companys financial position and liquidity. At
December 31, 2002, the Company had unrestricted cash on
hand of $1,967,710 and accounts payable and accrued expenses of
$4,481,153. Certain of these liabilities are past their stated
terms of payment, including those owed to vendors that provide
services and inventory which are required by the Company to
execute its business plan. In general, any company that does not
pay its suppliers in a timely manner is at risk of being forced
into an involuntary bankruptcy proceeding instituted by
creditors, which may provide for the liquidation of assets or
the reorganization of assets and debts. The Company generally
believes that it has a reasonably good relationship with most of
its vendors and creditors. However certain of its vendors have
filed legal actions to recover overdue accounts payables and
ceased providing services and products to the Company. There can
be no assurances that other vendors will not pursue similar
actions.

During 2002, 2001 and 2000, the Company funded
its operating and investing activities through its financing
activities, which consist primarily of private placements of
common stock, warrant and stock option exercises and borrowings.

The Companys management has taken steps
that it believes are necessary to improve the Companys
operations and raise additional capital, both of which are
needed to enhance its ability to meet its cash flow needs
through December 31, 2003 and thereafter. Beginning in
April 2002 and continuing through the date of this filing,
management has performed reviews of the Companys
operations and implemented various cost cutting programs to
significantly reduce the Companys operating expenses.

Assuming there are no significant changes to the
Companys business plan, management expects to maintain
savings of over 50% from annualized fourth quarter 2001 levels.
In the fourth quarter of 2002, management met its initial target
to reach a quarterly operating expense level of between
$4,000,000 and $5,000,000. Future significant fluctuations may
still occur as a result of non-recurring charges associated with
cost-saving initiatives as well as the Companys research
and development activities, which will vary depending on the
Companys wearable/mobile computer product development
cycle during any given period.

The key cash saving initiatives that have been,
and will continue to be, implemented are listed below:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Worldwide headcount will have been reduced by 45%
    from approximately 145 full-time equivalent employees to
    approximately 80 full-time employees.                                                                                                                                                                                                                                                                                                                        
|
| |  | The Companys worldwide engineering and
    product functions have been consolidated.                                                                                                                                                                                                                                                                                                                                                                                           
|
| |  | Operations in Asia were significantly reduced,
    especially related to direct sales, marketing and product
    efforts. Future Asian operations will focus primarily on channel
    sales, potential business combinations and business development.
    The Companys branch operations in Japan, which focused
    primarily on product efforts, were closed. The Companys
    subsidiary Xybernaut KK, which focuses primarily on sales and
    marketing, was not closed.
|
| |  | Operations in Europe were significantly reduced,
    especially related to direct sales and marketing efforts. Future
    European operations will focus primarily on channel sales, sales
    and marketing relationships with strategic partners, business
    development and research and development.                                                                                                                                                                      
|
| |  | Participation in trade shows has been reduced.                                                                                                                                                                                                                                                                                                                                                                                                                                  
|
| |  | An agreement was reached with the manufacturer of
    the pomaproduct line through which the Company
    eliminated its obligation to purchase approximately $1,500,000
    in additional systems.                                                                                                                                                                                                                                                                              
|
| |  | An agreement was reached with the manufacturer of
    the MA V product line through which the Company received a
    discount on certain inventory commitments originally scheduled
    for purchase                                                                                                                                                                                                                                                                            

F-15



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



3. Liquidity and Operations,
continued:




| |   |                                                                                                                                                                                                                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | during 2003 and 2004 and eliminated over
    approximately $40,000,000 in obligations to purchase additional
    systems as well as a potential cancellation fee of approximately
    $4,000,000. Under this agreement, the Company is required to
    purchase $4,910,000 in additional MA V systems, primarily
    during 2003.
|
| |  | An agreement with a vendor to provide the Company
    with marketing services and certain retail space at the Waldorf
    Astoria Hotel in New York City was canceled.                                                                                                                                                           
|
| |  | Management expects to not invest significant
    future time or capital resources pursuing certain of its foreign
    patent applications.                                                                                                                                                                                       
|
| |  | Agreements with certain consultants, vendors and
    partners have been, and will continue to be, cancelled or
    renegotiated in order to minimize cash expenditures through the
    issuance of the Companys equity securities, the
    renegotiation of terms and a reduction or elimination of
    services.               
|
| |  | Other various reductions in discretionary costs
    have been, and will continue to be, implemented.                                                                                                                                                                                                                             

Subsequent to these changes, management believes
that the Companys staffing and resources will be
sufficient to carry out its business plan for the foreseeable
future.

In addition to the cost cutting initiatives
detailed above, management continues to review all aspects of
the Companys operations and may take additional actions to
reduce operating expenses further.

At the forecasted levels discussed above,
management expects that the Company will incur operating
expenses of between $16,000,000 and $20,000,000 during 2003. The
Company will also be required to fund inventory procurement and
other expenditures. While management expects to fund a portion
of these activities through gross profits resulting from
revenues, the Company will be required to obtain most of such
amounts through outside financings. Potential sources of
additional financing include private equity offerings, warrant
exercises, strategic investments and various forms of debt
financing. In certain instances, concurrently with the exercise
of certain of these warrants, the exercise prices were reduced.
Such reduction has resulted in the issuance of substantially
more shares of common stock than would have occurred had the
warrants been exercised at their original exercise prices. The
Company may reduce the exercise price of additional warrants in
the future. If additional funds are raised through the issuance
of equity securities, the percentage of ownership of current
stockholders of the Company will be reduced and if additional
funds are raised at current prices for the Companys stock,
such dilution could be significant. If additional funds are
raised through borrowings, the Company will be subject to
interest charges and principal repayments, will likely be
required to comply with financial covenants or other
restrictions, and will likely have to collateralize such
borrowings with its assets, which could be taken by the lender
in the event of default.

During 2002, the Company raised $22,011,620 in
cash through sales of its common stock to institutional
investors, through warrant and stock option exercises and
through borrowings that were repaid through the issuance of
common stock. Subsequent to December 31, 2002, the Company
raised over approximately $6,100,000 in additional funds through
warrant exercises, sales of its common stock to institutional
investors and borrowings. Due in large part to the
Companys current stock price, the depressed general
capital markets and cost-cutting efforts described above, the
individual equity financings that the Company has completed in
recent quarters have been of a smaller size when compared to
those transacted in previous periods.

The Companys management believes that the
combination of cash on hand, cash flows from operations and
outside funding will provide sufficient liquidity to meet the
Companys ongoing cash requirements. This is based both on
the Companys historical ability to raise capital and on
debt and equity financings currently available to the Company.
However, there can be no assurance that the Company can or will
obtain sufficient funds from operations or from additional
financings on terms acceptable to the Company.

F-16



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

4. Property and Equipment

Property and equipment consist of the following:

|                                               |  |              |            |   |      |   |            |  
|---------------------------------------------- |  | ------------ | ---------- | - | ---- | - | ---------- | -
|                                               |  |             
|                                               |  | December 31, |           
|                                               |  |              |           
|                                               |  | 2002         |            |   | 2001 |  
|                                               |  |              |            |   |      |  
|Furniture and fixtures                         |  | $            | 312,161    |   |      | $ | 363,499    |  
|Equipment                                      |  |              | 1,450,300  |   |      |   | 1,445,741  |  
|Leasehold improvements                         |  |              | 328,147    |   |      |   | 288,467    |  
|Demonstration units                            |  |              | 1,658,840  |   |      |   | 2,092,285  |  
|                                               |  |              |            |   |      |  
|                                               |  |              | 3,749,448  |   |      |   | 4,189,992  |  
|Less accumulated depreciation and amortization |  |              | (3,159,061 | ) |      |   | (3,106,581 | )
|                                               |  |              |            |   |      |  
|                                               |  | $            | 590,387    |   |      | $ | 1,083,411  |  
|                                               |  |              |            |   |      |  

Depreciation expense for the years ended
December 31, 2002, 2001, and 2000 was $1,159,277, $914,288,
and $776,133, respectively. Included in property is computer
equipment purchased by XSI under capital lease of $27,190 less
accumulated depreciation of $12,181. Effective December 31,
2002, the Company wrote off $990,144 of fully depreciated
demonstration units.

5. Accrued Expenses

Accrued expenses consist of the following:

|                                               |  |              |           |  |      |   |           | 
|---------------------------------------------- |  | ------------ | --------- |  | ---- | - | --------- | 
|                                               |  |             
|                                               |  | December 31, |          
|                                               |  |              |          
|                                               |  | 2002         |           |  | 2001 |  
|                                               |  |              |           |  |      |  
|Accrued salaries, benefits and vacation        |  | $            | 795,699   |  |      | $ | 1,141,854 | 
|Professional fees                              |  |              | 295,336   |  |      |   | 454,073   | 
|Other                                          |  |              | 203,776   |  |      |   | 375,981   | 
|Warranty reserve                               |  |              | 100,251   |  |      |   | 86,915    | 
|Restructuring liability                        |  |              | 78,444    |  |      |   |          | 
|Accrued loss on inventory purchase commitments |  |              |          |  |      |   | 885,020   | 
|                                               |  |              |           |  |      |  
|                                               |  | $            | 1,473,506 |  |      | $ | 2,943,843 | 
|                                               |  |              |           |  |      |  

The accrued loss on inventory purchase commitment
represents a charge recorded in 2001 to reflect
managements estimate of losses to be incurred on the total
initial production run of the pomaproduct line. The
Company elected to sell the pomasystems at prices that
are less than their initial production costs to favorably
position pomain the price-sensitive light-commercial and
near-consumer markets. Although the pomainventory had
not been received by the Company as of December 31, 2001,
the Company recorded the expected losses during 2001, which was
the period in which the underlying contracts were entered into.
Because the inventory had not been received by the company as of
December 31, 2001, and was therefore not recorded as an
asset, this charge was recorded as an accrued liability which
was being reclassified to an inventory reserve as pomainventory shipments were received during 2002. During 2002,
the Company entered into an agreement with the manufacturer of
pomathrough which the Company was relieved of its
obligation to purchase additional pomaunits. Pursuant to
the terms of this agreement, the Company made a payment of
$80,000 during 2002 and reduced certain of the royalty rates
that are used to calculate the licensing fees that the Company
receives from the manufacturer for its sales of pomaor
other wearable computer products. During 2002, the remaining
accrued liability balance, net of the $80,000 payment, was
reversed, resulting in a $631,556 reduction to the provision for
inventory and tooling reserve.

Other accruals consist of amounts related to
expenses incurred in the normal course of business, such as
employee travel costs, sales and other taxes, and royalty costs
for software sales.

F-17



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

6. Borrowings

In January 2000, the Company borrowed $3,025,000
from several lenders pursuant to promissory notes which accrued
interest at 10% per annum. In connection with these borrowings,
the Company issued warrants to purchase 302,500 shares of
unregistered common stock at $0.10 per share. Based on the
relative fair values of the securities issued, these warrants
were assigned a value of $921,452, which amount was recorded as
a note discount and amortized into interest expense over the
lives of the notes. In November and December 2000, the Company
repaid the principal and unpaid interest and the remaining note
discount balance was charged to interest expense.

In June 2000, XSI entered into three capital
leases for computer equipment totaling $27,190. The leases have
interest rates between 14.0% and 19.5% and mature in three
years. At December 31, 2002, the capital lease obligation
was $8,376. During 2002, 2001 and 2000, the Company incurred
interest expense of $2,320, $3,781 and $1,057, respectively,
related to these capital leases.

In July 2000, the Company entered into a
six-month $1,400,000 term loan with IBM Global Finance. The
borrowing was secured by certain of the Companys
equipment, inventory and accounts receivable balances. The
borrowing accrued interest at the prime rate plus 1.5% and was
repaid in three equal installments in September and November
2000 and January 2001. During 2001 and 2000, the Company
incurred interest expense of $2,377 and $48,431, respectively,
related to this borrowing.

During June 2002, the Company received $250,000
in cash from an investor that was recorded by the Company as a
note payable. This note bore interest at 6.0% per annum and was
due on or before June 30, 2003. This note was repaid in
August 2002 from the proceeds of a private placement.

7. Stockholders Equity

Common Stock

During 2000, the Company received net cash
proceeds of $23,163,645 through the issuance of 7,923,359 shares
of its common stock through four separate private placements.
The Company also issued warrants to purchase 3,312,437 shares of
its common stock for between $4.33 and $10.00 per share related
to these private placements.

During 2001, the Company received net cash
proceeds of $22,801,278 through the issuance of 12,018,772
shares of its common stock through three separate private
placements. The Company also issued warrants to purchase
3,409,347 shares of its common stock for between $2.55 and $5.00
per share related to these private placements.

During March 2002, the Company received gross
proceeds of $9,000,000 through a private placement of 5,625,000
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 1,406,250 shares of common stock
at an exercise price of $3.00 per share. In connection with this
placement, the Company paid $270,000 in cash to financial
advisors.

During June 2002, the Company received gross
proceeds of $4,000,000 through a private placement of 6,666,666
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 1,666,666 shares of common stock
at an exercise price of $1.50 per share. In connection with this
placement, the Company issued 740,740 shares of its common stock
to financial and business development advisors.

During August 2002, the Company received gross
proceeds of $2,000,000 through a private placement of 5,714,286
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 5,714,286 shares of common stock
at an

F-18



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



7. Stockholders Equity,
continued:


exercise price of $0.70 per share and callable
warrants to purchase 5,714,286 shares of common stock at an
exercise price of $1.50 per share. A portion of the proceeds
from this private placement was used to repay a $250,000 note
payable.

During November 2002, the Company received gross
proceeds of $4,100,000 through a private placement of 17,083,332
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
callable warrants to purchase 8,541,668 shares of common stock
at an exercise price of $1.25 per share.

The Company issues warrants to purchase shares of
its common stock, primarily in connection with the
Companys financings and borrowings. The Company received
net proceeds of $2,186,802, $3,773,405 and $8,274,975 through
the issuance of 17,350,627, 1,881,470 and 2,077,700 shares of
its common stock during 2002, 2001 and 2000, respectively,
through the exercise of certain of these warrants. Concurrently
with the exercise of such warrants in 2002, the exercise price
of 17,350,627 warrants was reduced from $1.61 per share to $0.18
per share. At December 31, 2002, the Company had warrants
outstanding to purchase 12,992,204 shares of its common stock at
prices that range from $0.50 to $5.00 per share, with a weighted
average of $1.99 per share.

Employees and consultants of the Company have
exercised stock options that had been issued pursuant to the
Companys various stock incentive plans. During 2002, 2001
and 2000, the Company issued 35,835, 57,097 and 662,724 shares,
respectively, of its common stock and received gross proceeds of
$11,048, $135,659 and $1,547,011, respectively, related to these
exercises.

Preferred Stock

From 1997 through 1999, the Company issued
certain series of convertible preferred stock. The preferred
stock issuances generally accrued interest at 5.0% per year. At
December 31, 2000, all shares of the Companys
convertible preferred stock had been converted into shares of
its common stock and no preferred stock has been issued since
that time.

During 1999, the Company issued 10,500 shares of
Series D Preferred Stock for gross proceeds of $10,000,000.
As of December 31, 2000, all of the Series D Preferred
Stock principal and interest had been converted into 8,204,596
shares of common stock. During 1999, the Company issued 2,100
shares of Series E Preferred Stock for gross proceeds of
$2,000,000. As of December 31, 2000, all of the
Series E Preferred Stock principal and interest had been
converted into 1,655,714 shares of common stock.

8. Stock Options

On April 18, 1996, the Board of Directors
approved, effective January 1, 1996, the Companys
1996 Omnibus Stock Incentive Plan (the 1996 Plan).
The Companys 1997, 1999, 2000 and 2002 Stock Incentive
Plans (the 1997, 1999, 2000,
and 2002 Plans, respectively) were approved at the
annual meetings of stockholders held during these respective
years.

Effective June 12, 1990, XSIs Board of
Directors approved the XSI Stock Option Plan. In 1999 and 2000,
prior to the Merger of XSI and Xybernaut, all outstanding
options were exercised into XSI common stock for proceeds of
$58,897 and subsequently converted into 29,000 shares of the
Companys common stock pursuant to the terms of the Merger
agreements.

Under these plans, the Company may grant
incentive stock options, non-qualified stock options, stock
appreciation rights and shares of common stock to officers,
directors, employees and others. Under the terms of these plans,
no stock option may be granted at less than the fair market
value of the Companys common stock on the date of grant.
Stock options granted to employees are generally exercisable in
five equal annual

F-19



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



8. Stock Options, continued:


installments beginning one year after the date of
grant. Stock options granted to officers and directors are
generally exercisable immediately.

The 1996 Plan, the 1997 Plan, the 1999 Plan, the
2000 Plan and the 2002 Plan authorize the issuance of 650,000,
1,650,000, 3,000,000, 3,000,000 and 3,000,000 shares of the
Companys common stock, respectively. At December 31,
2002, 485,611, 1,313,516, 2,818,072, 2,534,168 and 5,000 of the
shares authorized under the 1996 Plan, the 1997 Plan, the 1999
Plan, the 2000 Plan and the 2002 Plan, respectively, were
outstanding.

The following table summarizes information on the
Companys stock options:

|                  |  |             |            |          |               |   |      |             |          |  |               |   |  |           |      |  |               |  |           |   |  |   |      | 
|----------------- |  | ----------- | ---------- | -------- | ------------- | - | ---- | ----------- | -------- |  | ------------- | - |  | --------- | ---- |  | ------------- |  | --------- | - |  | - | ---- | 
|                  |  |             |            |          |               |  
|                  |  | Fiscal 2002 |            |          | Fiscal 2001   |   |      | Fiscal 2000 |         
|                  |  |             |            |          |               |   |      |             |         
|                  |  |             |            | Weighted |               |   |      |             | Weighted |  |               |   |  | Weighted  |     
|                  |  | Number of   |            |          | Average Price |   |      | Number of   |          |  | Average Price |   |  | Number of |      |  | Average Price | 
|                  |  | Shares      |            |          | per Share     |   |      | Shares      |          |  | per Share     |   |  | Shares    |      |  | per Share     | 
|                  |  |             |            |          |               |   |      |             |          |  |               |   |  |           |      |  |               | 
|Beginning balance |  |             | 6,844,832  |          |               | $ | 3.88 |             |          |  | 4,850,752     |   |  | $         | 4.39 |  |               |  | 4,761,311 |   |  | $ | 3.17 | 
|Granted           |  |             | 1,678,308  |          |               | $ | 0.88 |             |          |  | 2,674,819     |   |  | $         | 3.29 |  |               |  | 1,208,600 |   |  | $ | 8.08 | 
|Exercised         |  |             | (261,456   | )        |               | $ | 0.33 |             |          |  | (57,097       | ) |  | $         | 2.44 |  |               |  | (662,724  | ) |  | $ | 2.49 | 
|Cancelled         |  |             | (1,105,317 | )        |               | $ | 4.94 |             |          |  | (623,642      | ) |  | $         | 5.46 |  |               |  | (456,435  | ) |  | $ | 4.02 | 
|                  |  |             |            |          |               |   |      |             |          |  |               |   |  |           |      |  |               | 
|Ending balance    |  |             | 7,156,367  |          |               | $ | 3.13 |             |          |  | 6,844,832     |   |  | $         | 3.88 |  |               |  | 4,850,752 |   |  | $ | 4.39 | 
|                  |  |             |            |          |               |   |      |             |          |  |               |   |  |           |      |  |               | 

The following table summarizes information about
fixed stock options outstanding at December 31, 2002:

|             |  |                     |           |                  |                  |  |                     |                  |  |   |             |  |  |                  |           |  |  |   |      | 
|------------ |  | ------------------- | --------- | ---------------- | ---------------- |  | ------------------- | ---------------- |  | - | ----------- |  |  | ---------------- | --------- |  |  | - | ---- | 
|             |  |                     |           |                  |                  |  |                     |                 
|             |  | Options Outstanding |           |                  |                  |  |                    
|             |  |                     |           |                  |                  |  | Options Exercisable |                 
|Range of     |  |                     |           | Weighted Average |                  |  |                     |                  |  |  
|Exercise     |  | Number              |           |                  | Remaining        |  |                     | Weighted Average |  |   | Number      |  |  | Weighted Average |          
|Prices       |  | Outstanding         |           |                  | Contractual Life |  |                     | Exercise Price   |  |   | Exercisable |  |  | Exercise Price   |          
|             |  |                     |           |                  |                  |  |                     |                  |  |   |             |  |  |                  |          
|$0.24-$1.67  |  |                     | 2,196,718 |                  |                  |  | 8.2                 |                  |  | $ | 0.92        |  |  |                  | 1,342,092 |  |  | $ | 1.15 | 
|$1.68-$3.32  |  |                     | 2,245,999 |                  |                  |  | 6.8                 |                  |  | $ | 2.36        |  |  |                  | 1,886,116 |  |  | $ | 2.37 | 
|$3.33-$4.97  |  |                     | 1,535,300 |                  |                  |  | 6.5                 |                  |  | $ | 4.17        |  |  |                  | 1,249,400 |  |  | $ | 4.24 | 
|$4.98-$23.75 |  |                     | 1,178,350 |                  |                  |  | 6.7                 |                  |  | $ | 7.40        |  |  |                  | 822,200   |  |  | $ | 6.84 | 
|             |  |                     |           |                  |                  |  |                     |                  |  |   |             |  |  |                  |          
|             |  |                     | 7,156,367 |                  |                  |  | 7.2                 |                  |  | $ | 3.13        |  |  |                  | 5,299,808 |  |  | $ | 3.19 | 
|             |  |                     |           |                  |                  |  |                     |                  |  |   |             |  |  |                  |          

The Company complies with the disclosure-only
provisions of SFAS No. 123, Accounting for Stock
Based Compensation. In accordance with the provisions of
SFAS 123, the Company applies APB Opinion No. 25 and
related interpretations in accounting for its plans and,
accordingly, does not recognize compensation expense. Had
compensation expense for the Companys plan been determined
based on the fair value at the grant date for plan awards
consistent with the provisions of SFAS 123, the
Companys net loss and net loss per common and common
equivalent shares outstanding would have been the pro forma
amounts indicated below:

|                                 |  |                         |             |   |      |   |             |      |  |   |             |  
|-------------------------------- |  | ----------------------- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | -
|                                 |  |                        
|                                 |  | Year Ended December 31, |            
|                                 |  |                         |            
|                                 |  | 2002                    |             |   | 2001 |   |             | 2000 | 
|                                 |  |                         |             |   |      |   |             |      | 
|Net loss  as reported           |  | $                       | (26,580,833 | ) |      | $ | (32,199,579 | )    |  | $ | (24,185,222 | )
|Net loss  pro forma             |  | $                       | (31,039,230 | ) |      | $ | (38,765,245 | )    |  | $ | (29,300,074 | )
|Net loss per share  as reported |  | $                       | (0.37       | ) |      | $ | (0.63       | )    |  | $ | (0.63       | )
|Net loss per share  pro forma   |  | $                       | (0.43       | ) |      | $ | (0.76       | )    |  | $ | (0.76       | )

The weighted-average fair values of each option
at the date of grant for 2002, 2001 and 2000 were $0.88, $3.29
and $6.40, respectively, and were estimated on the date of grant
using the Black-Scholes option-pricing model with the following
weighted-average assumptions used in 2002, 2001 and 2000:
dividend yield of 0%;

F-20



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



8. Stock Options, continued:


expected volatility of 134% in 2002, 115% in 2001
and 139% in 2000; risk-free interest rate of 1.82% in 2002,
4.09% in 2001 and 6.22% in 2000; and expected lives of
3 years.

9. Segment and Enterprise Wide
Reporting

The Company discloses certain financial and
supplementary information about its operating segments, products
and services, geographic areas and major customers pursuant to
SFAS No. 131, Disclosures About Segments of an
Enterprise and Related Information. Operating segments are
defined as components of an enterprise about which separate
discrete financial information is evaluated regularly by the
chief operating decision maker or decision making group, in
deciding how to allocate resources and assess performance. The
financial information disclosed herein materially presents all
of the financial information related to the Companys
principal operating segments as a provider of wearable computing
and communications systems and software and service solutions.

The Company established subsidiaries in both
Germany and Japan in January 1999. Revenues by geographical
destination as a percentage of total revenues for the year ended
December 31, 2002, 2001, and 2000 are as follows:

|                            |  |              |    |   |      |  |    |      |  |  |    |  
|--------------------------- |  | ------------ | -- | - | ---- |  | -- | ---- |  |  | -- | -
|                            |  |             
|                            |  | December 31, |   
|                            |  |              |   
|                            |  | 2002         |    |   | 2001 |  |    | 2000 | 
|                            |  |              |    |   |      |  |    |      | 
|United States               |  |              | 82 | % |      |  | 72 | %    |  |  | 75 | %
|Europe, principally Germany |  |              | 13 | % |      |  | 22 | %    |  |  | 17 | %
|Asia, principally Japan     |  |              | 5  | % |      |  | 6  | %    |  |  | 8  | %

Operations in various geographical areas are
summarized as follows:

|               |                     |              |   |            |      |  |   |            |  |  |   |            | 
|-------------- | ------------------- | ------------ | - | ---------- | ---- |  | - | ---------- |  |  | - | ---------- | 
|               |                     |             
|               |                     | December 31, |  
|               |                     |              |  
|               |                     | 2002         |   |            | 2001 |  |   | 2000       | 
|               |                     |              |   |            |      |  |   |            | 
|North America: |                     |              |   |            |      |  |   |            |  |  |   |           
|               | Total revenue       |              | $ | 8,203,286  |      |  | $ | 7,100,445  |  |  | $ | 7,176,117  | 
|               | Net loss            |              |   | 21,882,030 |      |  |   | 25,858,000 |  |  |   | 21,050,549 | 
|               | Identifiable assets |              |   | 10,288,624 |      |  |   | 12,726,593 |  |  |   | 15,624,029 | 
|Europe (1):    |                     |              |   |            |      |  |   |            |  |  |   |           
|               | Total Revenue       |              | $ | 1,312,241  |      |  | $ | 2,164,674  |  |  | $ | 1,599,861  | 
|               | Net loss            |              |   | 4,354,189  |      |  |   | 4,458,126  |  |  |   | 1,602,518  | 
|               | Identifiable assets |              |   | 1,383,755  |      |  |   | 3,278,857  |  |  |   | 1,585,115  | 
|Asia:          |                     |              |   |            |      |  |   |            |  |  |   |           
|               | Total revenue       |              | $ | 458,034    |      |  | $ | 554,874    |  |  | $ | 728,913    | 
|               | Net loss            |              |   | 344,614    |      |  |   | 1,883,453  |  |  |   | 1,532,155  | 
|               | Identifiable assets |              |   | 462,992    |      |  |   | 658,868    |  |  |   | 2,035,557  | 



---



|    |                                                                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Included in the Companys operations in
    Europe are $1,634,381, $1,738,676 and $511,596, respectively, in
    expenses related to research and development activities
    conducted by a branch of the Company operating in Germany.

F-21



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



9. Segment and Enterprise Wide Reporting,
continued:


The following table summarizes the number of
customers that individually comprise greater than 10% of total
revenue or total accounts receivable and their aggregate
percentage of the Companys total revenue or total accounts
receivable.

|                     |                                      |                        |  |    |      |  |  |      |   |  |  |    |  
|-------------------- | ------------------------------------ | ---------------------- |  | -- | ---- |  |  | ---- | - |  |  | -- | -
|                     |                                      |                       
|                     |                                      | As of and for the year | 
|                     |                                      | ended December 31,     | 
|                     |                                      |                        | 
|                     |                                      | 2002                   |  |    | 2001 |  |  | 2000 |  
|                     |                                      |                        |  |    |      |  |  |      |  
|Revenue:             |                                      |                        |  |    |      |  |  |      |   |  |  |   
|                     | Number of Customers                  |                        |  | 1  |      |  |  | 2    |   |  |  | 1  |  
|                     | Percent of Total Revenue             |                        |  | 16 | %    |  |  | 30   | % |  |  | 11 | %
|Accounts Receivable: |                                      |                        |  |    |      |  |  |      |   |  |  |   
|                     | Number of Customers                  |                        |  | 2  |      |  |  | 3    |   |  |  | 3  |  
|                     | Percent of Total Accounts Receivable |                        |  | 64 | %    |  |  | 56   | % |  |  | 64 | %

For the years ended December 31, 2002, 2001
and 2000, revenue from the following customers comprised greater
than 10% of total revenue: IBM; the State of Tennessee
Department of Transportation (Tennessee DOT) and
Europart KG; and Cambridge Technologies Partners (MA), Inc.,
respectively. As of December 31, 2002, 2001 and 2000, the
following customers accounts receivable balances comprised
greater than 10% of total accounts receivable: IBM and Tennessee
DOT; IBM, Tennessee DOT and Europart KG; and Federal Express,
Tennessee DOT and Europart KG, respectively.

The Company has contracted with IBM to design,
develop and manufacture certain components of the MA V
product line, including the computer portion and two versions of
FPDs (the Engineering and Inventory Agreement). The
Company has also entered into agreements with IBM under which
IBM purchases MA V and Atigo products from the Company and
markets and sells the systems worldwide to its own customers
(the Sales and Marketing Agreement). During 2002,
2001 and 2000, the Company paid $2,772,457, $4,148,523 and
$2,406,020, respectively, to IBM related to design and
development services and inventory purchases. During 2002 and
2001, the Company recorded revenues of $1,109,743 and $532,675,
respectively, related to sales of MA V and Atigo products
to IBM. Before selecting IBM as its partner for the Engineering
and Inventory Agreement, the Company reviewed IBMs
proposal to provide such services, which included discussion of
the estimated costs to be incurred, IBMs track-record of
bringing new technologies to market, IBMs reputation for
quality and other customary evaluations. The Sales and Marketing
Agreement was reached with similar terms and conditions provided
to other volume resellers of the Companys products. As a
result, the Companys management believes that the
Engineering and Inventory Agreement and the Sales and Marketing
Agreement contain arms-length terms and conditions.

Certain of the end-users of the Companys
wearable computer products are universities and other
not-for-profit entities (collectively, the
End-Users) that purchase these products from a Value
Added Reseller (the VAR) of Xybernaut GmbH. The
Company also contracts with certain of the End-Users to provide
research and development and sales and marketing services to the
Company. The research and development services provided to the
Company include activities such as hardware and software
development, product testing and evaluation. The sales and
marketing services include activities such as Company
participation in and sponsorship of industry trade shows, the
preparation of competitive market analysis and the use of the
End-Users as named reference accounts. During 2002, 2001 and
2000, the Company recorded revenues of approximately $950,000,
$1,700,000, and $750,000, respectively, related to sales of its
products to the VAR. During 2002, 2001 and 2000, the Company
recorded total research and development and sales and marketing
expenses of $1,250,000, $1,250,000 and $50,000, respectively,
related to services performed by the End-Users. The Company
compares the cost of the projects performed by the End-Users
against the cost it would likely incur if it were to obtain
these services from entities other than the End-Users.
Management also evaluates the cost if the Company performed
these services in-house, including expenses that would be
incurred for salary

F-22



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

9. Segment and Enterprise Wide Reporting,
continued:

and benefits, training, travel, supplies and
equipment, and overhead. As a result, the Companys
management believes that the agreements and contracts underlying
both the sale of the products and the performance of the
services contain arms-length terms and conditions.

10. Income Taxes

For the years ended December 31, 2002, 2001
and 2000, no income tax benefit has been provided because the
losses could not be carried back and realization of the benefit
of the net operating losses carried forward was not assured. In
2002, 2001 and 2000, the Company recognized approximately $0,
$34,000 and $46,000, respectively, in income tax expense related
to foreign operations.

At December 31, 2002, the Company had
approximately $116,312,000 and $6,560,000 of net operating loss
carryforwards for U.S. federal and foreign income tax purposes,
respectively. The U.S. losses begin to expire in 2010 and the
losses from foreign operations do not expire. The use of the
U.S. carryforwards may be limited in any one year under Internal
Revenue Code Section 382 if significant ownership changes
occur.

Net deferred tax assets are comprised of the
following:

|                                          |  |                         |             |   |      |   |             |  
|----------------------------------------- |  | ----------------------- | ----------- | - | ---- | - | ----------- | -
|                                          |  |                        
|                                          |  | Year Ended December 31, |            
|                                          |  |                         |            
|                                          |  | 2002                    |             |   | 2001 |  
|                                          |  |                         |             |   |      |  
|Excess of book over tax depreciation      |  | $                       | 860,000     |   |      | $ | 432,000     |  
|Net operating loss carryforwards          |  |                         | 45,726,000  |   |      |   | 37,469,000  |  
|Adjustment to accrual basis of accounting |  |                         |            |   |      |   |            |  
|Accrued expenses and reserves             |  |                         | 443,000     |   |      |   | 382,000     |  
|Tax credit carryforwards                  |  |                         | 63,000      |   |      |   | 63,000      |  
|Foreign tax credits                       |  |                         |            |   |      |   |            |  
|Foreign net operating loss carryforwards  |  |                         | 2,940,000   |   |      |   | 1,704,000   |  
|Foreign other                             |  |                         | 3,000       |   |      |   | 21,000      |  
|Less valuation allowance                  |  |                         | (50,035,000 | ) |      |   | (40,071,000 | )
|                                          |  |                         |             |   |      |  
|Net deferred tax asset                    |  | $                       |            |   |      | $ |            |  

The following table is a reconciliation of the
effective income tax rate at December 31, 2002, 2001 and
2000:

|                                  |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |   |             |   |  |  |        |   
|--------------------------------- |  | ------ | ----------- | - | ------- |  | ------ | ------ |  | - | ----------- | - |  | ------ | ------ | -- | ------- | - | ----------- | - |  |  | ------ | --
|                                  |  |        |             |   |         | 
|                                  |  | 2002   |             |   | 2001    |  |        | 2000   | 
|                                  |  |        |             |   |         |  |        |        | 
|                                  |  | Amount |             |   | Percent |  |        | Amount |  |   | Percent     |   |  | Amount |        |    | Percent |  
|                                  |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  
|Pretax book income (loss)         |  | $      | (25,802,364 | ) |         |  | 0.00   | %      |  | $ | (31,577,061 | ) |  |        | 0.00   | %  |         | $ | (24,152,955 | ) |  |  | 0.00   | % 
|                                  |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  
|Federal, U.S. statutory rate      |  |        | (8,773,000  | ) |         |  | (34.00 | %)     |  |   | (10,736,000 | ) |  |        | (34.00 | %) |         |   | (8,212,000  | ) |  |  | (34.00 | %)
|State, net of federal tax benefit |  |        | (1,022,000  | ) |         |  | (3.96  | %)     |  |   | (1,242,000  | ) |  |        | (3.93  | %) |         |   | (948,000    | ) |  |  | (3.92  | %)
|Valuation allowance               |  |        | 9,964,000   |   |         |  | 38.62  | %      |  |   | 11,402,000  |   |  |        | 36.11  | %  |         |   | 10,668,000  |   |  |  | 44.17  | % 
|Stock options exercised           |  |        |            |   |         |  | 0.00   | %      |  |   | (182,000    | ) |  |        | (0.58  | %) |         |   | (1,554,000  | ) |  |  | (6.43  | %)
|Foreign rate difference           |  |        | (182,000    | ) |         |  | (0.71  | %)     |  |   | 26,000      |   |  |        | 0.08   | %  |         |   | 38,000      |   |  |  | 0.16   | % 
|Other                             |  |        | 13,562      |   |         |  | 0.05   | %      |  |   | 757,840     |   |  |        | 2.40   | %  |         |   | 45,468      |   |  |  | 0.19   | % 
|                                  |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  
|Provision for income taxes        |  | $      | 526         |   |         |  | 0.00   | %      |  | $ | 25,840      |   |  |        | 0.08   | %  |         | $ | 37,468      |   |  |  | 0.16   | % 
|                                  |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  

F-23



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

11. Commitments and
Contingencies

Lease
Commitments

The Company leases operating facilities and
equipment under operating leases expiring on various dates
through 2005. Future minimum payments under noncancelable
operating leases at December 31, 2002 are:

|                         |  |   |         | 
|------------------------ |  | - | ------- | 
|Year Ending December 31, |  |  
|                         |  |  
|2003                     |  | $ | 602,773 | 
|2004                     |  |   | 210,526 | 
|2005                     |  |   | 165,041 | 
|2006                     |  |   |        | 
|2007                     |  |   |        | 
|                         |  |   |        
|                         |  | $ | 978,340 | 
|                         |  |   |        

Total rental expense charged to operations for
the years ended December 31, 2002, 2001 and 2000 was
$820,679, $778,108 and $680,674, respectively.

Inventory
Commitments

At December 31, 2001, the Company had
commitments to purchase inventory, tooling and engineering and
other services from its suppliers and manufacturers related to
its current and future hardware product lines. The Company
expects that it will enter into similar commitments in the
future as it designs, develops and procures future wearable
computer product lines.

Under its original agreements with IBM, the
Company was obligated to purchase certain components of the
MA V system, including 24,000 computing units as well as
various numbers of FPDs and other accessories. The total cost to
the Company of these purchases would have been approximately
$40,000,000. Under the original agreements, the Company had the
right to cancel this purchase commitment by paying a
cancellation fee in an amount of approximately $4,000,000. In
March 2003, the Company entered into an agreement with IBM under
which the Company was released of its obligation to pay the
penalty or procure this inventory other than $4,910,000 in
MA V computing units, FPDs, peripherals and component
parts. The final pricing provided to the Company represents a
discount from the original contractual prices. Under the March
2003 agreement, IBM will ship inventory monthly from March 2003
through December 2003 and the Company will remit payments
monthly from March 2003 through January 2004. IBM Global Finance
is providing a credit facility to the Company which will provide
credit to the Company for purchases of inventory under the March
2003 agreement. In connection with the credit facility, IBM
Global Finance was granted a security interest in certain of the
Companys assets and the Company obtained a letter of
credit from a third party lender for the benefit of IBM Global
Finance in the amount of $375,000, for which the Company posted
an equal amount of restricted cash. This security interest does
not include patents and intellectual property.

In addition to the above obligation to IBM
related to the MA V, the Company has commitments to
purchase computing units, flat panel and head mounted displays,
miscellaneous computing components as well as engineering and
other services from its various vendors related to the
MA V, Atigo, MA TC and future product lines. The
Company believes that, if needed, the timing and amount of many
of these shipments, services and payments may be adjusted
through the payment of cancellation fees, contract negotiations
or the satisfaction of obligations through the issuance of the
Companys equity securities. However, there can be no
assurance that the Company can or will successfully modify these
contracts or commitments.

Excluding the potential impact of contract
modifications, the Company estimates that it will make total
payments of approximately $5,000,000 during 2003 related to
current inventory commitments at the time of this filing, which
amount includes the commitment to purchase the additional
MA V products from IBM

F-24



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



11. Commitments and Contingencies,
continued:


monthly during 2002 discussed above. The Company
expects that it will enter into similar inventory and
engineering commitments in the future as it designs, develops
and procures future wearable computer product lines.

Legal Proceedings

The Company is involved in routine legal and
administrative proceedings and claims of various types. While
any such proceeding or claim contains an element of uncertainty,
management does not expect that they will have a material
adverse effect on the Companys results of operations or
financial position.

12. Related Party Transactions

The Company uses a member of its Board of
Directors as its patent counsel. The Company had expenditures of
$331,112, $421,333 and $174,468 during 2002, 2001 and 2000,
respectively, in legal services payable to this Director. These
amounts represent gross payments made by the Company and the
counsel is responsible for all overhead, professional,
administrative and other expenditures incurred by his law firm.
The law firm bills the Company in accordance with its
established standard billing rates used in the past with its
other clients. During 2002 and 2001, the Company represented the
law firms only significant client. During approximately
half of 2002 and all of 2001 and 2000, the Director also serves
as the Companys processing agent for payments made to
various other domestic and international law firms and agencies
used to file and maintain patents and trademarks. The director
is paid only the amount that is passed through to these other
law firms and agencies and pays administrative services related
to these services. The Company made additional payments of
$274,040, $485,827 and $266,026 during 2002, 2001 and 2000,
respectively, to this Directors law firm related to
services rendered by the Directors law firm as the
Companys processing agent for all foreign patent and
trademark filing and prosecution expenses. The Companys
management believes that the relationship with this law firm is
based on arms-length terms and conditions.

The Company uses a law firm, in which an officer
and member of its Board of Directors is a partner, for services
related to financings, litigation, SEC filings and other general
legal matters. The Company had expenditures of $464,067,
$392,524 and $446,320 during 2002, 2001 and 2000, respectively,
in legal services payable to this law firm.

Two of the Companys former executive
officers were members of the board of directors of a former
customer that purchased software products and consulting
services from the Company. During 2001, this customer was forced
to cease operations when its largest customer withheld payment
for ongoing services. During 2001 and 2000, the Company recorded
revenues on sales to this customer of $29,603 and $573,955,
respectively. As of December 31, 2000, the Company had a
$259,566 accounts receivable balance remaining from this
customer. During 2001, the Company collected $259,333 from this
customer and wrote off the remaining $29,836 balance.

During 2000, Xybernaut GmbH used a company to
provide configuration and technical support services and a
separate company to act as a distributor of the Companys
hardware products. The executive officers of these two companies
are the son and daughter-in-law of one of the Companys
Senior Vice Presidents and member of its Board of Directors.
During 2000, the Company incurred expenses related to the
technical support services totaling $180,456 and recognized
revenue related to distribution sales of its hardware products
totaling $313,843. During 2000, the Company terminated its
relationship with these two companies and established a reserve
of $108,856 against the accounts receivable balance owed by one
of the companies. This balance was written off in 2001.

During 2002, 2001 and 2000, the Company incurred
expenses of $323,163, $315,146 and $412,473, respectively, for
salary and other compensation payable to an Executive Vice
President and the Vice

F-25



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



12. Related Party Transactions,
continued:


Chairman of the Board of Directors of the
Company, who is the brother of the Companys President,
Chief Executive Officer and Chairman of its Board of Directors.
During 2002, 2001 and 2000, the Company incurred expenses of
$305,076, $354,491 and $389,687, respectively, for salary and
other compensation payable to the Companys President,
Chief Executive Officer and Chairman of its Board of Directors.
Prior to her resignation in October 2002, during 2002, 2001 and
2000, the Company incurred expenses of $76,650, $84,886 and
$74,110, respectively, for salary and other compensation payable
to the Vice President for International Affairs, who is the wife
of the Companys President, Chief Executive Officer and
Chairman of its Board of Directors; upon her resignation, this
officer received a four-month severance package. The Company
believes that the salary, benefits and severance package paid to
these employees is commensurate with that which would be paid to
other qualified candidates or employees with similar skills,
experience and tenure. Further, the compensation committee of
the Companys Board of Directors reviews and approves the
salary and benefits provided to the Executive Vice President and
Vice Chairman of the Board of Directors and the President, Chief
Executive Officer and Chairman of its Board of Directors and
also reviewed and approved the severance package provided to the
Vice President of International Affairs.

Between November 2000 and February 2001, the
Company loaned a net balance of $940,188 to the Companys
President, Chief Executive Officer and Chairman of the Board of
Directors. The proceeds were used to prevent a forced sale of a
portion of this officers personal common stock holdings of
the Company that secured a personal margin loan from an
investment bank. The loan was made pursuant to a promissory note
that was secured by shares of the officers personal common
stock holdings of the Company and accrued interest at 8% per
year. On December 31, 2001, the Companys Board of
Directors increased the number of shares securing the loan from
200,000 shares to 250,000 shares, extended the maturity date
from December 31, 2001 to December 31, 2002 and
reduced the interest rate to 6%, reflective of a general decline
in interest rates over this period. On December 17, 2002,
the $1,086,891 in outstanding principal and interest was repaid
in full through the i) transfer by the officer to the
Company of 1,108,343 shares of the Companys common stock
personally held by the officer, which amount includes the shares
that were pledged as collateral, which were valued at $681,631,
and ii) cancellation of all of the officers 742,049
options to purchase shares of the Companys common stock
that had been granted prior to the date of repayment, which were
valued at $405,260. Effective December 31, 2002, the
Company cancelled the 1,108,343 shares of common stock
transferred through this repayment. To determine the fair market
value of the transfer of shares of stock and the cancellation of
stock options, the Company used the market price of the
Companys common stock on the date of repayment and the
Black-Scholes option-pricing model, respectively. The variables
used in the Black-Scholes option-pricing model were as follows:
i) the risk free rate was 3.03%, which was the yield of
5-year Treasury Notes issued November 15, 2002, ii) the
standard deviation of stock return was 131.25%, which was the
volatility of the Companys stock calculated using the end
of the month stock price for the period from January 1,
2000 through December 31, 2002. The outstanding principal
and interest owed by the officer to the Company under this
promissory note totaled $0 and $1,026,708 at December 31,
2002 and 2001, respectively.

13. Business Combination

On April 7, 2000, the Company acquired XSI
for approximately $8,100,000 (the Merger) through
the issuance of 429,327 shares of the Companys common
stock. The Merger was accounted for as a pooling of interests.
Prior to the Merger, there were no material transactions between
Xybernaut and XSI. The Company incurred costs of $621,048
associated with the Merger. These expenses consist of $452,683
in direct costs, including fees for investment banking, legal,
and accounting services, and $168,365 in non-cash charges to
conform certain of XSIs accounting policies to those of
the Company.

F-26



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



13. Business Combination,
continued:


The following information presents certain income
statement data of Xybernaut and XSI for the periods preceding
the Merger:

|          |           |                |   |           |           | 
|--------- | --------- | -------------- | - | --------- | --------- | 
|          |           | For the Three  |  
|          |           | Months Ended   |  
|          |           | March 31, 2000 |  
|          |           |                |  
|Revenue:  |           |                |   |          
|          | Xybernaut |                | $ | 1,498,192 |          
|          | XSI       |                |   | 606,280   |          
|          |           |                |  
|          |           | Total          |   | $         | 2,104,472 | 
|          |           |                |  
|Net Loss: |           |                |   |          
|          | Xybernaut |                | $ | 4,534,762 |          
|          | XSI       |                |   | 240,643   |          
|          |           |                |  
|          |           | Total          |   | $         | 4,775,405 | 
|          |           |                |  

14. Subsequent Events

Subsequent to December 31, 2002, the Company
received gross proceeds of $6,104,167 through a private
placement, a borrowing and exercises of outstanding warrants. In
February 2003, the Company received gross proceeds of $2,000,000
through a private placement of 6,666,667 shares of its common
stock to an investor. The shares were sold at $0.30 per share,
representing an approximate 20% discount to the closing price of
the shares for the trading day immediately preceding the
closing. In connection with this private placement, the Company
issued to the investor callable warrants to purchase 3,333,333
shares of common stock at an exercise price of $1.25 per share.
In March 2003, the Company borrowed $1,750,000 from an investor
pursuant to a one-year promissory note that bears interest at
3.5% per annum. In connection with this borrowing, the Company
issued to the investor warrants to purchase 1,750,000 shares of
common stock at an exercise price of $1.25 per share and
warrants to purchase 2,000,000 shares of common stock at an
exercise price of $0.43 per share. In January 2003, the Company
received gross proceeds of $1,000,000 through the issuance of
3,125,000 shares of its common stock upon the exercise of
outstanding warrants. Concurrently with the exercise of such
warrants, the exercise price was reduced from $1.25 per share to
$0.32 per share. In March 2003, the Company received gross
proceeds of $1,354,167 through the issuance of 5,416,668 shares
of its common stock upon the exercise of outstanding warrants.
Concurrently with the exercise of such warrants, the exercise
price was reduced from $1.25 per share to $0.25 per share.

Under its original agreements with IBM, the
Company was obligated to purchase certain components of the MA V
system, including 24,000 computing units, as well as various
numbers of FPDs and other accessories. The total cost to the
Company of these purchases would have been over approximately
$40,000,000. Under the original agreements, the Company had the
right to cancel this purchase commitment by paying a
cancellation fee in an amount of approximately $4,000,000. In
March 2003, the Company entered into an agreement with IBM under
which the Company was released of its obligation to pay the
penalty or procure this inventory other than $4,910,000 in MA V
computing units, FPDs, peripherals and component parts. The
final pricing provided to the Company represents a discount from
the original contractual prices. Under the March 2003 agreement,
IBM will ship inventory monthly from March 2003 through December
2003 and the Company will remit payments monthly from March 2003
through January 2004. IBM Global Finance is providing a credit
facility to the Company which will provide credit to the Company
for purchases of inventory under the March 2003 agreement. In
connection with this credit facility, IBM Global Finance was
granted a security interest in certain of the Companys
assets and the Company obtained a letter of credit from a third
party lender for the benefit of IBM Global Finance in the amount
of $375,000, for which the

F-27



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Company posted an equal amount of restricted
cash. This security interest does not include patents and
intellectual property.

Quarterly Financial Data (Unaudited)

In managements opinion, the interim
financial data below reflects all adjustments necessary to
fairly state the results of the interim period presented.
Included in the second, third, and fourth quarters of 2002 are
charges related to restructuring of $155,234, $361,227 and
$521,699, respectively. All other adjustments are of a normal
recurring nature necessary for a fair presentation of the
information for the periods presented. Results of any one or
more quarters are not necessarily indicative of annual results
or continuing trends.

XYBERNAUT CORPORATION

Schedule I  Quarterly
Consolidated Financial Data

|                                       |  |                     |            |   |          |   |            |               |  |   |              |   |  |   |            |  
|-------------------------------------- |  | ------------------- | ---------- | - | -------- | - | ---------- | ------------- |  | - | ------------ | - |  | - | ---------- | -
|                                       |  |                    
|                                       |  | 2002 Quarters Ended |           
|                                       |  |                     |           
|                                       |  | March 31,           |            |   | June 30, |   |            | September 30, |  |   | December 31, |  
|                                       |  |                     |            |   |          |   |            |               |  |   |              |  
|Total revenue                          |  | $                   | 2,809,921  |   |          | $ | 2,013,463  |               |  | $ | 2,545,327    |   |  | $ | 2,604,850  |  
|Gross profit                           |  |                     | 686,944    |   |          |   | 382,692    |               |  |   | 206,719      |   |  |   | 22,401     |  
|Net loss                               |  |                     | (8,015,640 | ) |          |   | (6,656,151 | )             |  |   | (7,873,415   | ) |  |   | (4,035,627 | )
|Net loss per share (basic and diluted) |  | $                   | (0.13      | ) |          | $ | (0.10      | )             |  | $ | (0.10        | ) |  | $ | (0.05      | )

|                                       |  |                     |            |   |          |   |            |               |  |   |              |   |  |   |            |  
|-------------------------------------- |  | ------------------- | ---------- | - | -------- | - | ---------- | ------------- |  | - | ------------ | - |  | - | ---------- | -
|                                       |  |                    
|                                       |  | 2001 Quarters Ended |           
|                                       |  |                     |           
|                                       |  | March 31,           |            |   | June 30, |   |            | September 30, |  |   | December 31, |  
|                                       |  |                     |            |   |          |   |            |               |  |   |              |  
|Total revenue                          |  | $                   | 2,275,222  |   |          | $ | 2,021,563  |               |  | $ | 2,316,413    |   |  | $ | 3,206,795  |  
|Gross profit/(loss)                    |  |                     | 570,847    |   |          |   | (557,078   | )             |  |   | 779,282      |   |  |   | 296,558    |  
|Net loss                               |  |                     | (5,936,589 | ) |          |   | (8,453,995 | )             |  |   | (8,073,236   | ) |  |   | (9,735,759 | )
|Net loss per share (basic and diluted) |  | $                   | (0.13      | ) |          | $ | (0.17      | )             |  | $ | (0.15        | ) |  | $ | (0.17      | )

F-28



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

REPORT OF INDEPENDENT CERTIFIED PUBLIC
ACCOUNTANTS

ON SUPPLEMENTAL INFORMATION


To the Board of Directors and 
 Stockholders of Xybernaut Corporation

In connection with our audit of the consolidated
financial statements of Xybernaut Corporation referred to in our
report dated February 13, 2003 which is included in this
Form 10-K, we have also audited Schedule II as of
December 31, 2002 and for each of the three years then ended. In
our opinion, this schedule present fairly, in all material
respects, the information required to be set forth therein.

/s/ Grant Thornton LLP

Vienna, VA

February 13, 2003


F-29



---



##### 



XYBERNAUT CORPORATION

SUPPLEMENTAL FINANCIAL INFORMATION

Schedule II  Valuation and
Qualifying Accounts

|                                           |                             |              |   |            |            |  |   |            |  |         |         |            |   |  |   |            | 
|------------------------------------------ | --------------------------- | ------------ | - | ---------- | ---------- |  | - | ---------- |  | ------- | ------- | ---------- | - |  | - | ---------- | 
|                                           |                             | Balance at   |   |            | Charged to |  |   |            |  | Balance |        
|                                           |                             | Beginning of |   |            | Costs and  |  |   |            |  | at End  |        
|                                           |                             | Year         |   |            | Expenses   |  |   | Write-offs |  |         | of Year |           
|                                           |                             |              |   |            |            |  |   |            |  |         |         |           
|Allowance for accounts receivable          |                             |              |   |            |            |  |   |            |  |         |         |            |   |  |   |           
|                                           | Year ended December 31,2002 |              | $ | 213,434    |            |  | $ | 128,250    |  |         | $       | (138,773   | ) |  | $ | 202,911    | 
|                                           | Year ended December 31,2001 |              | $ | 129,355    |            |  | $ | 335,396    |  |         | $       | (251,317   | ) |  | $ | 213,434    | 
|                                           | Year ended December 31,2000 |              | $ | 140,968    |            |  | $ | 59,120     |  |         | $       | (70,733    | ) |  | $ | 129,355    | 
|Reserve for inventory                      |                             |              |   |            |            |  |   |            |  |         |         |            |   |  |   |           
|                                           | Year ended December 31,2002 |              | $ | 141,280    |            |  | $ |           |  |         | $       | (141,280   | ) |  | $ |           | 
|                                           | Year ended December 31,2001 |              | $ | 1,370,000  |            |  | $ | 944,214    |  |         | $       | (2,172,934 | ) |  | $ | 141,280    | 
|                                           | Year ended December 31,2000 |              | $ | 120,000    |            |  | $ | 1,250,000  |  |         | $       |           |   |  | $ | 1,370,000  | 
|Reserve for tooling costs                  |                             |              |   |            |            |  |   |            |  |         |         |            |   |  |   |           
|                                           | Year ended December 31,2002 |              | $ |           |            |  | $ | 299,077    |  |         | $       | (49,077    | ) |  | $ | 250,000    | 
|                                           | Year ended December 31,2001 |              | $ | 250,000    |            |  | $ | 139,145    |  |         | $       | (389,145   | ) |  | $ |           | 
|                                           | Year ended December 31,2000 |              | $ |           |            |  | $ | 250,000    |  |         | $       |           |   |  | $ | 250,000    | 
|Valuation allowance for deferred tax asset |                             |              |   |            |            |  |   |            |  |         |         |            |   |  |   |           
|                                           | Year ended December 31,2002 |              | $ | 40,071,000 |            |  | $ | 9,964,000  |  |         | $       |           |   |  | $ | 50,035,000 | 
|                                           | Year ended December 31,2001 |              | $ | 28,495,000 |            |  | $ | 11,576,000 |  |         | $       |           |   |  | $ | 40,071,000 | 
|                                           | Year ended December 31,2000 |              | $ | 17,827,000 |            |  | $ | 10,668,000 |  |         | $       |           |   |  | $ | 28,495,000 | 

F-30



---



##### 





|        |                                                                                              
|------- | ---------------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial
    Disclosure.

None.

PART III

Items 10 through 13 will be filed pursuant to a
definitive proxy statement or an amendment to this
Form 10-K.



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

Within the 90 days 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
and Chief Financial Officer, of the effectiveness of the design
and operation of the Companys disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. Based upon that
evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that the design and execution of the
Companys disclosure controls and procedures is effective.
There were no significant changes in the Companys internal
controls or in other factors that could significantly affect
these controls subsequent to the date of their evaluation.



|         |                                           
|-------- | ------------------------------------------
|Item 15. | Principal Accountant Fees and
    Services

The Company and its subsidiaries did not engage
Grant Thornton LLP to provide advice regarding financial
information systems design or implementation, consulting
services or other non-audit services, except as discussed below
for tax-related services, during the fiscal year ended December
31, 2002, or December 31, 2001. Non-audit services
performed by the Companys auditor have been approved by
the Companys Audit Committee on a case by case basis. In
connection with the standards for independence of the
Companys independent public accountants promulgated by the
Securities and Exchange Commission, the Audit Committee would
consider whether the provision of such non-audit services would
be compatible with maintaining the independence of Grant
Thornton. During the year ended December 31, 2002, Grant
Thornton LLP provided the Company with tax related services for
which fees totaling $70,390 were billed to the Company. Such
services included preparation of the Companys federal and
state income tax returns, consultations related to state and
local tax returns and the tax effects of stock compensation.

Audit Fees

During the Companys fiscal year ended
December 31, 2002 and 2001, respectively, Grant Thornton
LLPs fees for audit and audited related services were as
follows:

|                                                                                |  |   |         | 
|------------------------------------------------------------------------------- |  | - | ------- | 
|Audit fees, including review of quarterly
    financial statements on Form 10-Q |  | $ | 119,000 | 
|Audit related fee                                                               |  | $ | 53,112  | 

Audit related fees result from services rendered
in connection with rendering consents for periodic registration
statements as a result of several private placement transactions
in 2002, consultations on the application of general accepted
accounting principles and newly issued accounting
pronouncements, statutory audits of foreign subsidiary financial
statements, consultations on the impact of the Sarbanes Oxley
Act to the Company and periodic meetings with the Companys
Audit Committee.

PART IV



|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 16. | Exhibits, Financial Statement Schedules and
    Reports on Form 8-K.

| |     |  |  |   |  |                                                                                        |  |  |     | 
| | --- |  |  | - |  | -------------------------------------------------------------------------------------- |  |  | --- | 
| | 1.1 |  |  |  |  | Form of Financial Consulting Agreement between
    the Company and the Representative. |  |  | (1) | 

40



---



##### 



| |      |  |  |   |  |                                                                                                                                                                                                                   |  |  |      | 
| | ---- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- | 
| | 2    |  |  |  |  | Form of Agreement and Plan of Merger by and among
    Xybernaut, Selfware, Subsidiary and certain shareholders of
    Selfware.                                                                                   |  |  | (10) | 
| | 3.1  |  |  |  |  | Certificate of Incorporation of the Company, as
    Amended.                                                                                                                                                      |  |  | (5)  | 
| | 3.2  |  |  |  |  | Bylaws of the Company (as Amended on
    September 24, 1998).                                                                                                                                                     |  |  | (5)  | 
| | 3.3  |  |  |  |  | Certificate of Designation of the Series D
    Preferred Stock.                                                                                                                                                   |  |  | (6)  | 
| | 3.4  |  |  |  |  | Certificate of Designation of the Series E
    Preferred Stock.                                                                                                                                                   |  |  | (7)  | 
| | 3.5  |  |  |  |  | Form of Amendment to Article Fourth to the
    Companys Certificate of Incorporation.                                                                                                                            |  |  | (24) | 
| | 4.1  |  |  |  |  | Warrant Exercise Fee Agreement.                                                                                                                                                                                   |  |  | (1)  | 
| | 4.2  |  |  |  |  | Form of Forfeiture Escrow.                                                                                                                                                                                        |  |  | (1)  | 
| | 4.3  |  |  |  |  | Form of specimen certificate for Units.                                                                                                                                                                           |  |  | (1)  | 
| | 4.4  |  |  |  |  | Form of specimen certificate for Common Stock.                                                                                                                                                                    |  |  | (1)  | 
| | 4.5  |  |  |  |  | Form of Warrant.                                                                                                                                                                                                  |  |  | (2)  | 
| | 4.6  |  |  |  |  | Form of Securities Purchase Agreement for
    Series D Preferred Stock.                                                                                                                                           |  |  | (6)  | 
| | 4.7  |  |  |  |  | Form of Warrant in connection with the placement
    of Series D Preferred Stock.                                                                                                                                 |  |  | (6)  | 
| | 4.8  |  |  |  |  | Form of Securities Purchase Agreement for
    Series E Preferred Stock.                                                                                                                                           |  |  | (7)  | 
| | 4.9  |  |  |  |  | Form of Warrant in connection with the placement
    of Series E Preferred Stock.                                                                                                                                 |  |  | (7)  | 
| | 4.10 |  |  |  |  | Warrant issued in connection with the October
    1999 Bridge Loan Financing.                                                                                                                                     |  |  | (13) | 
| | 4.11 |  |  |  |  | Form of Warrant issued to Crystalite Investments,
    Ltd.                                                                                                                                                        |  |  | (9)  | 
| | 4.12 |  |  |  |  | Form of Warrant issued to International Business
    Solutions, Inc.                                                                                                                                              |  |  | (9)  | 
| | 4.13 |  |  |  |  | Form of Warrant issued to E. Dell Smith.                                                                                                                                                                          |  |  | (9)  | 
| | 4.14 |  |  |  |  | Form of Warrant issued to Christina S. Kohlhaas.                                                                                                                                                                  |  |  | (9)  | 
| | 4.15 |  |  |  |  | Form of Warrant issued to E. Dell Smith.                                                                                                                                                                          |  |  | (9)  | 
| | 4.16 |  |  |  |  | Form of Registration Rights Agreement by and
    among Xybernaut and Selfware Stockholders.                                                                                                                       |  |  | (10) | 
| | 4.17 |  |  |  |  | Form of Warrant issued to Dalston Holdings
    Limited.                                                                                                                                                           |  |  | (14) | 
| | 4.18 |  |  |  |  | Form of Warrant issued to Archway Holdings
    Limited.                                                                                                                                                           |  |  | (12) | 
| | 4.19 |  |  |  |  | Form of Warrant issued in connection with the
    November 2000 private placement.                                                                                                                                |  |  | (12) | 
| | 4.20 |  |  |  |  | Form of Common stock Purchase Agreement dated
    September 29, 2000.                                                                                                                                             |  |  | (12) | 
| | 4.21 |  |  |  |  | Form of Common stock and Warrant Purchase
    Agreement dated as of Nov. 2000 private placement.                                                                                                                  |  |  | (12) | 
| | 4.22 |  |  |  |  | Form of Registration Rights Agreement in
    connection with November 2000 private placement.                                                                                                                     |  |  | (12) | 
| | 4.23 |  |  |  |  | Form of Warrant issued to Archway Holdings
    Limited.                                                                                                                                                           |  |  | (17) | 
| | 4.24 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of April 19, 2001, between Archway
    Holdings Limited and Xybernaut Corporation.                                                              |  |  | (17) | 
| | 4.25 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of April 19, 2001, between Archway Holdings Limited and
    Xybernaut Corporation.                                                                            |  |  | (17) | 
| | 4.26 |  |  |  |  | Form of Warrant issued to Cranshire Capital,
    L.P., Euram Cap Strat. A Fund Limited, The dotCom
    Fund, LLC, Alpha Capital Aktiengesellschaft, Vertical Ventures,
    LLC and Atlas Capital Services, Inc. |  |  | (17) | 
| | 4.27 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of May 4, 2001, among Xybernaut
    Corporation, Cranshire Capital, L.P., Euram Cap Strat.
    A Fund Limited and The dotCom Fund, LLC.       |  |  | (17) | 
| | 4.28 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of May 4, 2001, among Xybernaut Corporation, Cranshire
    Capital, L.P., Euram Cap Strat. A Fund Limited and
    The dotCom Fund, LLC.                     |  |  | (17) | 
| | 4.29 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of May 4, 2001, between Alpha Capital
    Aktiengesellschaft and Xybernaut Corporation.                                                         |  |  | (17) | 
| | 4.30 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of May 4, 2001, between Alpha Capital Aktiengesellschaft
    and Xybernaut Corporation.                                                                       |  |  | (17) | 
| | 4.31 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of May 4, 2001, between Vertical
    Ventures, LLC and Xybernaut Corporation.                                                                   |  |  | (17) | 
| | 4.32 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of May 4, 2001, between Vertical Ventures, LLC and
    Xybernaut Corporation.                                                                                 |  |  | (17) | 

41



---



##### 



| |      |  |  |   |  |                                                                                                                                                                                                                              |  |  |      | 
| | ---- |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- | 
| | 4.33 |  |  |  |  | Form of Agreement, dated May 1, 2001,
    between Atlas Capital Services, Inc. and Xybernaut Corporation.                                                                                                                    |  |  | (17) | 
| | 4.34 |  |  |  |  | Form of Warrant issued to Eva Holdings Limited.                                                                                                                                                                              |  |  | (18) | 
| | 4.35 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of June 30, 2001, between Eva Holdings
    Limited and Xybernaut Corporation.                                                                              |  |  | (18) | 
| | 4.36 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of June 30, 2001, between Eva Holdings Limited and
    Xybernaut Corporation.                                                                                            |  |  | (18) | 
| | 4.37 |  |  |  |  | Form of Warrant issued to DaVinci International
    Limited.                                                                                                                                                                 |  |  | (18) | 
| | 4.38 |  |  |  |  | Form of Warrant issued to Texas Instruments
    Incorporated.                                                                                                                                                                |  |  | (18) | 
| | 4.39 |  |  |  |  | Form of Warrant issued to Holly Investments
    Limited.                                                                                                                                                                     |  |  | (19) | 
| | 4.40 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 15, 2001, between Holly
    Investments Limited and Xybernaut Corporation.                                                                     |  |  | (19) | 
| | 4.41 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 15, 2001, between Holly Investments Limited and
    Xybernaut Corporation.                                                                                   |  |  | (19) | 
| | 4.42 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 15, 2001, among Cranshire
    Capital, L.P., Euram Cap Strat. A Fund Limited and
    Xybernaut Corporation.                                  |  |  | (19) | 
| | 4.43 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 15, 2001, among Cranshire Capital, L.P., Euram
    Cap Strat. A Fund Limited and Xybernaut Corporation.                                                    |  |  | (19) | 
| | 4.44 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 15, 2001, among Cleveland
    Overseas Ltd., ZLP Master Technology Fund, Ltd., Vertical
    Ventures Ltd. And Xybernaut Corporation.           |  |  | (19) | 
| | 4.45 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 15, 2001, among Cleveland Overseas Ltd., ZLP
    Master Technology Fund, Ltd., Vertical Ventures Ltd. and
    Xybernaut Corporation.                         |  |  | (19) | 
| | 4.46 |  |  |  |  | Form of Warrant issued to each of Cranshire
    Capital, L.P., Euram Cap Strat. A Fund Limited,
    Cleveland Overseas Ltd., ZLP Master Technology Fund, Ltd.,
    Vertical Ventures Ltd. and Atlas Capital Services, LLC. |  |  | (19) | 
| | 4.47 |  |  |  |  | Agreement, dated November 15, 2001, between
    Atlas Capital Services, LLC and Xybernaut Corporation.                                                                                                                       |  |  | (19) | 
| | 4.48 |  |  |  |  | Agreement for Payment of Account, dated
    November 27, 2001, between frog werk, Inc. and Xybernaut
    Corporation.                                                                                                        |  |  | (19) | 
| | 4.49 |  |  |  |  | Form of Warrant issued to Yeshuah Investments
    Limited.                                                                                                                                                                   |  |  | (20) | 
| | 4.50 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of March 13, 2002, between Yeshuah
    Investments Limited and Xybernaut Corporation.                                                                      |  |  | (20) | 
| | 4.51 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of March 13, 2002, between Yeshuah Investments Limited and
    Xybernaut Corporation.                                                                                    |  |  | (20) | 
| | 4.52 |  |  |  |  | Form of Warrant issued to Alpha Capital
    Aktiengesellschaft.                                                                                                                                                              |  |  | (20) | 
| | 4.53 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of March 13, 2002, between Xybernaut
    Corporation and Alpha Capital Aktiengesellschaft.                                                                 |  |  | (20) | 
| | 4.54 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of March 13, 2002, between Xybernaut Corporation and Alpha
    Capital Aktiengesellschaft.                                                                               |  |  | (20) | 
| | 4.55 |  |  |  |  | Form of Warrant issued to Cranshire Capital, L.P.                                                                                                                                                                            |  |  | (20) | 
| | 4.56 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of March 13, 2002, between Xybernaut
    Corporation and Cranshire Capital, L.P.                                                                           |  |  | (20) | 
| | 4.57 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of March 13, 2002, between Xybernaut Corporation and
    Cranshire Capital, L.P.                                                                                         |  |  | (20) | 
| | 4.58 |  |  |  |  | Form of Letter Agreement, dated as of
    January 1, 2002 between IBS Technologies LLC and Xybernaut
    Corporation.                                                                                                        |  |  | (20) | 
| | 4.59 |  |  |  |  | Form of Agreement for Payment of Account, dated
    March 20, 2002, between Zykronix, Inc. and Xybernaut
    Corporation.                                                                                                    |  |  | (20) | 
| | 4.60 |  |  |  |  | Form of Warrant issued to Alpha Capital
    Aktiengesellschaft.                                                                                                                                                              |  |  | (21) | 
| | 4.61 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of June 30, 2002, between Alpha Capital
    Aktiengesellschaft and Xybernaut Corporation.                                                                  |  |  | (21) | 

42



---



##### 



| |      |  |  |   |  |                                                                                                                                                        |  |  |      | 
| | ---- |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------ |  |  | ---- | 
| | 4.62 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of June 30, 2002, between Alpha Capital Aktiengesellschaft
    and Xybernaut Corporation.          |  |  | (21) | 
| | 4.63 |  |  |  |  | Form of Warrant issued to Rema Investments
    Limited.                                                                                                |  |  | (21) | 
| | 4.64 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of June 30, 2002, between Xybernaut
    Corporation and Rema Investments Limited.    |  |  | (21) | 
| | 4.65 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of June 30, 2002, between Xybernaut Corporation and Rema
    Investments Limited.                  |  |  | (21) | 
| | 4.66 |  |  |  |  | Form of Consulting Agreement, dated as of
    June 30, 2002, between Xybernaut Corporation and Libra
    Finance, S.A.                                 |  |  | (21) | 
| | 4.67 |  |  |  |  | Form of Consulting Agreement, dated as of
    June 30, 2002, between Xybernaut Corporation and Dune
    Holdings Ltd.                                  |  |  | (21) | 
| | 4.68 |  |  |  |  | Form of Warrant issued to each of Yeshuah
    Investments Limited, Holly Investments Limited and Eva Holdings
    Limited.                             |  |  | (21) | 
| | 4.69 |  |  |  |  | Form of Agreement for Payment of Account, dated
    June 4, 2002, between Carlton R. Turner and Xybernaut
    Corporation.                             |  |  | (21) | 
| | 4.70 |  |  |  |  | Form of Sponsorship Agreement, dated May 1,
    2002, between Alex Job Racing, Inc. and Xybernaut Corporation.                                         |  |  | (21) | 
| | 4.71 |  |  |  |  | Form of Agreement for Payment of Account, dated
    June 24, 2002, between Fathom Creative, Inc. and Xybernaut
    Corporation.                        |  |  | (21) | 
| | 4.72 |  |  |  |  | Form of Warrant issued to Rewell Holdings, Ltd.                                                                                                        |  |  | (22) | 
| | 4.73 |  |  |  |  | Form of Warrant issued to Rewell Holdings, Ltd.                                                                                                        |  |  | (22) | 
| | 4.74 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of August 29, 2002, between Rewell
    Holdings, Ltd. and Xybernaut Corporation.     |  |  | (22) | 
| | 4.75 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of August 29, 2002, between Rewell Holdings, Ltd. and
    Xybernaut Corporation.                   |  |  | (22) | 
| | 4.76 |  |  |  |  | Form of Warrant issued to Sundale Corporation.                                                                                                         |  |  | (22) | 
| | 4.77 |  |  |  |  | Form of Warrant issued to Sundale Corporation.                                                                                                         |  |  | (22) | 
| | 4.78 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of August 29, 2002, between Sundale
    Corporation and Xybernaut Corporation.       |  |  | (22) | 
| | 4.79 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of August 29, 2002, between Sundale Corporation and
    Xybernaut Corporation.                     |  |  | (22) | 
| | 4.80 |  |  |  |  | Form of Separation Agreement, dated as of
    August 1, 2002, between Xybernaut GmbH, Xybernaut
    Corporation and Mr. Daniel J. Butler.              |  |  | (22) | 
| | 4.81 |  |  |  |  | Form of Warrant issued to Greta Holdings, Ltd.                                                                                                         |  |  | (23) | 
| | 4.82 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between Greta
    Holdings, Ltd. and Xybernaut Corporation.     |  |  | (23) | 
| | 4.83 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between Greta Holdings, Ltd. and
    Xybernaut Corporation.                  |  |  | (23) | 
| | 4.84 |  |  |  |  | Form of Warrant issued to Reno Holdings, Ltd.                                                                                                          |  |  | (23) | 
| | 4.85 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between Reno
    Holdings, Ltd. and Xybernaut Corporation.      |  |  | (23) | 
| | 4.86 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between Reno Holdings, Ltd. and
    Xybernaut Corporation.                   |  |  | (23) | 
| | 4.87 |  |  |  |  | Form of Warrant issued to State Street
    Corporation.                                                                                                |  |  | (23) | 
| | 4.88 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between State
    Street Corporation and Xybernaut Corporation. |  |  | (23) | 
| | 4.89 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between State Street Corporation and
    Xybernaut Corporation.              |  |  | (23) | 
| | 4.90 |  |  |  |  | Form of Warrant issued to Company Management Ltd.                                                                                                      |  |  | (23) | 
| | 4.91 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between Company
    Management Ltd. and Xybernaut Corporation.  |  |  | (23) | 
| | 4.92 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between Company Management Ltd. and
    Xybernaut Corporation.               |  |  | (23) | 
| | 4.93 |  |  |  |  | Form of Service Agreement, dated as of
    September 10, 2002, by and between Elite Financial
    Communications Group, LLC and Xybernaut Corporation. |  |  | (23) | 

43



---



##### 



| |       |  |  |   |  |                                                                                                                                                 |  |  |      | 
| | ----- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- | 
| | 4.94  |  |  |  |  | Form of Letter Agreement, dated August 7,
    2002, by and between James J. Ralabate and Xybernaut Corporation.                                 |  |  | (23) | 
| | 10.1  |  |  |  |  | December 31, 1994 Acquisition Agreement
    between the Company and Tech Virginia.                                                              |  |  | (1)  | 
| | 10.2  |  |  |  |  | Form of Indemnification Agreement to be entered
    into between the Company and each officer and director of the
    Company.                  |  |  | (1)  | 
| | 10.3  |  |  |  |  | Form of Employment Agreement between the Company
    and Edward G. Newman.                                                                      |  |  | (13) | 
| | 10.4  |  |  |  |  | Form of Employment Agreement between the Company
    and Steven A. Newman.                                                                      |  |  | (13) | 
| | 10.5  |  |  |  |  | Form of Employment Agreement between the Company
    and Eugene Amobi.                                                                          |  |  | (16) | 
| | 10.6  |  |  |  |  | November 30, 1994 Lease Agreement between
    Hyatt Plaza Limited Partnership and the Company.                                                  |  |  | (1)  | 
| | 10.7  |  |  |  |  | October 27, 1994 Residential Deed of Lease
    between the Company and Frank E. and Heather H. Moxley.                                          |  |  | (1)  | 
| | 10.8  |  |  |  |  | 1996 Omnibus Stock Incentive Plan.                                                                                                              |  |  | (1)  | 
| | 10.9  |  |  |  |  | 1997 Omnibus Stock Incentive Plan. (2)                                                                                                          |  |  |      | 
| | 10.10 |  |  |  |  | Multicosm Ltd. Software Licensing Agreement. (1)                                                                                                |  |  |      | 
| | 10.11 |  |  |  |  | Business Loan Agreement, Promissory Note and
    Commercial Security Agreement by and Between Fairfax Bank &
    Trust Company and the Company. |  |  | (1)  | 
| | 10.12 |  |  |  |  | December 10, 1996 Lease Agreement between
    Autumnwood Apartments and the Company.                                                            |  |  | (3)  | 
| | 10.13 |  |  |  |  | First Amendment to Office Lease Agreement between
    Hyatt Plaza Limited Ptr. and the Company.                                                 |  |  | (4)  | 
| | 10.14 |  |  |  |  | December 5, 2000 Lease Agreement between the
    Company and American Management Systems Inc.                                                   |  |  | (16) | 
| | 10.15 |  |  |  |  | Form of Exclusive Licensing Agreement between
    Data DiskTechnology, Inc. and the Company.                                                    |  |  | (4)  | 
| | 10.16 |  |  |  |  | Form of Exclusive Licensing Agreement between SBS
    Vertrieb GmbH and the Company.                                                            |  |  | (4)  | 
| | 10.17 |  |  |  |  | Form of Software Distribution Agreement between
    Multicosm LTD and the Company.                                                              |  |  | (4)  | 
| | 10.18 |  |  |  |  | First Amendment to Office Lease Agreement between
    Hyatt Plaza Limited Partnership and Tech International of
    Virginia, L.L.C.            |  |  | (4)  | 
| | 10.19 |  |  |  |  | Second Amendment to Storage Space Lease Agreement
    between Hyatt Plaza Limited Ptr. and the Company.                                         |  |  | (5)  | 
| | 10.20 |  |  |  |  | Second Amendment to Office Lease Agreement
    between Hyatt Plaza Limited Ptr. and the Company.                                                |  |  | (5)  | 
| | 10.21 |  |  |  |  | Third Amendment to Office Lease Agreement between
    Hyatt Plaza Limited Ptr. and the Company.                                                 |  |  | (5)  | 
| | 10.22 |  |  |  |  | Form of Registration Rights Agreement in
    connection with the placement of Series D Preferred Stock.                                         |  |  | (6)  | 
| | 10.23 |  |  |  |  | Form of Escrow Agreement in connection with the
    placement of Series D Preferred Stock.                                                      |  |  | (6)  | 
| | 10.24 |  |  |  |  | Form of finders agreement in connection
    with the placement of Series D Preferred Stock.                                                    |  |  | (6)  | 
| | 10.25 |  |  |  |  | Form of Registration Rights Agreement in
    connection with the placement of Series E Preferred Stock.                                         |  |  | (7)  | 
| | 10.26 |  |  |  |  | Form of Escrow Agreement in connection with the
    placement of Series E Preferred Stock.                                                      |  |  | (7)  | 
| | 10.27 |  |  |  |  | Form of finders agreement in connection
    with the placement of Series E Preferred Stock.                                                    |  |  | (7)  | 
| | 10.28 |  |  |  |  | Purchase Agreement dated as of November 19,
    1999.                                                                                           |  |  | (13) | 
| | 10.29 |  |  |  |  | Registration Rights Agreement dated
    November 19, 1999.                                                                                      |  |  | (13) | 
| | 10.30 |  |  |  |  | Escrow Agreement dated as of November 19,
    1999.                                                                                             |  |  | (13) | 
| | 10.31 |  |  |  |  | 1999 Stock Incentive Plan.                                                                                                                      |  |  | (8)  | 
| | 10.32 |  |  |  |  | 2000 Stock Incentive Plan.                                                                                                                      |  |  | (15) | 
| | 10.33 |  |  |  |  | Form of Restated Bridge Loan Financing Agreement
    dated October 18, 1999.                                                                    |  |  | (11) | 
| | 10.34 |  |  |  |  | Form of Employment Agreement between the Company
    and John F. Moynahan.                                                                      |  |  | (11) | 

44



---



##### 



| |       |  |  |   |  |                                                                                                                                            |  |  |      | 
| | ----- |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------ |  |  | ---- | 
| | 10.35 |  |  |  |  | Form of Purchase Agreement dated as of
    November 19, 1999.                                                                              |  |  | (11) | 
| | 10.36 |  |  |  |  | Form of Restated Bridge Financing Agreement dated
    as of October 18, 1999, restated as of December 30,
    1999.                        |  |  | (11) | 
| | 10.37 |  |  |  |  | Form of Common Stock Purchase Agreement dated as
    of January 3, 2000.                                                                   |  |  | (9)  | 
| | 10.38 |  |  |  |  | Form of Registration Rights Agreement dated as of
    November 19, 1999.                                                                   |  |  | (11) | 
| | 10.39 |  |  |  |  | Form of Escrow Agreement dated as of
    November 19, 1999.                                                                                |  |  | (11) | 
| | 10.40 |  |  |  |  | Agreement and Plan of Merger dated as of
    April 7, 2000.                                                                                |  |  | (10) | 
| | 10.41 |  |  |  |  | Registration Rights Agreement dated as of
    April 7, 2000.                                                                               |  |  | (10) | 
| | 10.42 |  |  |  |  | Form of Common Stock Purchase Agreement dated as
    of June 23, 2000.                                                                     |  |  | (14) | 
| | 10.43 |  |  |  |  | Form of Amended and Restated Agreement for
    Wholesale Financing (Security Agreement).                                                   |  |  | (24) | 
| | 10.44 |  |  |  |  | Form of Addendum to Agreement for Wholesale
    Financing Flexible Payment Plan.                                                           |  |  | (24) | 
| | 10.45 |  |  |  |  | Form of Exhibit A (FPP
    Exhibit A) to Addendum to Agreement for Wholesale
    Financing1 Flexible Payment Plan (FPP
    Addendum). |  |  | (24) | 
| | 10.46 |  |  |  |  | Form of Promissory Note.                                                                                                                   |  |  | (24) | 
| | 10.47 |  |  |  |  | Form of Pledge Agreement.                                                                                                                  |  |  | (24) | 
| | 10.48 |  |  |  |  | Form of Employment Agreement between the Company
    and Thomas D. Davis.                                                                  |  |  | *    | 
| | 16    |  |  |  |  | Letter on Change in Certifying Accountant.                                                                                                 |  |  | (10) | 
| | 23.1  |  |  |  |  | Consent of Grant Thornton LLP.                                                                                                             |  |  | *    | 
| | 99.1  |  |  |  |  | Sarbanes-Oxley Act of 2002 Certifications                                                                                                  |  |  | *    | 




|    |                                                                                                                                                  
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to the Companys
    Registration Statement on Form SB-2, No. 333-4156,
    filed on July 15, 1996.                    
|   
|(2) | Incorporated by reference to the Amendment to the
    Companys Registration Statement on Form SB-2,
    No. 333-65123, filed on October 30, 1998
|   
|(3) | Incorporated by reference to the Companys
    1996 Annual Report on Form 10-KSB, No. 0-15086, filed
    on March 3, 1997.                       
|   
|(4) | Incorporated by reference to the Companys
    1997 Annual Report on Form 10-KSB, No. 0-15086, filed
    on March 3, 1998.                       
|   
|(5) | Incorporated by reference to the Companys
    1998 Annual Report on Form 10-KSB, No. 0-15086, filed
    on April 15, 1999.                      
|   
|(6) | Incorporated by reference to the Registration
    Statement on Form S-3, as amended, file No. 333-77769,
    filed on May 4, 1999.               
|   
|(7) | Incorporated by reference to the Registration
    Statement on Form S-3, as amended, file No. 333-80837,
    filed on June 16, 1999.             
|   
|(8) | Incorporated by reference to the Registration
    Statement on Form S-8, file No. 333-94463, filed on
    January 12, 2000.                      
|   
|(9) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-33940 filed on
    April 4, 2000.                          



|     |                                                                                                                                                                                                                        
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the report on
    Form 8-K, file No. 000-21013, filed on April 18,
    2000.                                                                                                              
|    
|(11) | Incorporated by reference to the report on
    Form 10-KSB, No. 000-21013, filed on April 21,
    2000.                                                                                                                
|    
|(12) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-51974, filed on
    December 15, 2000.                                                                                           
|    
|(13) | Incorporated by reference to the Companys
    1999 Annual Report on Form 10KSB No. 000-21013, filed
    on March 17, 2000.                                                                                            
|    
|(14) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-40996, filed on
    July 7, 2000.                                                                                                
|    
|(15) | Incorporated by reference to the
    registrants Definitive Proxy Statement on
    Schedule 14A, as filed with the Securities and Exchange
    Commission on September 29, 2000, and annexed as
    Exhibit A thereto.
|    
|(16) | Incorporated by reference to the report on
    Form 10-K, No. 000-21013, filed on March 9, 2001.                                                                                                                       

45



---



##### 





|     |                                                                                                                             
|---- | ----------------------------------------------------------------------------------------------------------------------------
|(17) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-60556, filed on
    May 9, 2001.      
|    
|(18) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-68832, filed on
    August 31, 2001.  
|    
|(19) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-74182, filed on
    November 29, 2001.
|    
|(20) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-85188, filed on
    March 29, 2002    
|    
|(21) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-92348, filed on
    July 12, 2002     
|    
|(22) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-99041, filed on
    August 20, 2002   
|    
|(23) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-101257, filed on
    November 15, 2002
|    
|(24) | Incorporated by reference to the report on
    Form 10-K, No. 000-21013, filed on March 28, 2002.                           



|  |                
|- | ---------------
|* | Filed Herewith.

REPORTS ON FORM
8-K

The Company has not filed any Report on
Form 8-K during the last quarter of fiscal year 2002.

46



---



##### 



SIGNATURES

Pursuant to the requirements of the Securities
Exchange Act of 1934, the registrant has duly caused this report
to be signed on its behalf by the undersigned thereunto duly
authorized.



| |                      
| | ---------------------
| | XYBERNAUT CORPORATION



| |     |                     
| | --- | --------------------
| | By: | /s/ EDWARD G. NEWMAN

| |                                           
| | ------------------------------------------
| |                                           
| | Edward G. Newman                          
| | President, Chief Executive Officer
    and
| | Chairman of the Board of Directors        



| |     |                    
| | --- | -------------------
| | By: | /s/ THOMAS D. DAVIS

| |                          
| | -------------------------
| |                          
| | Thomas D. Davis          
| | Senior Vice President and
| | Chief Financial Officer  

Date: March 27, 2003

In accordance with the Securities Exchange Act of
1934, this report has been signed below by the following persons
on behalf of the Company and the capacities and on the dates
indicated.

|                                              |  |                                                                               |  |               
|--------------------------------------------- |  | ----------------------------------------------------------------------------- |  | --------------
|Signature                                     |  | Title                                                                         |  | Date          
|                                              |  |                                                                               |  |               
|/s/ EDWARD G. NEWMANEdward G. Newman          |  | President, Chief Executive Officer and Chairman
    of the Board of Directors |  | March 27, 2003
|                                             
|/s/ STEVEN A. NEWMANSteven A. Newman          |  | Executive Vice President and Vice Chairman of the
    Board of Directors      |  | March 27, 2003
|                                             
|/s/ KAZUYUKI TOYOSATOKaz Toyosato             |  | Executive Vice President and Director                                         |  | March 27, 2003
|                                             
|/s/ THOMAS D. DAVISThomas D. Davis            |  | Senior Vice President and Chief Financial Officer                             |  | March 27, 2003
|                                             
|/s/ EDWIN VOGTEdwin Vogt                      |  | Senior Vice President and Director                                            |  | March 27, 2003
|                                             
|/s/ EUGENE J. AMOBIEugene J. Amobi            |  | Vice President and Director                                                   |  | March 27, 2003
|                                             
|/s/ MARTIN ERIC WEISBERGMartin Eric Weisberg  |  | Secretary and Director                                                        |  | March 27, 2003
|                                             
|/s/ JAMES S. GILMORE IIIJames S. Gilmore, III |  | Director                                                                      |  | March 27, 2003
|                                             
|/s/ MARC GINSBERGMarc Ginsberg                |  | Director                                                                      |  | March 27, 2003

47



---



##### 



|                                                       |  |          |  |               
|------------------------------------------------------ |  | -------- |  | --------------
|Signature                                              |  | Title    |  | Date          
|                                                       |  |          |  |               
|                                                      
|/s/ PHILLIP E. PEARCEPhillip E. Pearce                 |  | Director |  | March 27, 2003
|                                                      
|/s/ JAMES J. RALABATEJames J. Ralabate                 |  | Director |  | March 27, 2003
|                                                      
|/s/ LT. GEN. HARRY E. SOYSTERLt. Gen. Harry E. Soyster |  | Director |  | March 27, 2003
|                                                      
|/s/ NORITSUGU YAMAOKANoritsugu Yamaoka                 |  | Director |  | March 27, 2003

48



---



##### 



CERTIFICATIONS

I, Edward G. Newman, certify that:

1. I have reviewed this annual report on
Form 10-K of Xybernaut Corporation;

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 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
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.

March 27, 2003



| |                      
| | ---------------------
| | XYBERNAUT CORPORATION



| |     |                     
| | --- | --------------------
| | By: | /s/ EDWARD G. NEWMAN

| |                                       
| | --------------------------------------
| |                                       
| | Edward G. Newman                      
| | President, Chief Executive Officer and
| | Chairman of the Board of Directors    

49



---



##### 



I, Thomas D. Davis, certify that:

1. I have reviewed this annual report on
Form 10-K of Xybernaut Corporation;

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 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
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.

March 27, 2003



| |                      
| | ---------------------
| | XYBERNAUT CORPORATION



| |     |                    
| | --- | -------------------
| | By: | /s/ THOMAS D. DAVIS

| |                                                  
| | -------------------------------------------------
| |                                                  
| | Thomas D. Davis                                  
| | Senior Vice President and Chief Financial Officer

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