##### 









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,
    2003                                             

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 x  No o

The aggregate market value of the Common Stock of
the issuer, its only class of voting stock, was $99,049,238, of
which $97,512,190 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 30, 2003, 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 9, 2004 was
176,776,818.

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                                                                         |    |      | 16 | 
|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                            |    |      | 33 | 
|Item 8.      |  | Financial Statements and
    Supplementary Data                                           |    |      | 35 | 
|Item 9.      |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure  |    |      | 36 | 
|            
|Item 9A.     |  | Controls and Procedures                                                                   |    |      | 36 | 
|PART III    
|Items 1013. |  | Not included herein                                                                       |    |      | 36 | 
|Item 14.     |  | Principal Accountant Fees
    and Services                                                |    |      | 36 | 
|            
|PART IV     
|Item 15.     |  | Exhibits, Financial
    Statement Schedules and Reports on Form 8-K                       |    |      | 37 | 
|Signatures   |  |                                                                                           | 42 |     



1



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PART I




Item 1.     Business.

Introduction

Xybernaut Corporation, a Delaware corporation
(the Company), originally incorporated in 1990, is
engaged in the research, development, manufacture, marketing and
sale 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 critical
enterprise 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). In 2004, the Company began actively marketing
its mobile/ wearable hardware solutions in the Peoples
Republic of China through its 60% ownership in Xybernaut China
Limited, a joint venture with Softbank Investment International
(Strategic) Ltd.

Introduced in 1995, the Mobile Assistant®
(MA®) series is the Companys primary line
of wearable computer hardware products, the current versions of
which are the MA V and MA TC. Introduced in 2002, the
Atigo® product line is a family of mobile 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. Both the
MA and Atigo product lines are protected by the
Companys intellectual property. Since their commercial
introductions, the Company has recognized revenue of
approximately $26,000,000 on sales of approximately 6,900
MA and Atigo systems.

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 WiFi, radio frequency (RF) 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 an
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.

2



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Through Xybernaut Solutions, Inc.
(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 industry
standard operating systems, such as WinTel and
Linux, in conjunction with widely used database technologies. In
addition, XSI sells Highways by Exor 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. Additional
software offerings include the Maint-X Electronic Performance
Support System (EPSS) designed to provide comprehensive
technical and support information for maintenance and inspection
personnel at the point of maintenance.

XSI offers the proprietary OPMIST computerized
maintenance management system that has been installed in many
sites worldwide at shipyards, utilities, manufacturers, military
bases and railroads. Also offered by XSI is the Program and
Project Management System (PPMS) solution that has
been provided to 9 state Departments of Transportation
(DOTs) or similar entities. 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. Another software/ service offering new to the
XSI portfolio is Xyber-Scheduling Software (XSS), a customizable
scheduling, reservation and registration system designed to help
school, park and recreation organizations to control and
communicate scheduling of facilities, programs and events.

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 sales, 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 PDAs, internet-enabled cell
phones, multi-function pagers and portable email devices. This
shift in the

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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, DVD 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 mobile and wearable products are uniquely
suited to meet this demand for convergence, and that
limited-capability or special-purpose devices will eventually be
replaced by mobile and 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 there is now 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 solely within
certain functions of the organization. The Company believes that
its products and services allow customers to leverage their
existing investment in information technology to provide
information access and computing capabilities to mobile workers.
The Company further believes that its products and services are
well suited to capture the growing consumer interest in mobile
computing and communications devices.

Several independent organizations have reported
on wearable and mobile computing technologies and their impact
on the marketplace. For example, a September 2003 report by IDC,
entitled Mobility Trends: Are Xybernauts Wearable
Computing Technologies and Services Finally Gaining
Acceptance?, notes that the concept of wearable computing
is beginning to make a global impact. An October 2001 report by
Gartner Group included wearable computers as one of four key
emerging technology trends for the first decade of the
millennium and predicted that the prevalence of wearable
computers will lead to commerce and service opportunities as
significant as those resulting from the wired Web. Gartner Group
further estimated 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.
A September 2002 report by Venture Development Corporation
(VDC) forecasts that the worldwide wearable computer market
will expand at a compounded annual growth rate (CAGR) of
over 51% through 2006.

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 vendors (ISVs) and distributor channels
that demonstrate comprehensive market knowledge in their

4



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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 copyrighted 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.

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.

Develop and Strengthen Strategic Alliances.The Company has established and
intends to continue to establish strategic alliances with
world-class partners such as Softbank Strategic, 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, knowledge of foreign markets
and access to the expertise and efficiencies of these
world-class manufacturing, financial 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 routinely investigates
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.

Utilize Licensing to Enhance Revenues.The Company intends to continue 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 recent years, the
Company has established such licenses with Hitachi and
Mitsubishi Heavy Industries and is in active discussions with
other companies regarding licensing. In March 2003, the Company
announced a 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

5



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Device intellectual property. This plan
offers potential licensees as well as current or potential
infringers a non-exclusive licensing opportunity. Approximately
100 such companies have been identified and formally contacted
by DeltaTech on the behalf of the Company. In December 2003, the
Company filed a lawsuit against Viewsonic Corporation alleging
infringement of the Companys Dual-Use Computing Device
intellectual property. The Company has retained legal counsel to
prosecute its claims against Viewsonic on a contingency basis.
The Company plans to continue to aggressively pursue licensing
activities for all of its intellectual property.


Provide Customized Solutions for Diverse
Customer Needs.Through XSI, the
Company has in-house software and service evaluation, design,
customization 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, conventional PCs or other mobile computing
devices. Through development, acquisition or teaming
relationships, the Company has many mobile solutions that enable
it to deliver a diverse set of custom services that enhance the
mobile experience such as wireless analysis and installation,
voice enabling, video streaming and peripheral integration, just
to name a few. 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 relationships with companies such as IBM,
Sony Digital Products, Texas Instruments, DT Research, Zykronix,
Hitachi, MicroVision, Transmeta, 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 18

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| |   |                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | 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 Atigo product line is designed to be used as
a stand-alone handheld computer and/or as a wireless FPD for a
MA or standard PC. 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. The hardware
used in Atigo features:



| |   |                                                                                                                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Windows XP Embedded or Windows CE. NET, Transmeta
    Crusoe or Intel XScale processors, 256MB RAM/ 512MB Flash
    or 128MB RAM/ 32MB Flash, PC Card and Compact Flash slots,
    built-in IEEE 802.11b wireless LAN support, USB 2.0 or USB 1.1
    ports and ActiveSync support on CE .NET units.
|
| |  | 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.                                                                 

Full Functionality.MA and Atigo units can both act
as full-function computing and communications devices. 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.

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

7



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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 and
mobile 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, pharmaceutical,
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. 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 a number of
horizontal segments that cover many industries and
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. 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: 2003).

Selected
Horizontal Markets



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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. FedEx
    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 18 million
    workers. Primary applications include mobile monitoring of
    manufacturing processes, logistics and materials manage-                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

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| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | ment, 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.

Selected
Vertical Markets



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Telecommunications:the primary applications in this
    segment are in the field, including maintenance and repair of
    field assets and facilities . A leading U.S. telecommunications
    company is deploying over 1,000 Atigo systems. This customer is
    using the Companys solutions for field force and workflow
    automation related to inspection, maintenance and asset
    management operations. The Company has also completed a pilot
    program with Bell Canada involving 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 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s Alternative
    Solutions group has also recently deployed hundreds of mobile
    computing devices for use in the field operations of a leading
    cable provider. These field service engineers use the devices
    for a wide variety of functions, including hook-up/modification
    of customers cable service, work order management for
    daily technician tasks and customer relationship management
    (CRM). The Company also believes that its products and solutions
    will be well suited as delivery devices for the next generation
    of wireless communications services.
|
| |  | 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 approximately
    6 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. CSX Technology,
    Inc., the technology subsidiary of CSX Corporation, uses the
    Atigo product line to meet various unique computing and
    knowledge management needs. In 2003, this Atigo solution won the
    QUALCOMM Best of Show 3G cdmA-List® Award.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|
| |  | 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |  | Homeland Defense:The Company is very involved in U.S. homeland defense efforts.
    Its solutions were recently evaluated during a formal Department
    of Justice emergency response exercise in Charleston, SC. Based
    on the MA V and Atigo platforms, the Critical Incident
    Response Tool Set (CIRT) used in Charleston allows first
    responders and subsequent emergency personnel to manage
    operations by having various types of critical information at
    their fingertips, including building floor-plans, schematics,
    photographs, incident command protocols and other critical
    response data. The Company also regularly conducts various
    emergency management exercises throughout the U.S. Law
    enforcement agencies, fire and rescue, HAZMAT, SWAT teams, EMS
    personal, and County Planners often conduct full-day live
    demonstrations using the Companys solutions to evaluate
    best-practices and technology solutions that assist
    first-responders during emergencies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Medical:in the
    U.S., this segment includes approximately 13 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
    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.
|
| |  | 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. 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 six level marketing
and distribution strategy to maximize market penetration through
the generation of hardware 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 the Companys proprietary 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 approximately 100 active
    VARs and partners worldwide. Members of Team Xybernaut typically
    have significant technical and industry expertise and may couple
    the Companys 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.

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Alternative Solutions:Understanding that customers
    needs are often varied and unique, the Company has recently
    established the Alternative Solutions group. This group is set
    up to deliver solutions that include third party hardware and
    software. The Alternative Solutions group provides the Company
    with greater flexibility, improved presence as a leader in
    mobile/ wearable computing and greater affinity amongst targeted
    customers in key industry sectors.
|
| |  | 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:The
    Company maintains 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 Customer Advisory Board (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 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. The organizations that currently serve on the CAB
include ATA, Bell Canada, Boeing, CSX, Daimler Chrysler, FedEx,
Hilton Hotels, Mitsubishi Heavy Industries, NTT Communications
Corporation, Rocketdyne, Siemens and South Carolina Research
Authority.

Sales and
Backlog

The Companys Atigo sales are typically
customized to meet each customers specific needs.
Therefore, most large Atigo sales are built to order. As of
December 31, 2003, the Company had a backlog of
approximately $1.8 million for its hardware products. This
backlog consisted primarily of one customer purchase order for
Atigo systems, most of which have been shipped as of the date of
this filing. 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, 2002, the Company had a backlog of
approximately $2.2 million for its hardware products.

As of December 31, 2003 and 2002, the
Company had a backlog of approximately $3.5 and
$3.2 million, respectively, for its services business,
primarily consisting of multi-year contracts that are in
progress.

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 delays or interruptions in supply while such
changes

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are incorporated. The order time for certain
components is often lengthy, including parts integral to the
Companys FPD and Atigo products. Delays or interruptions
in supply could occur if the Company is required to find a new
supplier for these components. Any disruptions in the supply of
key vendor parts could result in the delay or cancellation of
customer orders and have a material adverse effect on the
Company.


Production

The Company outsources the production of its
wearable and mobile computer product lines. As a result, 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 often retains the underlying
intellectual property, tools and molds necessary for it to
enable other partners to manufacture its products.

The Company has manufacturing agreements with DT
Research for the manufacture of the Atigo. The Company
previously had manufacturing agreements with IBM for the
manufacture of the MA V and with Digital Logic (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.

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 provides call
center support through a partner from 9AM to 9PM eastern
standard time from Monday through Friday.

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
typically provides the Company with a corresponding warranty. In
certain instances, the Company provides warranties in excess of
those provided by its vendors to meet the specific needs of its
customers. At the time of sale, the Company estimates and
accrues the cost of such warranties. If such warranty costs are
ultimately higher than anticipated, 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 ten 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 $450,073 and are
recorded as long-term other assets on the Companys balance
sheet as of December 31, 2003.

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.,
MicroSlate, Texas Microsystems, OQO, 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

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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, Hansen,
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, 68
are filed with the United States Patent and Trademark Office
(U.S. Patent Office), consisting of 43 granted
patents and 25 pending patent applications. Of the U.S. patents
issued or pending, 54 are utility patents or patent applications
that cover the concepts in the patents regardless of specific
execution or design and the remaining 14 are design patents that
cover a specific design of a product or its components. The
remaining patents, virtually all of which are utility patents,
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 its patents are a
valuable asset of the Company. The Company has obtained licenses
from Hitachi and Mitsubishi Heavy Industries and has sued
Viewsonic Corporation for infringement of one of its patents.
The Company believes that its patents 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.

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

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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 Transferable Core. This
concept covers 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 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

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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 XP, 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 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.
Approximately 100 such companies have been identified and
formally contacted by DeltaTech on the behalf of the Company. In
December 2003, the Company filed a lawsuit against Viewsonic
Corporation alleging infringement of the Companys Dual-Use
Computing Device intellectual property. The Company has retained
legal counsel to prosecute its claims against Viewsonic on a
contingency basis. The Company plans to continue to aggressively
pursue licensing activities and, where necessary, litigation, to
protect its intellectual property against infringement from
third parties.

Notwithstanding anything to the contrary
contained in 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, that foreign countries will
honor its patents or that challenges will not be instituted
against the validity or enforceability of any patent. The cost
of litigation to uphold the validity and prevent infringement of
patents can be substantial. While retaining legal counsel on a
contingency basis lowers the cost of litigation, it also reduces
any future royalty payments from licensees. 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.

15



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##### 



Employees and Consultants

As of December 31, 2003, the Company had 91
full-time equivalent employees, and had consulting arrangements
with 15 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, 22 are
technical and administrative support employees, 6 are engaged in
research and development, and 59 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.

Other Information

The Company maintains an internet web site at
www.xybernaut.com. Copies of the Companys Annual Report on
Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on
Form 8-K, and amendments to those reports, if any, are available
free of charge on the Companys website as soon as
reasonably practicable following the filing of each document
with the SEC.






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

The offices for the Companys U.S.
headquarters and XSI are located in 17,592 square feet of office
and development space at 12701 Fair Lakes Circle, Fairfax,
Virginia. The Companys lease is for an eighteen-month term
expiring March 31, 2005 and requires monthly rent of
$34,198.

XSIs former offices consist of 5,000 square
feet of office space located at 8618 Westwood Center Drive,
Vienna, Virginia. The lease is for a 7-year term expiring
December 31, 2005 and requires monthly rent of $13,532. 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.

To minimize lodging expenses related to visiting
consultants and new, visiting or relocating employees, the
Company leases two apartments in Fairfax, Virginia with combined
monthly rental costs of $3,057. Management believes that the
cost of these apartments is less than what would be incurred if
these visitors stayed in hotels.

The Companys European facility consists of
1,415 square feet of office space located at the SBS Software
Center, Otto Lilienthal Strasse 36, D-71034 Böblingen,
Germany. The Companys lease automatically renews and
requires a 6-month notice for termination. The lease requires
monthly rent of $2,200 at current exchange rates.

The Companys Asian facility consists of
1,218 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 automatically renews for 3-month
terms. The lease requires monthly rent of $2,400 at current
exchange rates.






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

The Company is involved in litigation with
Zykronix, Inc. in the District Court of Denver Colorado and in
the Circuit Court of Fairfax Virginia. The Colorado suit is
against the Companys Chairman and Chief Executive Officer
based on a personal guarantee that he provided to Zykronix for
payment of fees alleged by Zykronix to be owed by the Company.
The Virginia suit is against the Company for the same $238,000
in fees allegedly owed under the guarantee. The Company believes
that it has substantive defenses to these claims and that the
alleged fees are not owed. The Company is defending, and expects
to continue to defend, against both suits.

In December 2003, the Company filed a lawsuit
against Viewsonic Corporation (Viewsonic) in the
United States District Court for the Eastern District of
Virginia. The suit alleges that Viewsonic infringed one of the
Companys Dual-Use Computing Device patents. The suit
requests unspecified damages and an injunction against Viewsonic
from infringing the patent.

16



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##### 



In December 2003, the IRS filed a tax lien
against the Company totaling $1,132,198. This lien covers taxes,
penalties and interest that the IRS alleges that the Company
owes related to certain payroll tax filings during 2000. The
Company believes that all such taxes were remitted to the IRS
during 2000 and does not believe that such taxes are still owed
to the IRS. The Company is in ongoing discussions with the IRS
related to this matter and has formally requested that the lien
be withdrawn. The Company believes that the probability of
future payment of the taxes is remote and therefore the Company
has not accrued any liability or charges. The Company believes
that any related interest or penalties will not be material.

The Company is involved in routine legal and
administrative proceedings and claims of various types. The
Company has no material pending legal or administrative
proceedings, other than as discussed above or 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. While any proceeding or claim
contains an element of uncertainty, management does not expect
that any such proceeding or claim will have a material adverse
effect on the Companys results of operations or financial
position.






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

At the Companys annual meeting held on
December 11, 2003, the following items were submitted to a
vote by the common stockholders and were approved by the
following majority votes:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. The election of three Class III
    directors of the Company to serve for a term of three years and
    until their successors are duly elected and qualified. The
    election of Edward G. Newman was approved by 99% of voting
    shareholders, with votes of 152,000,000 shares for
    and 1,400,000 shares withheld. The election of
    Steven A. Newman was approved by 99% of voting shareholders,
    with votes of 151,800,000 shares for and 1,600,000
    shares withheld. The election of James J. Ralabate,
    Esq. was approved by 99% of voting shareholders, with votes of
    152,400,000 shares for and 1,000,000 shares
    withheld.
|
| | 2. The ratification of the appointment of
    Grant Thornton LLP as the Companys independent accountants
    for the fiscal year ending December 31, 2003. This item was
    approved by 99% of voting shareholders, with votes of
    152,200,000 shares for, 700,000 shares
    against and 500,000 shares abstained.                                                                                                                                                                                                                                                                                                                                             




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 on the
Nasdaq SmallCap Market.

As of December 31, 2003, there were
approximately 1,365 shareholders of record, representing
approximately 75,000 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, 2003 and
2002, as reported in published financial sources.

17



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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 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 | 
|1st Quarter 2003 |  | $            | 0.60 |  |     | $ | 0.33 | 
|2nd Quarter 2003 |  | $            | 0.75 |  |     | $ | 0.35 | 
|3rd Quarter 2003 |  | $            | 2.26 |  |     | $ | 0.56 | 
|4th Quarter 2003 |  | $            | 2.30 |  |     | $ | 1.54 | 

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 any 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, forecasted operations, 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.

|                          |  |      |             |   |      |   |             |      |  |   |             |   |  |      |             |   |  |   |             |  
|------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | - |  | ---- | ----------- | - |  | - | ----------- | -
|                          |  | 2003 |             |   | 2002 |   |             | 2001 |  |   | 2000        |   |  | 1999 |            
|                          |  |      |             |   |      |   |             |      |  |   |             |   |  |      |            
|Total revenue             |  | $    | 10,999,987  |   |      | $ | 9,973,561   |      |  | $ | 9,819,993   |   |  | $    | 9,504,891   |   |  | $ | 8,352,774   |  
|Net loss                  |  | $    | (18,584,229 | ) |      | $ | (26,580,833 | )    |  | $ | (32,199,579 | ) |  | $    | (24,185,222 | ) |  | $ | (16,697,413 | )
|Net loss per common share |  | $    | (0.13       | ) |      | $ | (0.37       | )    |  | $ | (0.63       | ) |  | $    | (0.63       | ) |  | $ | (0.76       | )
|Total assets              |  | $    | 20,820,067  |   |      | $ | 12,135,371  |      |  | $ | 16,664,318  |   |  | $    | 19,244,701  |   |  | $ | 12,870,679  |  
|Long-term obligations     |  | $    | 226,084     |   |      | $ | 119,295     |      |  | $ |            |   |  | $    |            |   |  | $ |            |  






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

Overview

Xybernaut Corporation, a Delaware corporation
(the Company), is engaged in the research,
development, manufacture, marketing and sale 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 critical enterprise data. The
Company offers solutions with a software and services focus
through its wholly-owned subsidiary Xybernaut Solutions, Inc.
(Virginia, U.S.). The Company offers solutions with a hardware
focus through its U.S. operations and through its wholly-owned
subsidiaries Xybernaut K.K. (Yokohama, Japan) and Xybernaut GmbH
(Böblingen, Germany). In 2004, the Company began actively
marketing its mobile and wearable hardware solutions in the
Peoples Republic of China through its 60% ownership in
Xybernaut China Limited, a joint venture with

18



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Softbank Investment International (Strategic)
Ltd. The Company was originally incorporated in 1990 and
completed its initial public offering (IPO) in July
1996.


The consolidated financial statements include the
accounts of the Company and its wholly owned subsidiaries:
Xybernaut Solutions, Inc. (XSI), Xybernaut K.K. and
Xybernaut GmbH. All significant intercompany accounts and
transactions have been eliminated in the consolidation. The
consolidated financial statements for periods subsequent to
December 31, 2003 are also expected to include the accounts
of Xybernaut China Limited (Hong Kong, China).

Introduced in 1995, the Mobile Assistant®
(MA®) series is the Companys primary line
of wearable computer hardware products, the current versions of
which are the MA V and MA TC. Introduced in 2002, the
Atigo product line is a family of mobile 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. Since their
commercial introductions, the Company has recognized revenue of
approximately $26,000,000 on sales of approximately 6,900
MA and Atigo systems. The Company derives its revenues from
sales of its wearable 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 past quarters, many of the Companys large
customers deferred or delayed anticipated purchases of the
Companys products because of uncertain economic conditions
and other concerns. If these conditions and issues 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 believes that
general economic conditions began to improve during late 2003
and expects that they will continue to improve during 2004,
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, 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 parts of Europe.
The Company predicts that 3G service will be available in large
metropolitan areas worldwide in the next few years. For example,
NTT DoCoMo and AT&T Wireless have announced plans to launch
3G service in select U.S. cities by December 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 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

19



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##### 



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 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. The Company recorded a $157,307 charge during 2002
against the carrying value of certain of its non-strategic
patents. This charge was 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 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 typically provides the Company with a corresponding
warranty. In certain instances, the Company provides warranties
in excess of those provided by its vendors to meet the

20



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##### 



specific needs of its customers. At the time of
sale, the Company estimates and accrues the cost of such
warranties. If such warranty costs are ultimately higher than
anticipated, 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 and unique nature 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 on fixed price contracts based on the percentage of
completion method by calculating the ratio of costs incurred
over total estimated costs to complete, a basis which management
believes reasonably matches revenue to proportional performance
under each related contract.

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.

Results of Operations

The following table sets forth certain
consolidated financial data as a percentage of revenues for the
years ended December 31, 2003, 2002 and 2001.

|                                    |                            |              |        |       |      |  |        |       |  |  |        |       | 
|----------------------------------- | -------------------------- | ------------ | ------ | ----- | ---- |  | ------ | ----- |  |  | ------ | ----- | 
|                                    |                            |             
|                                    |                            | December 31, |       
|                                    |                            |              |       
|                                    |                            | 2003         |        |       | 2002 |  |        | 2001  | 
|                                    |                            |              |        |       |      |  |        |       | 
|Revenue                             |                            |              | 100.0  | %     |      |  | 100.0  | %     |  |  | 100.0  | %    
|Cost of sales                       |                            |              | 72.2   |       |      |  | 77.8   |       |  |  | 70.3   |      
|Provision for inventory and tooling |                            |              | 45.4   |       |      |  | 9.2    |       |  |  | 18.6   |      
|                                    |                            |              |        |       |      |  |        |       | 
|                                    | Gross (loss) income        |              |        | (17.6 | )    |  |        | 13.0  |  |  |        | 11.1  | 
|                                    |                            |              |        |       |      |  |        |       | 
|Operating expenses:                 |                            |              |        |       |      |  |        |       |  |  |        |      
|                                    | Sales and marketing        |              |        | 79.4  |      |  |        | 149.8 |  |  |        | 178.5 | 
|                                    | General and administrative |              |        | 37.9  |      |  |        | 57.2  |  |  |        | 67.9  | 
|                                    | Research and development   |              |        | 31.1  |      |  |        | 63.8  |  |  |        | 95.8  | 
|                                    | Restructuring charges      |              |        | 0.0   |      |  |        | 10.4  |  |  |        | 0.0   | 
|                                    |                            |              |        |       |      |  |        |       | 
|Total operating expenses            |                            |              | 148.4  |       |      |  | 281.2  |       |  |  | 342.2  |      
|                                    |                            |              |        |       |      |  |        |       | 
|Interest and other                  |                            |              | (2.9   | )     |      |  | 1.6    |       |  |  | 3.2    |      
|                                    |                            |              |        |       |      |  |        |       | 
|Net loss                            |                            |              | (168.9 | )%    |      |  | (266.5 | )%    |  |  | (327.9 | )%   
|                                    |                            |              |        |       |      |  |        |       | 

21



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Years Ended December 31, 2003 and
December 31, 2002

Revenue.The Company
derives its revenue from product sales of mobile/ wearable
computers and components, product sales of software, and
consulting services. Total revenue for the year ended
December 31, 2003 was $10,999,987, an increase of
$1,026,426, or 10%, compared to $9,973,561 for the year ended
December 31, 2002. Product revenue remained consistent
between the year ended December 31, 2003 and 2002 at
$6,176,533 and $6,131,759, respectively, representing a 1%
increase. Hardware revenues from U.S. operations increased 14%
to $5,082,410 in 2003 compared to 2002, driven primarily by
Atigo and Alternative Solutions sales. Alternative Solutions
consist of sales of non-proprietary mobile/ wearable hardware
based on a customers specific needs and requirements.
Alternative Solutions sales totaled $695,939 during 2003,
compared with $0 in 2002. This increase in U.S. hardware
revenues was offset by a 33% decrease to $810,996 in 2003
compared to 2002 of European hardware sales of MA TC and
MA V systems. This decrease in European revenues was due to
a drop in orders from a large European customer. Hardware
revenues from Asia, consisting primarily of MA V systems,
decreased by 38% to $283,127 in 2003 compared to 2002. There was
no software product revenue in 2003 or 2002. Revenue from
software products generally consists of a few large transactions
that are unrelated to the Companys hardware products.
Consulting, licensing and other revenue for the year ended
December 31, 2003 was $4,823,454, an increase of $981,652,
or 26%, compared to $3,841,802 for 2002. This increase was
driven by revenues earned on two new large contracts in the U.S.

Cost of Sales.The
Companys cost of sales include the costs of components for
mobile/ wearable computer systems, 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 for the year ended
December 31, 2003 was $12,939,038, an increase of
$4,264,233, or 49%, compared to $8,674,805 for the year ended
December 31, 2002.

The cost of sales related to the Companys
hardware products decreased 8% to $4,959,974 for the year ended
December 31, 2003. This decrease in hardware product cost
of sales occurred during a period in which hardware product
sales increased 1%. This fluctuation was caused by several
factors. First, total warranty costs for the year ended
December 31, 2002 included $323,897 in charges for product
replacement related to MA V sales 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 related to the MA V or
other current product lines. In addition, margins on sales of
the MA V and TC were lower in 2002 since these products had
been introduced in 2001 and margins typically drop following a
products commercial launch. Partially offsetting the above
factors, which negatively affected 2002 hardware margins, was
the commercial launch of the Atigo product line in the third
quarter of 2002, which resulted in higher margins in the second
half of 2002. During 2003, the Company continued to introduce
new products in the Atigo family, namely the Atigo M and Atigo
T, and was therefore able to maintain relatively high hardware
margins following their launches. Also affecting margins was the
Alternative Solutions sale consisting of non-proprietary
wearable/mobile hardware during 2003 for which no similar sales
occurred during 2002. The Company recorded gross margins on this
Alternative Solutions sale of 4% during 2003. The Company
expects margins on Alternative Solution sales to vary depending
on the wearable/mobile product deployed. As a result of the
above activities, gross margins from hardware sales for the year
ended December 31, 2003 were 20%, compared to 12% for 2002.
Cost of sales of consulting, licensing and other revenue
increased 26%, which is consistent with the 26% increase in
consulting, license and other revenue. As a result, consulting,
licensing and other revenue gross margin was 38% for both 2003
and 2002. Total gross margins, excluding the provision for
inventory and tooling, were 28% and 22% for the year ended
December 31, 2003 and 2002, respectively.

The Company recognized inventory and tooling
provisions of $4,999,354 and $913,175 in the fiscal years 2003
and 2002, respectively, related to its wearable computer product
lines. The 2003 inventory and tooling provision included charges
of i) $4,205,949 against MA V inventory, components
and tooling, ii) $503,436 against MA TC inventory,
iii) $257,737 against MA IV inventory and
iv) $32,232 against pomainventory. 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

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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 and iv) a $299,077 reserve against
tooling associated with the MA V product line. Total gross
margins, including the provisions for inventory and tooling,
were -18% and 13%, for the year ended December 31, 2003 and
2002, respectively.


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 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. The significant majority of the
inventory and tooling charges during 2003 and 2002 were recorded
against the MA V product line. Even after the successful
renegotiation of certain of the MA V manufacturing
contracts during 2003, the Company had commitments to purchase
significant quantities of inventory. The Company was required to
write-down and reserve a substantial portion of the MA V
inventory in 2003 and 2002 as historical and forecasted sales
are not sufficient to sell such quantities of 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. 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. 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, 2003 were $8,735,089, a decrease of
$6,206,750, or 42%, compared to $14,941,839 for the same period
in 2002. This decrease is due to sustained cost savings measures
that began in 2002 which resulted in 2003 decreases of
approximately $1,666,000, $642,000, $935,000 and $691,000,
respectively, in salaries and benefits, consulting, promotional
items and trade shows. Non-cash expense for outside marketing
services funded through the issuance of the Companys
equity securities decreased by $596,080 to $177,896 in 2003
compared to $773,976 in 2002. General expenditures for sales and
marketing expenses of the European and Asian operations also
decreased $1,265,000 from 2002 to 2003.

General and Administrative Expenses.General and administrative expenses
for the year ended December 31, 2003 were $4,168,468, a
decrease of $1,534,934, or 27%, compared to $5,703,402, for the
corresponding period in 2002. As a result of the sustained cost
savings measures that began in 2002, general and administrative
expenses in 2003 relating to salaries and benefits and
consulting decreased approximately $757,000 and $327,000,
respectively, compared to the same period in 2002.

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, 2003 were
$3,417,919, a decrease of $2,940,964, or 46%, compared to
$6,358,883 for the corresponding period in 2002. As a result of
sustained cost saving measures that began in 2002, research and
development expenses in 2003 related to salaries, benefits and
consulting decreased approximately $504,000, $105,000 and
$108,000, respectively. An additional decrease resulted from a
$452,000 decline in expenditures to third parties and
consultants for design and development of the Companys
mobile/ wearable product lines. Expenditures during both the
2003 and 2002 periods related primarily to the Atigo product
line. In addition, the research and development expenses of the
Companys European operations decreased by $1,514,000 from
2002 to 2003 due to sustained cost saving measures that began in
2002.

Interest and Other (Expenses) Income, Net.Interest expense for the year ended
December 31, 2003 was $323,133, a decrease of $486,390 or
298%, compared to 2002 interest income of $163,257. This decrease

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resulted primarily from the write-off of a
discount on a note payable in 2003 from early repayment of
$407,246.


Provision for Income Taxes.The Company accrued $569 and $562 for
a tax provision for the years ended December 31, 2003 and
2002, respectively, related to the operations of its foreign
subsidiaries. The Companys U.S. operations had a net loss
for the years ended December 31, 2003 and 2002 and,
therefore, no provision for U.S. income taxes was required.

Net Loss.As a
result of the factors described above, the net loss for the year
ended December 31, 2003 was $18,584,229, a decrease of
$7,996,604, or 30%, compared to $26,580,833 for the
corresponding period in 2002.

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 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

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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 38% 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 and 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 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

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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 Income 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 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.

Other Operating Activities

For the year ended December 31, 2003, the
Companys operating activities used cash of $17,522,543,
primarily as a result of its net loss of $18,584,229, and its
investing activities used cash of $1,463,342. These activities
were funded through the Companys financing activities
which provided cash of $26,228,089, principally through the
issuance of common stock and warrants to purchase common stock
exercised during

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this period for cash. As a result, the
Companys cash balance increased to $9,524,541 at
December 31, 2003 from $1,967,710 at December 31, 2002.


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.

At December 31, 2003, the Company had
approximately $136,000,000 of net operating loss carryforwards
(NOLs) for U.S. federal income tax purposes which
expire in varying years from 2010 through 2023. The Company has
experienced several ownership changes pursuant to Internal
Revenue Code Section 382. These ownership changes, which
occurred in 1997, 1999, 2002, and 2003, have the effect of
limiting the Companys usage of its NOLs in years after
each ownership change. Due to these limitations, at least
$38,000,000 of the NOLs have been permanently impaired because
they will expire before they ever become available for use.
After consideration of this impairment, the Company had
approximately $98,000,000 of NOLs which become available for
future use based on an annual limitation of approximately
$4,600,000. After consideration of this limitation, the Company
had approximately $6,100,000 of NOLs available to offset future
taxable income as of December 31, 2003. The remaining
approximate $91,900,000 of NOLs are expected to become available
to offset future taxable income in the future. However, there
can be no assurance that such NOLs will not become impaired in
the future.

At December 31, 2003, the Company had
approximately $7,500,000 of NOLs for foreign income tax
purposes. These NOLs are not affected by Internal Revenue Code
Section 382 and are not impaired.

Transactions With Related and Certain Other
Parties

The Company retains a member of its Board of
Directors as its patent counsel. Since August 1, 2002, the
Company and this Director have entered into one-year agreements.
The current agreement expires on July 31, 2004. Under these
and prior agreements, the Company had cash expenditures of
$320,000, $331,112 and $421,333 during 2003, 2002 and 2001,
respectively, in legal services payable to this Director. The
Company is also obligated to issue to this Director 50,000
shares of its common stock for the one-year period ending
July 31, 2004, which had a value of $37,500 at the date the
agreement was entered into. The Company issued to this Director
100,000 shares of its common stock for the one-year period ended
July 31, 2003, which had a value of $50,000 as of the date
the agreement was entered into. Prior to August 1, 2002,
the Directors law firm billed the Company in accordance
with its established standard billing rates used in the past
with its other clients. These cash and stock payments represent
gross payments made by the Company and the Director is
responsible for all overhead, professional, administrative and
other expenditures incurred by his law firm. During 2003, 2002
and 2001, the Company represented the law firms only
significant client. During approximately half of 2002 and all of
2001, the Director also served as the Companys primary
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 was paid only the amount
that was passed through to these other law firms and agencies
and paid administrative services related to these services. The
Company made additional payments of $17,656, $274,040 and
$485,827 during 2003, 2002 and 2001, respectively, to this
Directors law firm related to services rendered by the
Directors law firm as the Companys processing agent
for foreign patent and trademark filing and prosecution
expenses. The Companys management and Board of Directors
believe that the relationship with this law firm is based on
arms-length terms and conditions.

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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 billings of $424,574, $464,067
and $392,524 during 2003, 2002 and 2001, 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. The Companys management and Board
of Directors believe that the relationship with this law firm is
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
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, and
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 at both December 31, 2003
and December 31, 2002.

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,
markets and sells the systems worldwide to its own customers and
introduces the Company to potential future customers (the
Sales and Marketing Agreement). During 2003, 2002
and 2001, the Company paid $4,741,313, $2,772,457 and
$4,148,523, respectively, to IBM related to design and
development services and inventory purchases. Such 2003 amount
includes payments made to IBM pursuant to the agreements
discussed in the Commitments section below. During
2003, 2002 and 2001, the Company recorded revenues of $88,137,
$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

28



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sponsorship of industry trade shows, the
preparation of competitive market analysis and the use of the
End-Users as named reference accounts. During 2003, 2002 and
2001, the Company recorded revenues of approximately $773,000,
$950,000 and $1,700,000, respectively, related to sales of its
products to the VAR. During 2003, 2002 and 2001, the Company
recorded total research and development and sales and marketing
expenses of $755,000, $1,250,000 and $1,250,000, 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
2003, and summary activities for 2002 and 2001, are provided
below.

Common Stock

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 2002, the Company received net cash
proceeds of $19,833,486 through the issuance of 35,830,024
shares of its common stock through four separate private
placements. The Company also issued warrants to purchase
23,043,156 shares of its common stock for between $0.70 and
$3.00 per share related to these private placements.

During 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. 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.

During May 2003, the Company received gross
proceeds of $3,000,000 through a private placement of 9,375,000
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
three-year callable warrants to purchase 3,281,250 shares of
common stock. These warrants had an exercise price of $0.45 if
exercised in the first year, $0.90 if exercised in the second
year and $1.35 if exercised in the third and final year.

During June 2003, the Company received gross
proceeds of $2,000,000 through a private placement of 5,405,405
shares of its common stock to an investor. In connection with
this private placement, the Company issued to the investor
three-year callable warrants to purchase 4,054,054 shares of
common stock. These warrants had an exercise price of $1.25 if
exercised in the first year, $2.50 if exercised in the second
year and $3.75 if exercised in the third and final year.

During September 2003, the Company received gross
proceeds of $5,000,000 through a private placement of 6,849,315
shares of its common stock to an investor. In connection with
this private placement, the Company issued to the investor
three-year callable warrants to purchase 3,424,658 shares of
common stock. These warrants had an exercise price of $0.91 if
exercised in the first year, $1.82 if exercised in the second
year and $2.73 if exercised in the third and final year.

29



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During September 2003, the Company received gross
proceeds of $2,000,000 through a private placement of 1,600,000
shares of its common stock to an investor. In connection with
this private placement, the Company issued to the investor
three-year callable warrants to purchase 800,000 shares of
common stock. These warrants have an exercise price of $1.25 if
exercised in the first year, $2.50 if exercised in the second
year and $3.75 if exercised in the third and final year.

During March 2004, the Company received gross
proceeds of $5,000,000 through the private placement of
3,731,343 shares of its common stock to an investor. The shares
were sold at $1.34 per share, representing an approximate 20%
discount to the closing market price of the Companys
common stock. In connection with this private placement, the
Company issued to the investor three-year callable warrants to
purchase 1,865,671 shares of common stock at a price of $1.52
per share and six-month callable warrants to purchase 1,865,671
shares of common stock at $1.52 per share.

During March 2004, the Company received gross
proceeds of $1,000,000 through the private placement of 662,252
shares of its common stock to an investor. The shares were sold
at $1.51 per share, representing an approximate 10% discount to
the closing market price of the Companys common stock. In
connection with this private placement, the Company issued to
the investor three-year callable warrants to purchase 331,126
shares of common stock at $1.52 per share and six-month callable
warrants to purchase 331,126 shares of common stock at $1.52 per
share.

The Company issues warrants to purchase shares of
its common stock, primarily in connection with the
Companys financings and borrowings. Exclusive of the
exercises made in connection with the note repayment discussed
in Borrowings below, the Company received net
proceeds of $10,392,282, $2,186,802 and $3,773,405 through the
issuance of 23,847,427, 17,350,627 and 1,881,470 shares of its
common stock during 2003, 2002 and 2001, respectively, through
the exercise of warrants. Concurrently with their exercise, the
exercise price of 17,116,852 warrants was reduced from a
weighted average of $1.14 per share to $0.34 per share during
2003. Concurrently with their exercise, the exercise price of
17,350,627 warrants was reduced from a weighted average of $1.61
per share to $0.18 per share during 2002. At December 31,
2003, the Company had warrants outstanding to purchase 4,117,739
shares of its common stock at prices that range from $0.60 to
$5.00 per share, with a weighted average of $3.56 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 2003, 2002
and 2001, the Company issued 248,996, 35,835 and 57,097 shares,
respectively, of its common stock and received gross proceeds of
$109,269, $11,048 and $135,659, respectively, related to these
exercises.

Borrowings

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, 2003, the capital lease obligation
was $0. During 2003, 2002 and 2001, the Company incurred
interest expense of $635, $2,320 and $3,781, 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, the Company incurred
interest expense of $2,377 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.

On March 26, 2003, the Company borrowed
$1,750,000 from a lender pursuant to a one-year promissory note
that bore interest at 3.5% per annum. In connection with this
borrowing, the Company issued to the lender 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. Based on the

30



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relative fair values of the securities issued,
these warrants were assigned a value of $393,594, which amount
was recorded as a note discount to be amortized into interest
expense over the life of the note. On May 30, 2003, the
Company repaid $860,000 in principal when the lender elected to
exercise the 2,000,000 warrants at $0.43 per share. Subsequent
to this partial repayment, the lender provided the Company with
a 10% discount on the remaining unpaid principal to induce the
Company to repay the remaining principal prior to its original
maturity date. The remaining principal and interest was repaid
on May 30, 2003 through the: i) $89,000 discount,
which was applied against the Companys Additional Paid-In
Capital, ii) application of the $560,000 aggregate exercise
price related to the exercise of the warrants to purchase
1,750,000 shares of common stock at $0.32 per share, a reduction
from the original $1.25 per share exercise price, iii) issuance
of 651,351 shares of common stock valued at $241,000, or $0.37
per share, and iv) issuance of 30,350 shares of common
stock valued at $11,229, or $0.37 per share, as repayment of
accrued interest. During 2003, the Company fully amortized the
$393,594 note discount into interest expense. The Company had no
outstanding principal or interest related to this note at
December 31, 2003.


Commitments

Inventory.From time
to time, the Company has commitments to purchase inventory,
tooling and/or engineering and other services from its suppliers
and manufacturers related to its current and future hardware
product lines. The Companys commitments are typically
highest during periods of product design and when the Company is
procuring inventory related to anticipated sales. The Company
expects that it will continue to enter into such commitments
during 2004 and thereafter as it designs, develops and procures
future wearable computer product lines.

During 2003, the Company entered into an
agreement with IBM under which the Company agreed to purchase
approximately $4,900,000 in MA V computing units, FPDs,
peripherals and component parts. During 2003 the Company
received all of this inventory and made payments of $4,363,458.
During January 2004, the Company made the final payments
required by this agreement. As of January 31, 2004, the Company
had paid all amounts owed under this agreement.

At December 31, 2003, the Company had
commitments to purchase approximately $2,000,000 in inventory,
related primarily to pending orders for the Atigo product line.

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, 2003 are:

|                                 |  |   |         | 
|-------------------------------- |  | - | ------- | 
|For the Year Ending December 31, |  |  
|                                 |  |  
|2004                             |  | $ | 605,077 | 
|2005                             |  |   | 270,562 | 
|2006                             |  |   |        | 
|2007                             |  |   |        | 
|2008                             |  |   |        | 
|                                 |  |   |        
|                                 |  | $ | 875,639 | 
|                                 |  |   |        

Other Liquidity and Capital Resources
Disclosures

At December 31, 2003, the Company had
accounts receivable, net of allowances, of $4,883,899, an
increase of $1,473,028, or 43%, from the December 31, 2002
balance of $3,410,871. This fluctuation is significantly larger
than the 10% increase in total revenues from 2002 to 2003 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, 2003 is $1,554,828 associated
with two December sales for which the Company collected the
balance in 2004. In addition, accounts receivable at
December 31, 2003 include $322,152 of unbilled accounts
receivable representing amounts earned and recorded under the
percentage of completion

31



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method of accounting. The Company expects to bill
this amount in its entirety in 2004 upon reaching certain
milestones in the contract.


At December 31, 2003, the Company had
prepaid assets of $984,425, an increase of $180,323, or 22%,
from the December 31, 2002 balance of $804,102. This
fluctuation is due to an increase in payments of $411,257 to a
vendor of Atigo products prior to the receipt of inventory.
These shipments are expected to be received in 2004. This
increase is offset by a decrease of $193,106 of prepaid assets
in the Companys European subsidiary due to cost saving
measures.

The deferred revenue balances at
December 31, 2003 and 2002 result from billings to
customers that were in excess of revenue recognized on service
contracts and from warranty revenue on hardware products.
Deferred revenue on service contracts will be recognized as
revenue as the revenue recognition criteria are met. At
December 31, 2003 and 2002, $200,864 and $84,685
respectively, were recorded as deferred revenue from service
contracts. Warranty revenue on hardware products is recorded as
deferred revenue until earned on the straight-line basis over
the life of the warranty. At December 31, 2003 and 2002,
$295,774 and $3,775, respectively, were recorded as deferred
revenue from warranties, of which, $163,754 and $0, were
classified as long-term liabilities at December 31, 2003
and 2002, respectively.

The Company has recorded net losses since its
inception. These losses are primarily attributable to the
operating expenses incurred by the Company to design, develop,
market and sell its mobile and wearable computer products and to
provide general and administrative support for these operating
activities. The Companys revenues and gross margins have
not been sufficient to fund these operating activities. As a
result, the Company has consistently reported negative cash
flows from operating activities and net losses and had an
accumulated deficit of $149,607,388 at December 31, 2003.
The combination of the Companys operating losses and its
working capital requirements has severely impacted the
Companys financial position and liquidity. During 2003,
2002 and 2001, 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 operations and raise
additional capital, both of which are needed to meet its cash
flow needs through December 31, 2004 and thereafter. During
2002 and 2003, management performed reviews of the
Companys operations and implemented various cost cutting
programs to reduce the Companys operating expenses to
better align costs with current and expected business volume.
The Company incurred total operating expenses in 2003 of
approximately $16.3 million, a decrease from $28.0 million
and $33.6 million in 2002 and 2001, respectively. Assuming
there are no significant changes to the Companys business
plan, management expects to maintain a quarterly operating
expense level of between $4 million and $5 million,
representing savings of over 50% from fourth quarter 2001
levels. Future significant fluctuations may still occur as a
result of the Companys research and development
activities, which will vary depending on the Companys
wearable and mobile computer product development cycle during
any given period. Additionally, new operations in China are
expected to increase the Companys operating expenses.
Management believes that the Companys current staffing and
resources will be sufficient to carry out its business plan for
the foreseeable future.

At the forecasted levels discussed above,
management expects that the Company will incur operating
expenses of between $16 million and $20 million during
2004. However, there can be no assurances that actual operating
expenses during 2004 or later periods will not be significantly
higher. The Company will also be required to fund inventory
procurement and other expenditures. Management expects to fund
these activities through cash on hand, gross profits and 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 warrants, the
exercise prices have been reduced. Such reduction has resulted
in the issuance of substantially more shares of common stock
than would have occurred had the exercise price of the warrants
not been reduced. 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 and
historical prices for the Companys stock, such dilution
could be significant. If additional funds are

32



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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 2003, the Company raised approximately
$26 million through sales of its common stock to
institutional investors, through warrant and stock option
exercises and through borrowings. 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. The Companys Certificate of
Incorporation limits its ability to issue more than 200,000,000
shares of common stock. The Company will be required to obtain
shareholder approval to increase this number. There can be no
assurance that such approval will be obtained. A limitation on
the number of authorized shares may hinder the Companys
ability to obtain additional equity financing.

Certain of the Companys 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. 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. Management does not believe that these actions will
have a material adverse effect on the Company, but there can be
no assurance that other vendors will not pursue similar actions.

The Companys management believes that the
combination of cash on hand, cash flows from operations and
outside additional funding from third party investors will
provide sufficient liquidity to meet the Companys ongoing
cash requirements. This is based on the Companys
historical ability to raise funds in the form of debt and equity
financings. 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 further in order to maintain
its operations at a reduced level. Management believes that it
would be able to reduce spending if required, however, there can
be no assurances that it can successfully do so.

Contractual Obligations and Commercial
Commitments

The Companys significant contractual
obligations as of December 31, 2003 are for lease payments
related to a reduction in facilities classified as restructuring
in 2002, operating leases (primarily for office space) and
inventory commitments.

Contractual Obligations

|                        |  |                         |           |           |        |   |           |           |           |   |           |  |         |   |   |  |  |   |   | 
|----------------------- |  | ----------------------- | --------- | --------- | ------ | - | --------- | --------- | --------- | - | --------- |  | ------- | - | - |  |  | - | - | 
|                        |  |                        
|                        |  | Payments Due by Periods
|                        |  |                        
|                        |  |                         |           | Less than |        |   |           |           | More than
|                        |  | Total                   |           |           | 1 year |   |           | 1-3 years |           |   | 3-5 years |  | 5 years
|                        |  |                         |           |           |        |   |           |           |           |   |           |  |        
|Restructuring Liability |  | $                       | 120,806   |           |        | $ | 58,476    |           |           | $ | 62,330    |  |         | $ |  |  |  | $ |  | 
|Operating Lease         |  |                         | 875,639   |           |        |   | 605,077   |           |           |   | 270,562   |  |         |   |  |  |  |   |  | 
|Inventory Commitments   |  |                         | 2,000,000 |           |        |   | 2,000,000 |           |           |   |          |  |         |   |  |  |  |   |  | 
|                        |  |                         |           |           |        |   |           |           |           |   |           |  |         |   |  
|                        |  | $                       | 2,996,445 |           |        | $ | 2,663,553 |           |           | $ | 332,892   |  |         | $ |  |  |  | $ |  | 
|                        |  |                         |           |           |        |   |           |           |           |   |           |  |         |   |  






|         |                                                                
|-------- | ---------------------------------------------------------------
|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

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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, 2003. 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. 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 or may be
subjected to increased foreign currency exchange risk. During
2003, the Companys operations in Europe and Asia comprised
9.3% and 2.9% of its total revenue and 5.9% and 0.7% of its net
loss, respectively. At December 31, 2003, the
Companys assets in Europe and Asia comprised 6.3% and 2.2%
of its total assets, respectively. 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. According to
published sources, the average fluctuation of the European Euro
during 2003, 2002 and 2001 was 7.1%, 5.5% and -4.9%,
respectively, and the average fluctuation of the Japanese Yen
during 2003, 2002 and 2001 was 2.3%, 4.5% and -6.4%,
respectively. Management believes that these fluctuations did
not have a material impact on the Companys results of
operations for 2003, 2002 or 2001 or financial position for 2003
or 2002.

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 2003, 2002 and 2001 was
4.13%, 4.71%, and 7.1%, respectively, or a prime interest rate
fluctuation at December 31 compared to the rate at the
beginning of the fiscal year in 2003, 2002, and 2001 of -0.25%,
-0.5% and -4.5%, respectively. Management believes that these
fluctuations did not have a material impact on the
Companys results of operations for 2003, 2002 or 2001 or
financial position for 2003 or 2002.

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Item 8.     Financial
Statements and Supplementary Data

Index to Financial Statements

|                                                                                                       |  |     
|------------------------------------------------------------------------------------------------------ |  | ----
|Report of Independent Accountants                                                                      |  | F-1 
|Consolidated Balance Sheets 
    December 31, 2003 and 2002                                           |  | F-2 
|Consolidated Statements of Operations 
    Years ended December 31, 2003, 2002 and 2001               |  | F-3 
|Consolidated Statements of Stockholders
    Equity  Years ended December 31, 2003, 2002 and
    2001 |  | F-4 
|Consolidated Statements of Cash Flows 
    Years ended December 31, 2003, 2002 and 2001               |  | F-5 
|Notes to Consolidated Financial Statements                                                             |  | F-6 
|Supplemental Financial Information                                                                     |  | F-27

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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, 2003 and 2002, 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, 2003
and 2002, 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 19, 2004


F-1



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##### 



XYBERNAUT CORPORATION

CONSOLIDATED BALANCE SHEETS

|                                                 |                        |                                                                                                                                 |                                            |   |              |            |         |   |              |            | 
|------------------------------------------------ | ---------------------- | ------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | - | ------------ | ---------- | ------- | - | ------------ | ---------- | 
|                                                 |                        |                                                                                                                                
|                                                 |                        | December 31,                                                                                                                    |                                           
|                                                 |                        |                                                                                                                                 |                                           
|                                                 |                        | 2003                                                                                                                            |                                            |   | 2002         |           
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|ASSETS                                          
|Current assets:                                  |                        |                                                                                                                                 |                                            |   |              |            |         |  
|                                                 |                        | Cash and cash equivalents                                                                                                       |                                            | $ | 9,524,541    |            |         | $ | 1,967,710    |           
|                                                 |                        | Restricted cash                                                                                                                 |                                            |   | 1,257,554    |            |         |   | 500,000      |           
|                                                 |                        | Accounts receivable, net of allowances of
    $207,679 and $202,911                                                             |                                            |   | 4,883,899    |            |         |   | 3,410,871    |           
|                                                 |                        | Inventory, net of reserves of $3,272,716 and $0                                                                                 |                                            |   | 2,131,436    |            |         |   | 2,393,465    |           
|                                                 |                        | Prepaid and other current assets                                                                                                |                                            |   | 984,425      |            |         |   | 804,102      |           
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total current assets                       |   |              | 18,781,855 |         |   |              | 9,076,148  | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|Property, equipment and demonstration units, net |                        |                                                                                                                                 | 382,792                                    |   |              |            | 590,387 |  
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|Other assets:                                    |                        |                                                                                                                                 |                                            |   |              |            |         |  
|                                                 |                        | Patent costs, net of accumulated amortization of
    $1,963,971 and $1,516,758                                                  |                                            |   | 945,126      |            |         |   | 1,052,518    |           
|                                                 |                        | Tooling costs, net of accumulated amortization of
    $0 and $141,122, and reserves of $0 and $250,000                          |                                            |   |             |            |         |   | 776,699      |           
|                                                 |                        | Other                                                                                                                           |                                            |   | 710,294      |            |         |   | 639,619      |           
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total other assets                         |   |              | 1,655,420  |         |   |              | 2,468,836  | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total assets                               |   | $            | 20,820,067 |         |   | $            | 12,135,371 | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|LIABILITIES AND STOCKHOLDERS
    EQUITY        
|Liabilities:                                     |                        |                                                                                                                                 |                                            |   |              |            |         |  
|                                                 | Current liabilities:   |                                                                                                                                 |                                            |   |              |            |         |   |             
|                                                 |                        | Accounts payable                                                                                                                |                                            | $ | 3,068,374    |            |         | $ | 3,007,647    |           
|                                                 |                        | Accrued expenses and other                                                                                                      |                                            |   | 1,283,200    |            |         |   | 1,481,882    |           
|                                                 |                        | Deferred revenue                                                                                                                |                                            |   | 332,884      |            |         |   | 88,460       |           
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total current liabilities                  |   |              | 4,684,458  |         |   |              | 4,577,989  | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 | Long-term liabilities: |                                                                                                                                 |                                            |   |              |            |         |   |             
|                                                 |                        | Restructuring liability                                                                                                         |                                            |   | 62,330       |            |         |   | 119,295      |           
|                                                 |                        | Deferred revenue                                                                                                                |                                            |   | 163,754      |            |         |   |             |           
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total long-term liabilities                |   |              | 226,084    |         |   |              | 119,295    | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total liabilities                          |   | $            | 4,910,542  |         |   | $            | 4,697,284  | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|Commitments and contingencies                    |                        |                                                                                                                                 |                                            |   |              |            |         |  
|Stockholders equity:                            |                        |                                                                                                                                 |                                            |   |              |            |         |  
|                                                 |                        | Common stock, $0.01 par value, 200,000,000 shares
    authorized, 172,358,223 and 113,615,722 shares issued and
    outstanding |                                            |   | 1,723,582    |            |         |   | 1,136,157    |           
|                                                 |                        | Additional paid-in capital                                                                                                      |                                            |   | 163,362,829  |            |         |   | 137,181,587  |           
|                                                 |                        | Foreign currency translation                                                                                                    |                                            |   | 430,502      |            |         |   | 143,502      |           
|                                                 |                        | Accumulated deficit                                                                                                             |                                            |   | (149,607,388 | )          |         |   | (131,023,159 | )         
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total stockholders equity                 |   | $            | 15,909,525 |         |   | $            | 7,438,087  | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           
|                                                 |                        |                                                                                                                                 | Total liabilities and stockholders equity |   | $            | 20,820,067 |         |   | $            | 12,135,371 | 
|                                                 |                        |                                                                                                                                 |                                            |   |              |           

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

F-2



---



##### 



XYBERNAUT CORPORATION

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                          |                                     |                            |                                                                       |                          |           |             |             |           |            |             |             |           |            |             |             |  
|----------------------------------------- | ----------------------------------- | -------------------------- | --------------------------------------------------------------------- | ------------------------ | --------- | ----------- | ----------- | --------- | ---------- | ----------- | ----------- | --------- | ---------- | ----------- | ----------- | -
|                                          |                                     |                           
|                                          |                                     | Year Ended December 31,    |                                                                      
|                                          |                                     |                            |                                                                      
|                                          |                                     | 2003                       |                                                                       |                          | 2002      |             |             | 2001      |           
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|Revenue:                                  |                                     |                            |                                                                       |                          |           |             |             |           |            |             |             |          
|                                          |                                     | Hardware                   |                                                                       | $                        | 6,176,533 |             |             | $         | 6,131,759  |             |             | $         | 5,227,502  |            
|                                          |                                     | Software                   |                                                                       |                          |          |             |             |           |           |             |             |           | 678,900    |            
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          | Total product                       |                            |                                                                       | 6,176,533                |           |             |             | 6,131,759 |            |             |             | 5,906,402 |           
|                                          | Consulting, licensing and other     |                            |                                                                       | 4,823,454                |           |             |             | 3,841,802 |            |             |             | 3,913,591 |           
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            |                                                                       | Total revenue            |           |             | 10,999,987  |           |            |             | 9,973,561   |           |            |             | 9,819,993   |  
|Cost of sales:                            |                                     |                            |                                                                       |                          |           |             |             |           |            |             |             |          
|                                          |                                     | Hardware                   |                                                                       |                          | 4,959,974 |             |             |           | 5,399,265  |             |             |           | 3,916,922  |            
|                                          |                                     | Software                   |                                                                       |                          |          |             |             |           |           |             |             |           | 397,094    |            
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          | Total product                       |                            |                                                                       | 4,959,974                |           |             |             | 5,399,265 |            |             |             | 4,314,016 |           
|                                          | Consulting, licensing and other     |                            |                                                                       | 2,979,710                |           |             |             | 2,362,365 |            |             |             | 2,587,134 |           
|                                          | Provision for inventory and tooling |                            |                                                                       | 4,999,354                |           |             |             | 913,175   |            |             |             | 1,829,234 |           
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            |                                                                       | Gross (loss) income      |           |             | (1,939,051  | )         |            |             | 1,298,756   |           |            |             | 1,089,609   |  
|Operating expenses:                       |                                     |                            |                                                                       |                          |           |             |             |           |            |             |             |          
|                                          |                                     | Sales and marketing        |                                                                       |                          | 8,735,089 |             |             |           | 14,941,839 |             |             |           | 17,528,912 |            
|                                          |                                     | General and administrative |                                                                       |                          | 4,168,468 |             |             |           | 5,703,402  |             |             |           | 6,665,321  |            
|                                          |                                     | Research and development   |                                                                       |                          | 3,417,919 |             |             |           | 6,358,883  |             |             |           | 9,409,834  |            
|                                          |                                     | Restructuring charges      |                                                                       |                          |          |             |             |           | 1,038,160  |             |             |           |           |            
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            |                                                                       | Total operating expenses |           |             | 16,321,476  |           |            |             | 28,042,284  |           |            |             | 33,604,067  |  
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            |                                                                       | Operating loss           |           |             | (18,260,527 | )         |            |             | (26,743,528 | )         |            |             | (32,514,458 | )
|Interest and other (expenses) income, net |                                     |                            | (323,133                                                              | )                        |           |             | 163,257     |           |            |             | 340,719     |          
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            | Loss before provision for income taxes                                |                          |           | (18,583,660 | )           |           |            | (26,580,271 | )           |           |            | (32,173,739 | )          
|Provision for income taxes                |                                     |                            | 569                                                                   |                          |           |             | 562         |           |            |             | 25,840      |          
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            | Net loss                                                              |                          | $         | (18,584,229 | )           |           | $          | (26,580,833 | )           |           | $          | (32,199,579 | )          
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            | Net loss per share (basic and diluted)                                |                          | $         | (0.13       | )           |           | $          | (0.37       | )           |           | $          | (0.63       | )          
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           
|                                          |                                     |                            | Weighted average number of shares outstanding
    (basic and diluted) |                          |           | 146,078,143 |             |           |            | 71,963,440  |             |           |            | 50,827,020  |            
|                                          |                                     |                            |                                                                       |                          |           |             |             |           |           

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

F-3



---



##### 



XYBERNAUT CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                                          |  |           |             |   |          |   |           |                 |  |            |            |   |             |               |             |   |             |       |          |              |  |   |              |   |  |   |             |  
|----------------------------------------------------------------------------------------- |  | --------- | ----------- | - | -------- | - | --------- | --------------- |  | ---------- | ---------- | - | ----------- | ------------- | ----------- | - | ----------- | ----- | -------- | ------------ |  | - | ------------ | - |  | - | ----------- | -
|                                                                                          |  | Number of |             |   | Value of |   |           |                 |  | Additional |            |   | Accumulated |               |             |   |             | Total |         
|                                                                                          |  | Common    |             |   | Common   |   |           | Note Receivable |  |            | Paid-in    |   |             | Comprehensive |             |   | Accumulated |       |          | Shareholders | 
|                                                                                          |  | Shares    |             |   | Shares   |   |           | From Officer    |  |            | Capital    |   |             | Income        |             |   | Deficit     |       |          | Equity       | 
|                                                                                          |  |           |             |   |          |   |           |                 |  |            |            |   |             |               |             |   |             |       |          |              | 
|Balance, January 1, 2001                                                                  |  |           | 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     |  
|Equity securities retired for the repayment of
    note receivable 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   |  
|                                                                                          |  |           |             |   |          |   |           |                 |  |            |            |   |             |               |             |   |             |       |          |              | 
|Issuance of common stock                                                                  |  |           | 29,896,387  |   |          |   | 298,964   |                 |  |            |           |   |             |               | 13,583,511  |   |             |       |         |              |  |   |             |   |  |   | 13,882,475  |  
|Exercise of warrants                                                                      |  |           | 23,847,427  |   |          |   | 238,474   |                 |  |            |           |   |             |               | 10,083,808  |   |             |       |         |              |  |   |             |   |  |   | 10,322,282  |  
|Exercise of stock options                                                                 |  |           | 248,996     |   |          |   | 2,490     |                 |  |            |           |   |             |               | 106,779     |   |             |       |         |              |  |   |             |   |  |   | 109,269     |  
|Equity securities issued for services                                                     |  |           | 317,990     |   |          |   | 3,180     |                 |  |            |           |   |             |               | 296,638     |   |             |       |         |              |  |   |             |   |  |   | 299,818     |  
|Equity securities issued for the repayment of
    note payable principal and interest     |  |           | 4,431,701   |   |          |   | 44,317    |                 |  |            |           |   |             |               | 1,716,912   |   |             |       |         |              |  |   |             |   |  |   | 1,761,229   |  
|Warrants issued in connection with note payable                                           |  |           |            |   |          |   |          |                 |  |            |           |   |             |               | 393,594     |   |             |       |         |              |  |   |             |   |  |   | 393,594     |  
|Foreign currency translation                                                              |  |           |            |   |          |   |          |                 |  |            |           |   |             |               |            |   |             |       | 287,000  |              |  |   |              |   |  |   | 287,000     |  
|Net loss                                                                                  |  |           |            |   |          |   |          |                 |  |            |           |   |             |               |            |   |             |       |         |              |  |   | (18,584,229  | ) |  |   | (18,584,229 | )
|                                                                                          |  |           |             |   |          |   |           |                 |  |            |            |   |             |               |             |   |             |       |          |              | 
|Total comprehensive loss                                                                  |  |           |            |   |          |   |          |                 |  |            |           |   |             |               |            |   |             |       |         |              |  |   |             |   |  |   | (18,297,229 | )
|                                                                                          |  |           |             |   |          |   |           |                 |  |            |            |   |             |               |             |   |             |       |          |              | 
|Balance, December 31, 2003                                                                |  |           | 172,358,223 |   |          | $ | 1,723,582 |                 |  | $          |           |   |             | $             | 163,362,829 |   |             | $     | 430,502  |              |  | $ | (149,607,388 | ) |  | $ | 15,909,525  |  
|                                                                                          |  |           |             |   |          |   |           |                 |  |            |            |   |             |               |             |   |             |       |          |              | 

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,                                                                    |                                  
|                                                                 |                                                                                 |                                                                                            |                                  
|                                                                 |                                                                                 | 2003                                                                                       |                                   |             | 2002        |            |            | 2001        |            
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Cash flows from operating activities:                            |                                                                                 |                                                                                            |                                   |             |             |            |            |             |             |            |            |            
|                                                                 | Net loss                                                                        |                                                                                            | $                                 | (18,584,229 | )           |            | $          | (26,580,833 | )           |            | $          | (32,199,579 | )          
|                                                                 | Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                                                            |                                   |             |             |            |            |             |             |            |            |             |            
|                                                                 |                                                                                 | Depreciation and amortization                                                              |                                   |             | 1,780,988   |            |            |             | 1,815,993   |            |            |             | 1,518,833   |           
|                                                                 |                                                                                 | Provision for inventory and tooling                                                        |                                   |             | 4,999,354   |            |            |             | 913,175     |            |            |             | 1,829,234   |           
|                                                                 |                                                                                 | Provision for bad debts                                                                    |                                   |             |            |            |            |             | 100,000     |            |            |             |            |           
|                                                                 |                                                                                 | Loss on disposal of assets                                                                 |                                   |             | 38,544      |            |            |             |            |            |            |             |            |           
|                                                                 |                                                                                 | Non-cash restructuring charges                                                             |                                   |             |            |            |            |             | 792,614     |            |            |             |            |           
|                                                                 |                                                                                 | Non-cash charges for equity securities issued for
    services                             |                                   |             | 315,153     |            |            |             | 1,894,836   |            |            |             | 606,406     |           
|                                                                 |                                                                                 | Changes in assets and liabilities:                                                         |                                   |             |             |            |            |             |             |            |            |             |             |           
|                                                                 |                                                                                 |                                                                                            | Inventory                         |             |             | (4,398,719 | )          |             |             | 1,302,306  |            |             |             | (1,905,917 | )
|                                                                 |                                                                                 |                                                                                            | Accounts receivable               |             |             | (1,415,732 | )          |             |             | (139,336   | )          |             |             | 127,705    |  
|                                                                 |                                                                                 |                                                                                            | Prepaid and other current assets  |             |             | (183,871   | )          |             |             | 85,051     |            |             |             | (212,533   | )
|                                                                 |                                                                                 |                                                                                            | Other assets                      |             |             | (165,524   | )          |             |             | 921        |            |             |             | (132,575   | )
|                                                                 |                                                                                 |                                                                                            | Accounts payable                  |             |             | (19,120    | )          |             |             | (1,165,609 | )          |             |             | 2,425,693  |  
|                                                                 |                                                                                 |                                                                                            | Accrued expenses and other        |             |             | (157,166   | )          |             |             | (1,512,686 | )          |             |             | 15,555     |  
|                                                                 |                                                                                 |                                                                                            | Long-term restructuring liability |             |             | (76,933    | )          |             |             | 119,295    |            |             |             |           |  
|                                                                 |                                                                                 |                                                                                            | Deferred revenue                  |             |             | 344,712    |            |             |             | 48,172     |            |             |             | (428,246   | )
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|                                                                 |                                                                                 | Net cash used in operating activities                                                      |                                   | $           | (17,522,543 | )          |            | $           | (22,326,101 | )          |            | $           | (28,355,424 | )         
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Cash flows from investing activities:                            |                                                                                 |                                                                                            |                                   |             |             |            |            |             |             |            |            |            
|                                                                 | Note receivable from officers, net                                              |                                                                                            |                                   |            |             |            |            | (37,961     | )           |            |            | 50,949      |            
|                                                                 | Acquisition of property, equipment and
    demonstration units                  |                                                                                            |                                   | (342,805    | )           |            |            | (626,719    | )           |            |            | (1,100,696  | )          
|                                                                 | Acquisition of patents and trademarks                                           |                                                                                            |                                   | (342,983    | )           |            |            | (270,017    | )           |            |            | (858,861    | )          
|                                                                 | Restricted cash                                                                 |                                                                                            |                                   | (757,554    | )           |            |            |            |             |            |            | (85,384     | )          
|                                                                 | Capitalization of tooling costs                                                 |                                                                                            |                                   | (20,000     | )           |            |            |            |             |            |            | (1,199,302  | )          
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|                                                                 |                                                                                 | Net cash used in investing activities                                                      |                                   | $           | (1,463,342  | )          |            | $           | (934,697    | )          |            | $           | (3,193,294  | )         
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Cash flows from financing activities:                            |                                                                                 |                                                                                            |                                   |             |             |            |            |             |             |            |            |            
|                                                                 | Proceeds from:                                                                  |                                                                                            |                                   |             |             |            |            |             |             |            |            |             |            
|                                                                 |                                                                                 | Common stock offerings                                                                     |                                   |             | 13,994,915  |            |            |             | 19,833,486  |            |            |             | 22,801,278  |           
|                                                                 |                                                                                 | Exercise of warrants                                                                       |                                   |             | 10,392,282  |            |            |             | 2,186,802   |            |            |             | 3,773,405   |           
|                                                                 |                                                                                 | Exercise of stock options                                                                  |                                   |             | 109,268     |            |            |             | 11,048      |            |            |             | 135,659     |           
|                                                                 |                                                                                 | Notes and loans                                                                            |                                   |             | 1,750,000   |            |            |             | 250,000     |            |            |             |            |           
|                                                                 | Payments for:                                                                   |                                                                                            |                                   |             |             |            |            |             |             |            |            |             |            
|                                                                 |                                                                                 | Notes and loans                                                                            |                                   |             |            |            |            |             | (250,000    | )          |            |             | (466,668    | )         
|                                                                 |                                                                                 | Capitalization of loan costs                                                               |                                   |             | (18,376     | )          |            |             | (19,716     | )          |            |             | (20,000     | )         
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|                                                                 |                                                                                 | Net cash provided by financing activities                                                  |                                   | $           | 26,228,089  |            |            | $           | 22,011,620  |            |            | $           | 26,223,674  |           
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Effect of exchange rate changes on cash and cash
    equivalents |                                                                                 |                                                                                            | 314,627                           |             |             |            | 44,279     |             |             |            | (351,062   | )          
|Net increase (decrease) in cash and cash
    equivalents         |                                                                                 |                                                                                            | 7,556,831                         |             |             |            | (1,204,899 | )           |             |            | (5,676,106 | )          
|Cash and cash equivalents, beginning of period                   |                                                                                 |                                                                                            | 1,967,710                         |             |             |            | 3,172,609  |             |             |            | 8,848,715  |            
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Cash and cash equivalents, end of period                         |                                                                                 | $                                                                                          | 9,524,541                         |             |             | $          | 1,967,710  |             |             | $          | 3,172,609  |            
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Supplemental disclosure of cash flow information:                |                                                                                 |                                                                                            |                                   |             |             |            |            |             |             |            |            |            
|                                                                 |                                                                                 | Cash paid for interest                                                                     |                                   | $           | 765         |            |            | $           | 2,402       |            |            | $           | 6,175       |           
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|                                                                 |                                                                                 | Cash paid for taxes                                                                        |                                   | $           | 654         |            |            | $           | 23,050      |            |            | $           | 40,109      |           
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Supplemental disclosure of non-cash financing
    activities:    |                                                                                 |                                                                                            |                                   |             |             |            |            |             |             |            |            |            
|                                                                 |                                                                                 | Equity securities issued for future services,
    recorded as prepaid expenses when issued |                                   | $           |            |            |            | $           | 1,929,498   |            |            | $           | 507,917     |           
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|                                                                 |                                                                                 | Equity securities issued for services rendered,
    expensed in periods issued             |                                   | $           | 299,818     |            |            | $           | 373,027     |            |            | $           | 129,549     |           
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|                                                                 |                                                                                 | Equity securities issued for settlement of
    accounts payable and accrued expenses       |                                   | $           |            |            |            | $           | 509,547     |            |            | $           | 337,666     |           
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Equity securities issued for settlement of
    notes payable     |                                                                                 | $                                                                                          | 1,750,000                         |             |             | $          |           |             |             | $          |           |            
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            
|Equity retired for repayment of note receivable
    from officer |                                                                                 | $                                                                                          |                                  |             |             | $          | 1,026,708  |             |             | $          |           |            
|                                                                 |                                                                                 |                                                                                            |                                   |             |             |            |            |             |            

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

F-5



---



##### 



XYBERNAUT CORPORATION

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

1. The Company, Liquidity and
Operations

Xybernaut Corporation, a Delaware corporation
(the Company), is engaged in the research,
development, manufacture, marketing and sale 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 critical enterprise 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). In 2004, the Company began actively marketing its
mobile and wearable hardware solutions in the Peoples
Republic of China through its 60% ownership in Xybernaut China
Limited, a joint venture with Softbank Investment International
(Strategic) Ltd. The Company was originally incorporated in 1990
and completed its initial public offering in July 1996.

Introduced in 1995, the Mobile Assistant®
(MA®) series is the Companys primary line
of wearable computer hardware products, the current versions of
which are the MA V and MA TC. Introduced in 2002, the
Atigo product line is a family of mobile 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. Since their
commercial introductions, the Company has recognized revenue of
approximately $26,000,000 on sales of approximately 6,900
MA and Atigo systems.

The Company has recorded net losses since its
inception. These losses are primarily attributable to the
operating expenses incurred by the Company to design, develop,
market and sell its mobile and wearable computer products and to
provide general and administrative support for these operating
activities. The Companys revenues and gross margins have
not been sufficient to fund these operating activities. As a
result, the Company has consistently reported negative cash
flows from operating activities and net losses and had an
accumulated deficit of $149,607,388 at December 31, 2003.

The Companys management has taken steps
that it believes are necessary to improve operations and raise
additional capital, both of which are needed to meet its cash
flow needs through December 31, 2004 and thereafter. During
2002 and 2003, management performed reviews of the
Companys operations and implemented various cost cutting
programs to reduce the Companys operating expenses to
better align costs with current and expected business volume.
The Company incurred total operating expenses in 2003 of
approximately $16.3 million, a decrease from $28.0 million
and $33.6 million in 2002 and 2001, respectively.
Management believes that the Companys current staffing and
resources will be sufficient to carry out its business plan for
the foreseeable future.

The Companys management believes that the
combination of cash on hand, cash flows from operations and
outside additional funding from third party investors will
provide sufficient liquidity to meet the Companys ongoing
cash requirements. This is based on the Companys
historical ability to raise funds in the form of debt and equity
financings. 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 further in order to maintain
its operations at a reduced level. Management believes that it
would be able to reduce spending if required, however, there can
be no assurances that it can successfully do so.

2. Summary of Significant Accounting
Policies

Principles of
Consolidation

The consolidated financial statements as of
December 31, 2003 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.). The
consolidated

F-6



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


financial statements for periods subsequent to
December 31, 2003 are also expected to consolidate the
accounts of Xybernaut China Limited (Hong Kong, China). 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.

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, 2003 and 2002,
the Company had $1,257,554 and $500,000, respectively, in
restricted cash. The balance at December 31, 2002 consisted
of a $500,000 cash deposit that secures a long-term services
contract. The balance at December 31, 2003 consisted of i)
this same $500,000 cash deposit, ii) a $376,442 cash deposit and
interest that secures a letter of credit held by a vendor and
iii) $381,112 held in escrow representing payment for inventory
purchases made by the Company during December 2003 to be paid to
the vendor in January 2004. The restrictions on the $500,000
deposit are scheduled to lapse in late 2004, at which point the
cash deposit is expected to be returned to the Company. The
restrictions on the $376,442 deposit lapsed in the first quarter
of 2004 and the amount was returned to the Companys
unrestricted cash balance. The restrictions on the $381,112
lapsed in the first quarter of 2004 and the cash deposit was
remitted to the vendor.

Inventory and
Tooling

At December 31, 2003, inventory consisted
primarily of wearable computer component parts held for resale
and allocated tooling costs, and is comprised primarily of
finished goods. 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. Inventory and tooling are 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 tooling and adjusts the carrying
value to its net realizable value when required.

The Company recognized inventory and tooling
charges on its consolidated statement of operations of
$4,999,354 during 2003 related to its wearable computer product
lines, representing charges of i) $4,205,949 against MA V
inventory, components and tooling, ii) $503,436 against
MA TC inventory, iii) $257,737 against MA IV inventory
and iv) $32,232 against pomainventory.

The Company had a $250,000 tooling reserve and a
$0 inventory reserve on its consolidated balance sheet at
December 31, 2002. During 2003, the Company reserved an
additional $2,772,716 against the MA V systems and $250,000
against the MA TC systems. During 2003, the production run
for the MA V product line was completed. As a result, all
MA V tooling and the $250,000 MA V reserve were
allocated to inventory. The Company had a $3,272,716 inventory
reserve and a $0 tooling reserve on its consolidated balance
sheet at December 31, 2003.

F-7



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


During 2003, the Company wrote-off $1,976,638 of
inventory, which amount is included in the inventory and tooling
charges recorded during 2003 and discussed above. Included in
this 2003 amount are write-offs of $1,433,233 of MA V
inventory consisting of i) $840,035 of excess accessories
that exceeded those required to make a complete MA system,
ii) $549,033 of microchips that were purchased for the
production of the MA V product line but that were not used
in such production, (iii) $18,632 of demo units and
(iv) $25,533 of related MA V flat panel display
tooling. Also included in this 2003 amount are write-offs of
i) $253,436 of MA TC microchips that were purchased
for the production of the MA TC product line but that were
not used in such production, ii) $257,737 of MA IV
inventory and iii) $32,232 of pomainventory.

The Company recognized inventory and tooling
charges on its consolidated statement of operations of $913,175
during 2002 related to its wearable computer product lines,
representing charges of i) $1,191,696 against MA V,
MA TC and MA IV product lines due to an estimated
decline in their value, ii) $53,958 against a small number of
early-production models of the MA V product line with
limited hard disk capacity received by the Company, iii)
$299,077 against MA V tooling, and iv) a $631,556 reversal
of a reserve recorded in 2001 related to the pomaproduct
line discussed below.

The Company had a $141,280 inventory reserve and
a $0 tooling reserve on its consolidated balance sheet at
December 31, 2001. During 2002, the Company reserved
$250,000 against MA V tooling. During 2002, the $141,280
reserve that was established for certain hard disk drives as of
December 31, 2001 was fully utilized when the hard drives
were sold at an amount approximating their net carrying value.
The Company had a $250,000 tooling reserve and a $0 inventory
reserve on its consolidated balance sheet at December 31,
2002.

During 2002, the Company wrote-off $1,294,731 of
inventory and tooling, which amount is included in the inventory
and tooling charges recorded during 2002 and discussed above.
Included in this 2002 amount are write-offs of
i) $1,191,696 against MA V, MA TC and MA IV
product lines due to an estimated decline in their value,
ii) $53,958 against a small number of early-production
models of the MA V product line with limited hard disk
capacity received by the Company and iii) $49,077 against
MA V tooling.

The Company recognized inventory and tooling
charges on its consolidated statement of operations of
$1,829,234 during 2001 related to it wearable computer product
lines, representing charges of i) $663,790 to reduce the
net carrying value of inventory associated with the MA IV
product line, ii) $141,280 against certain hard disk
drives, iii) $885,019 related to the poma product
line and iv) $139,145 related to MA IV tooling.

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. The significant majority of the inventory and tooling
charges during 2003 and 2002 were recorded against the MA V
product line. Even after the successful renegotiation of certain
of the MA V manufacturing contracts during 2003, the
Company had commitments to purchase significant quantities of
inventory. The Company was required to write-down and reserve a
substantial portion of the MA V inventory in 2003 and 2002
as historical and forecasted sales are not sufficient to sell
such quantities of 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. To the extent that actual future events are
different from the assumptions and estimates used by

F-8



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

2. Summary of Significant Accounting
Policies, continued:

management, additional charges, reserves or
adjustments may be recorded by the Company. Management does not
expect to record significant profits or losses upon the ultimate
sale of this inventory.

As of December 31, 2003, net of the effect
of reserves and write-offs, the Companys inventory
consisted of $1,623,791 in MA V systems, $219,468 in
MA TC systems and $288,177 in Atigo systems. As of
December 31, 2003, all of the Companys tooling assets
had been allocated to inventory or property and equipment.
Capitalized tooling costs during 2003, 2002 and 2001 were
$20,000, $0 and $1,199,302, respectively. Amortization to cost
of goods sold or depreciation, depending on classification of
tooling costs as inventory or property and equipment, was
$260,492, $43,126 and $148,866 in 2003, 2002 and 2001,
respectively.

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.

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 either not
reached the point of technological feasibility or cost incurred
after reaching technological feasibility have been immaterial.
At December 31, 2003, 2002 and 2001, 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 ten 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, 2003 and 2002 was $450,073 and $384,359,
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

F-9



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


general and administrative expenses. Patent and
trademark amortization expense was $477,313, $426,751 and
$350,110 during 2003, 2002 and 2001, respectively. Costs
associated with the maintenance and upkeep of existing patents
are expensed as incurred as part of general and administrative
expenses.

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 2003, 2002 or 2001.

Revenue
Recognition and Warranties

The Companys revenues are principally
derived from sales of 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 $88,454, $553,310 and $229,413 during 2003, 2002
and 2001, respectively, and had a warranty reserve of $89,553
and $81,552 at December 31, 2003 and 2002, respectively.

The Company recognizes 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 (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.

F-10



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


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, a basis
which management believes reasonable matches revenue to
proportional performance under each related contract. Revenue in
excess of billings on service contracts is recorded as unbilled
receivables. At December 31, 2003 and 2002, unbilled
receivables of $322,152 and $1,130,206, 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, 2003 and 2002, $200,864 and $84,685
respectively, were recorded as deferred revenue from service
contracts. Warranty revenue on hardware products is recorded as
deferred revenue until earned on the straight-line basis over
the life of the warranty. At December 31, 2003 and 2002,
$295,774 and $3,775, respectively, were recorded as deferred
revenue from warranties, of which, $163,754 and $0, were
classified as long-term liabilities at December 31, 2003
and 2002, respectively.

During 2003, the Company entered into the
high-volume electronic component parts distribution business.
Revenue from this distribution business is accounted for based
on the facts and circumstances of each individual transaction in
accordance with Emerging Issues Task Force (EITF)
Issue No. 99-19, Reporting Revenue Gross as a
Principal versus Net as an Agent. Based upon the facts and
circumstances of the transactions entered into during the year
ended December 31, 2003, the Company recorded consulting,
licensing and other revenue of $100,224, such amounts
representing the net fees the Company earned for services
performed during these periods. On a gross basis, the
transactions totaled $4,104,423 during the year ended
December 31, 2003.

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 2003, 2002
and 2001 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

F-11



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

2. Summary of Significant Accounting
Policies, continued:

securities were exercised or converted into
common stock. Warrant and stock options that could potentially
dilute basic loss per share in the future but were not included
in the computation of diluted loss per share because to do so
would have been antidilutive for the year ended
December 31, 2003, 2002 and 2001 were 712,771, 281,430 and
897,997, respectively. For all periods presented herein, the
Companys 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:

|                                                                                      |  |      |             |   |      |   |             |      |  |   |             |  
|------------------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | ---- |  | - | ----------- | -
|                                                                                      |  | 2003 |             |   | 2002 |   |             | 2001 | 
|                                                                                      |  |      |             |   |      |   |             |      | 
|Net loss, as reported                                                                 |  | $    | (18,584,229 | ) |      | $ | (26,580,833 | )    |  | $ | (32,199,579 | )
|Stock-based employee compensation cost included
    in net loss as reported           |  |      | 157,655     |   |      |   | 201,381     |      |  |   |            |  
|Stock-based employee compensation expense under
    fair value method of SFAS No. 123 |  |      | (1,896,199  | ) |      |   | (4,475,260  | )    |  |   | (6,565,666  | )
|                                                                                      |  |      |             |   |      |   |             |      | 
|Net loss pro forma                                                                    |  | $    | (20,322,773 | ) |      | $ | (30,854,712 | )    |  | $ | (38,765,245 | )
|                                                                                      |  |      |             |   |      |   |             |      | 
|Net loss per share basic and diluted 
    as reported                                |  | $    | (0.13       | ) |      | $ | (0.37       | )    |  | $ | (0.63       | )
|                                                                                      |  |      |             |   |      |   |             |      | 
|Net loss per share basic and diluted 
    pro forma                                  |  | $    | (0.14       | ) |      | $ | (0.43       | )    |  | $ | (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 2003, the Company recorded no prepaid
amounts related to the issuance of equity securities for future
services or goods to be provided. In 2002, the Company recorded
prepaid assets for future services or goods to be provided of
$1,929,498, of which, $19,167 and $1,910,331 was expensed in
2003 and 2002, respectively. 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, 2003 and 2002 are
equity securities issued for payment of future services of $0
and $19,167, 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

F-12



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


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 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 paid in cash and $188,762
was paid by the issuance of equity securities during the last
three quarters of 2002. At December 31, 2003 and 2002,
$58,476 and $78,444, respectively, is included in accrued
expenses and $62,330 and $119,295, respectively, 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.

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,
2003 and 2002 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, 2003 and 2002 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, 2003, 2002 and 2001.

Recent
Accounting Pronouncements

In January 2003, the Financial Accounting
Standards Board (FASB) issued FASB Interpretation
No. 46 (FIN 46), Consolidation of Variable
Interest Entities. This Interpretation clarifies the
application of Accounting Research Bulletin No. 51,
Consolidated Financial Statements, to certain
entities in which equity investors do not have the
characteristics of a controlling financial interest or do not
have sufficient

F-13



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



2. Summary of Significant Accounting
Policies, continued:


equity at risk for the entity to finance its
activities without additional subordinated financial support
from other parties. FIN 46 requires an enterprise to
consolidate a variable interest entity if that enterprise will
absorb a majority of the entitys expected losses, is
entitled to receive a majority of the entitys expected
residual returns, or both. FIN 46 also requires disclosures
about unconsolidated variable interest entities in which an
enterprise holds a significant variable interest. Application of
FIN 46, as revised in December 2003, is required for
financial statements of public entities that have interest in
variable interest entities, or potential variable interest
entities commonly referred to as special-purpose entities for
periods ending after December 15, 2003. Application by
public companies for all other types of entities is required in
financial statements for periods ending after March 15,
2004. The Company does not expect the adoption of FIN 46 to have
a material effect on its financial statements.

In May 2003, the FASB issued SFAS No. 150,
Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. SFAS
No. 150 establishes standards for issuer classification and
measurement of certain financial instruments with
characteristics of both liabilities and equity. Instruments that
fall within the scope of SFAS No. 150 must be classified as
a liability. Most of the guidance in SFAS 150 is effective for
financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003.
On November 7, 2003, the provisions of SFAS 150,
relating to mandatorily redeemable non-controlling interest,
were deferred indefinitely. Adoption of this standard is not
expected to have a material effect on the Companys
financial statements.

Reclassifications

Certain 2001 and 2002 balances and disclosures
have been reclassified to conform to the 2003 presentation.

3. Property and Equipment

Property and equipment consist of the following:

|                                               |  |              |            |   |      |   |            |  
|---------------------------------------------- |  | ------------ | ---------- | - | ---- | - | ---------- | -
|                                               |  |             
|                                               |  | December 31, |           
|                                               |  |              |           
|                                               |  | 2003         |            |   | 2002 |  
|                                               |  |              |            |   |      |  
|Furniture and fixtures                         |  | $            | 252,035    |   |      | $ | 312,161    |  
|Equipment                                      |  |              | 1,558,198  |   |      |   | 1,450,300  |  
|Leasehold improvements                         |  |              | 274,446    |   |      |   | 328,147    |  
|Demonstration units                            |  |              | 1,947,382  |   |      |   | 1,658,840  |  
|                                               |  |              |            |   |      |  
|                                               |  |              | 4,032,061  |   |      |   | 3,749,448  |  
|Less accumulated depreciation and amortization |  |              | (3,649,269 | ) |      |   | (3,159,061 | )
|                                               |  |              |            |   |      |  
|                                               |  | $            | 382,792    |   |      | $ | 590,387    |  
|                                               |  |              |            |   |      |  

Depreciation expense for the years ended
December 31, 2003, 2002 and 2001 was $521,211, $1,159,277
and $914,288, respectively. Effective December 31, 2002,
the Company wrote off $990,144 of fully depreciated
demonstration units.

F-14



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

4. Accrued Expenses and Other

Accrued expenses and other consist of the
following:

|                                        |  |              |           |  |      |   |           | 
|--------------------------------------- |  | ------------ | --------- |  | ---- | - | --------- | 
|                                        |  |             
|                                        |  | December 31, |          
|                                        |  |              |          
|                                        |  | 2003         |           |  | 2002 |  
|                                        |  |              |           |  |      |  
|Accrued salaries, benefits and vacation |  | $            | 785,985   |  |      | $ | 795,699   | 
|Professional fees                       |  |              | 204,738   |  |      |   | 295,336   | 
|Other                                   |  |              | 144,448   |  |      |   | 212,152   | 
|Warranty reserve                        |  |              | 89,553    |  |      |   | 100,251   | 
|Restructuring liability                 |  |              | 58,476    |  |      |   | 78,444    | 
|                                        |  |              |           |  |      |  
|                                        |  | $            | 1,283,200 |  |      | $ | 1,481,882 | 
|                                        |  |              |           |  |      |  

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

5. Borrowings

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, 2003, the capital lease obligation
was $0. During 2003, 2002 and 2001, the Company incurred
interest expense of $635, $2,320 and $3,781, 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, the Company incurred
interest expense of $2,377 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.

On March 26, 2003, the Company borrowed
$1,750,000 from a lender pursuant to a one-year promissory note
that bore interest at 3.5% per annum. In connection with this
borrowing, the Company issued to the lender 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. Based on the
relative fair values of the securities issued, these warrants
were assigned a value of $393,594, which amount was recorded as
a note discount to be amortized into interest expense over the
life of the note. On May 30, 2003, the Company repaid
$860,000 in principal when the lender elected to exercise the
2,000,000 warrants at $0.43 per share. Subsequent to this
partial repayment, the lender provided the Company with a 10%
discount on the remaining unpaid principal to induce the Company
to repay the remaining principal prior to its original maturity
date. The remaining principal and interest was repaid on
May 30, 2003 through the: i) $89,000 discount, which was
applied against the Companys Additional Paid-In Capital,
ii) application of the $560,000 aggregate exercise price related
to the exercise of the warrants to purchase 1,750,000 shares of
common stock at $0.32 per share, a reduction from the original
$1.25 per share exercise price, iii) issuance of 651,351 shares
of common stock valued at $241,000, or $0.37 per share, and iv)
issuance of 30,350 shares of common stock valued at $11,229, or
$0.37 per share, as repayment of accrued interest. During 2003,
the Company fully amortized the $393,594 note discount into
interest expense. The Company had no outstanding principal or
interest related to this note at December 31, 2003.

F-15



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

6. Stockholders Equity

Common
Stock

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 2002, the Company received net cash
proceeds of $19,833,486 through the issuance of 35,830,024
shares of its common stock through four separate private
placements. The Company also issued warrants to purchase
23,043,156 shares of its common stock for between $0.70 and
$3.00 per share related to these private placements.

During 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. 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.

During May 2003, the Company received gross
proceeds of $3,000,000 through a private placement of 9,375,000
shares of its common stock to certain investors. In connection
with this private placement, the Company issued to the investors
three-year callable warrants to purchase 3,281,250 shares of
common stock. These warrants had an exercise price of $0.45 if
exercised in the first year, $0.90 if exercised in the second
year and $1.35 if exercised in the third and final year.

During June 2003, the Company received gross
proceeds of $2,000,000 through a private placement of 5,405,405
shares of its common stock to an investor. In connection with
this private placement, the Company issued to the investor
three-year callable warrants to purchase 4,054,054 shares of
common stock. These warrants had an exercise price of $1.25 if
exercised in the first year, $2.50 if exercised in the second
year and $3.75 if exercised in the third and final year.

During September 2003, the Company received gross
proceeds of $5,000,000 through a private placement of 6,849,315
shares of its common stock to an investor. In connection with
this private placement, the Company issued to the investor
three-year callable warrants to purchase 3,424,658 shares of
common stock. These warrants had an exercise price of $0.91 if
exercised in the first year, $1.82 if exercised in the second
year and $2.73 if exercised in the third and final year.

During September 2003, the Company received gross
proceeds of $2,000,000 through a private placement of 1,600,000
shares of its common stock to an investor. In connection with
this private placement, the Company issued to the investor
three-year callable warrants to purchase 800,000 shares of
common stock. These warrants have an exercise price of $1.25 if
exercised in the first year, $2.50 if exercised in the second
year and $3.75 if exercised in the third and final year.

The Company issues warrants to purchase shares of
its common stock, primarily in connection with the
Companys financings and borrowings. Exclusive of the
exercises made in connection with the note repayment discussed
in Borrowings above, the Company received net
proceeds of $10,392,282, $2,186,802 and $3,773,405 through the
issuance of 23,847,427, 17,350,627 and 1,881,470 shares of its
common stock during 2003, 2002 and 2001, respectively, through
the exercise of warrants. Concurrently with their exercise, the
exercise price of 17,116,852 warrants was reduced from a
weighted average of $1.14 per share to $0.34 per share during
2003. Concurrently with their exercise, the exercise price of
17,350,627 warrants was reduced from a weighted average of $1.61
per share to $0.18 per share during 2002. At December 31,
2003, the Company had warrants outstanding to purchase 4,117,739
shares of its common stock at prices that range from $0.60 to
$5.00 per share, with a weighted average of $3.56 per share.

F-16



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

6. Stockholders Equity,
continued:

Employees and consultants of the Company have
exercised stock options that had been issued pursuant to the
Companys various stock incentive plans. During 2003, 2002
and 2001, the Company issued 248,996, 35,835 and 57,097 shares,
respectively, of its common stock and received gross proceeds of
$109,269, $11,048 and $135,659, respectively, related to these
exercises.

7. 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.

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
two to five equal annual installments beginning one year after
the date of grant. Stock options granted to officers and
directors are generally exercisable in one to three annual
installments beginning one year after the date of grant.

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,
2003, 425,611, 1,083,230, 2,763,186, 1,909,672 and 414,250 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:

|                  |  |           |            |          |               |   |      |           |          |  |               |   |  |           |      |  |               |  |           |   |  |   |      | 
|----------------- |  | --------- | ---------- | -------- | ------------- | - | ---- | --------- | -------- |  | ------------- | - |  | --------- | ---- |  | ------------- |  | --------- | - |  | - | ---- | 
|                  |  |           |            |          |               |  
|                  |  | 2003      |            |          | 2002          |   |      | 2001      |         
|                  |  |           |            |          |               |   |      |           |         
|                  |  |           |            | 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 |  |           | 6,909,318  |          |               | $ | 3.10 |           |          |  | 6,844,832     |   |  | $         | 3.88 |  |               |  | 4,850,752 |   |  | $ | 4.39 | 
|Granted           |  |           | 1,188,998  |          |               | $ | 0.59 |           |          |  | 2,432,984     |   |  | $         | 0.98 |  |               |  | 2,674,819 |   |  | $ | 3.29 | 
|Exercised         |  |           | (261,044   | )        |               | $ | 0.45 |           |          |  | (521,132      | ) |  | $         | 0.33 |  |               |  | (57,097   | ) |  | $ | 2.44 | 
|Cancelled         |  |           | (1,241,323 | )        |               | $ | 3.19 |           |          |  | (1,847,366    | ) |  | $         | 4.61 |  |               |  | (623,642  | ) |  | $ | 5.46 | 
|                  |  |           |            |          |               |   |      |           |          |  |               |   |  |           |      |  |               | 
|Ending balance    |  |           | 6,595,949  |          |               | $ | 2.75 |           |          |  | 6,909,318     |   |  | $         | 3.10 |  |               |  | 6,844,832 |   |  | $ | 3.88 | 
|                  |  |           |            |          |               |   |      |           |          |  |               |   |  |           |      |  |               | 

The following table summarizes information about
fixed stock options outstanding at December 31, 2003:

|                    |  |             |                     |  |                  |  |     |                  |  |   |             |  |  |                  |           |  |  |   |      | 
|------------------- |  | ----------- | ------------------- |  | ---------------- |  | --- | ---------------- |  | - | ----------- |  |  | ---------------- | --------- |  |  | - | ---- | 
|                    |  |            
|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         |  |             | 2,716,736           |  |                  |  | 8.3 |                  |  | $ | 0.81        |  |  |                  | 1,781,697 |  |  | $ | 0.74 | 
|$1.68$3.32         |  |             | 1,845,013           |  |                  |  | 5.9 |                  |  | $ | 2.36        |  |  |                  | 1,613,247 |  |  | $ | 2.37 | 
|$3.33$4.97         |  |             | 1,071,700           |  |                  |  | 5.1 |                  |  | $ | 4.08        |  |  |                  | 911,900   |  |  | $ | 4.14 | 
|$4.98$23.38        |  |             | 962,500             |  |                  |  | 6.2 |                  |  | $ | 7.50        |  |  |                  | 756,400   |  |  | $ | 7.15 | 
|                    |  |             |                     |  |                  |  |     |                  |  |   |             |  |  |                  |          
|                    |  |             | 6,595,949           |  |                  |  | 6.8 |                  |  | $ | 2.75        |  |  |                  | 5,063,244 |  |  | $ | 2.83 | 
|                    |  |             |                     |  |                  |  |     |                  |  |   |             |  |  |                  |          

F-17



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



7. Stock Options, continued:


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, |            
|                                 |  |                         |            
|                                 |  | 2003                    |             |   | 2002 |   |             | 2001 | 
|                                 |  |                         |             |   |      |   |             |      | 
|Net loss  as reported           |  | $                       | (18,584,229 | ) |      | $ | (26,580,833 | )    |  | $ | (32,199,579 | )
|Net loss  pro forma             |  | $                       | (20,322,773 | ) |      | $ | (30,854,712 | )    |  | $ | (38,765,245 | )
|Net loss per share  as reported |  | $                       | (0.13       | ) |      | $ | (0.37       | )    |  | $ | (0.63       | )
|Net loss per share  pro forma   |  | $                       | (0.14       | ) |      | $ | (0.43       | )    |  | $ | (0.76       | )

The weighted-average fair values of each option
at the date of grant for 2003, 2002 and 2001 were $0.59, $0.88
and $3.29, respectively, and were estimated on the date of grant
using the Black-Scholes option-pricing model with the following
weighted-average assumptions used in 2003, 2002 and 2001:
dividend yield of 0%; expected volatility of 102% in 2003, 134%
in 2002 and 115% in 2001; risk-free interest rate of 1.95% in
2003, 1.82% in 2002 and 4.09% in 2001; and expected lives of
3 years.

8. 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 has subsidiaries in Germany and
Japan. The Company has also entered into a joint venture in
China in 2004. Operations of this joint venture did not impact
the periods included in this Form 10-K but are expected to
impact the Companys operations for periods subsequent to
December 31, 2003. Revenues by geographical destination as
a percentage of total revenues for the year ended
December 31, 2003, 2002, and 2001 are as follows:

|                            |  |              |     |  |      |  |     |      |  |  |     | 
|--------------------------- |  | ------------ | --- |  | ---- |  | --- | ---- |  |  | --- | 
|                            |  |             
|                            |  | December 31, |    
|                            |  |              |    
|                            |  | 2003         |     |  | 2002 |  |     | 2001 | 
|                            |  |              |     |  |      |  |     |      | 
|United States               |  |              | 88% |  |      |  | 82% |      |  |  | 72% | 
|Europe, principally Germany |  |              | 9%  |  |      |  | 13% |      |  |  | 22% | 
|Asia, principally Japan     |  |              | 3%  |  |      |  | 5%  |      |  |  | 6%  | 

F-18



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



8. Segment and Enterprise Wide Reporting,
continued:


Operations in various geographical areas are
summarized as follows:

|               |                     |              |   |            |      |  |   |            |  |  |   |            | 
|-------------- | ------------------- | ------------ | - | ---------- | ---- |  | - | ---------- |  |  | - | ---------- | 
|               |                     |             
|               |                     | December 31, |  
|               |                     |              |  
|               |                     | 2003         |   |            | 2002 |  |   | 2001       | 
|               |                     |              |   |            |      |  |   |            | 
|North America: |                     |              |   |            |      |  |   |            |  |  |   |           
|               | Total revenue       |              | $ | 9,655,942  |      |  | $ | 8,203,286  |  |  | $ | 7,100,445  | 
|               | Net loss            |              |   | 17,359,419 |      |  |   | 21,882,030 |  |  |   | 25,858,000 | 
|               | Identifiable assets |              |   | 19,058,444 |      |  |   | 10,288,624 |  |  |   | 12,726,593 | 
|Europe (1):    |                     |              |   |            |      |  |   |            |  |  |   |           
|               | Total Revenue       |              | $ | 1,026,701  |      |  | $ | 1,312,241  |  |  | $ | 2,164,674  | 
|               | Net loss            |              |   | 1,099,271  |      |  |   | 4,354,189  |  |  |   | 4,458,126  | 
|               | Identifiable assets |              |   | 1,312,905  |      |  |   | 1,383,755  |  |  |   | 3,278,857  | 
|Asia:          |                     |              |   |            |      |  |   |            |  |  |   |           
|               | Total revenue       |              | $ | 317,344    |      |  | $ | 458,034    |  |  | $ | 554,874    | 
|               | Net loss            |              |   | 125,539    |      |  |   | 344,614    |  |  |   | 1,883,453  | 
|               | Identifiable assets |              |   | 448,718    |      |  |   | 462,992    |  |  |   | 658,868    | 



---



|    |                                                                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Included in the Companys operations in
    Europe are $232,738, $1,634,381 and $1,738,676, respectively, in
    expenses related to research and development activities
    conducted by a branch of the Company operating in Germany.

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,      | 
|                     |                                      |                   | 
|                     |                                      | 2003              |  |    | 2002 |  |  | 2001 |  
|                     |                                      |                   |  |    |      |  |  |      |  
|Revenue:             |                                      |                   |  |    |      |  |  |      |   |  |  |   
|                     | Number of Customers                  |                   |  | 2  |      |  |  | 1    |   |  |  | 2  |  
|                     | Percent of Total Revenue             |                   |  | 38 | %    |  |  | 16   | % |  |  | 30 | %
|Accounts Receivable: |                                      |                   |  |    |      |  |  |      |   |  |  |   
|                     | Number of Customers                  |                   |  | 2  |      |  |  | 2    |   |  |  | 3  |  
|                     | Percent of Total Accounts Receivable |                   |  | 38 | %    |  |  | 64   | % |  |  | 56 | %

For the years ended December 31, 2003, 2002
and 2001, revenue from the following customers comprised greater
than 10% of total revenue: CSX Technology, Inc. and Naval
Undersea Warfare Center (NUWC); IBM; and the State of Tennessee
Department of Transportation (Tennessee DOT) and
Europart KG, respectively. As of December 31, 2003, 2002
and 2001, the following customers accounts receivable
balances comprised greater than 10% of total accounts
receivable: NUWC and a Fortune 500 cable provider; IBM and
Tennessee DOT; and IBM, 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,
markets and sells the systems worldwide to its own customers and
introduces the Company to potential future customers (the
Sales and Marketing Agreement). During 2003, 2002
and 2001, the Company paid $4,741,313, $2,772,457 and
$4,148,523, respectively, to IBM related to design and
development services and inventory purchases. Such 2003 amount
includes

F-19



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



8. Segment and Enterprise Wide Reporting,
continued:


payments made to IBM pursuant to the agreements
discussed in the Inventory Commitments section
below. During 2003, 2002 and 2001, the Company recorded revenues
of $88,137, $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 2003, 2002 and
2001, the Company recorded revenues of approximately $773,000,
$950,000 and $1,700,000, respectively, related to sales of its
products to the VAR. During 2003, 2002 and 2001, the Company
recorded total research and development and sales and marketing
expenses of $755,000, $1,250,000 and $1,250,000, 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.

9. Income Taxes

At December 31, 2003, the Company had
approximately $136,000,000 of net operating loss carryforwards
(NOLs) for U.S. federal income tax purposes which
expire in varying years from 2010 through 2023. The Company has
experienced several ownership changes pursuant to Internal
Revenue Code Section 382. These ownership changes, which
occurred in 1997, 1999, 2002, and 2003, have the effect of
limiting the Companys usage of its NOLs in years after
each ownership change. Due to these limitations, at least
$38,000,000 of the NOLs have been permanently impaired because
they will expire before they ever become available for use.
After consideration of this impairment, the Company had
approximately $98,000,000 of NOLs which become available for
future use based on an annual limitation of approximately
$4,600,000. After consideration of this limitation, the Company
had approximately $6,100,000 of NOLs available to offset future
taxable income as of December 31, 2003. The remaining
approximate $91,900,000 of NOLs are expected to become available
to offset future taxable income in the future. However, there
can be no assurance that such NOLs will not become impaired in
the future.

At December 31, 2003, the Company had
approximately $7,500,000 of NOLs for foreign income tax
purposes. These NOLs are not affected by Internal Revenue Code
Section 382 and are not impaired.

F-20



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

9. Income Taxes, continued:

Net deferred tax assets are comprised of the
following:

|                                         |  |                         |             |   |      |   |             |  
|---------------------------------------- |  | ----------------------- | ----------- | - | ---- | - | ----------- | -
|                                         |  |                        
|                                         |  | Year Ended December 31, |            
|                                         |  |                         |            
|                                         |  | 2003                    |             |   | 2002 |  
|                                         |  |                         |             |   |      |  
|Excess of book over tax depreciation     |  | $                       | 741,000     |   |      | $ | 860,000     |  
|Net operating loss carryforwards         |  |                         | 37,042,000  |   |      |   | 45,726,000  |  
|Accrued expenses and reserves            |  |                         | 1,363,000   |   |      |   | 443,000     |  
|Tax credit carryforwards                 |  |                         | 63,000      |   |      |   | 63,000      |  
|Foreign tax credits                      |  |                         |            |   |      |   |            |  
|Foreign net operating loss carryforwards |  |                         | 2,866,000   |   |      |   | 2,940,000   |  
|Foreign other                            |  |                         | 3,000       |   |      |   | 3,000       |  
|Less valuation allowance                 |  |                         | (42,078,000 | ) |      |   | (50,035,000 | )
|                                         |  |                         |             |   |      |  
|Net deferred tax asset                   |  | $                       |            |   |      | $ |            |  
|                                         |  |                         |             |   |      |  

The following table is a reconciliation of the
effective income tax rate at December 31, 2003, 2002 and
2001:

|                                        |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |   |             |   |  |  |        |   
|--------------------------------------- |  | ------ | ----------- | - | ------- |  | ------ | ------ |  | - | ----------- | - |  | ------ | ------ | -- | ------- | - | ----------- | - |  |  | ------ | --
|                                        |  |        |             |   |         | 
|                                        |  | 2003   |             |   | 2002    |  |        | 2001   | 
|                                        |  |        |             |   |         |  |        |        | 
|                                        |  | Amount |             |   | Percent |  |        | Amount |  |   | Percent     |   |  | Amount |        |    | Percent |  
|                                        |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  
|Pretax book loss                        |  | $      | (18,583,660 | ) |         |  | 0.00   | %      |  | $ | (26,580,271 | ) |  |        | 0.00   | %  |         | $ | (32,173,739 | ) |  |  | 0.00   | % 
|                                        |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  
|Federal, U.S. statutory rate            |  |        | (6,318,444  | ) |         |  | (34.00 | )%     |  |   | (9,037,292  | ) |  |        | (34.00 | )% |         |   | (10,939,071 | ) |  |  | (34.00 | )%
|State, net of federal tax benefit       |  |        | (735,913    | ) |         |  | (3.96  | )%     |  |   | (1,052,579  | ) |  |        | (3.96  | )% |         |   | (1,264,428  | ) |  |  | (3.93  | )%
|Change in valuation allowance           |  |        | (7,950,000  | ) |         |  | (42.78 | )%     |  |   | 9,964,000   |   |  |        | 37.49  | %  |         |   | 11,402,000  |   |  |  | 35.44  | % 
|Stock options exercised                 |  |        | (79,000     | ) |         |  | (0.43  | )%     |  |   |            |   |  |        | 0.00   | %  |         |   | (182,000    | ) |  |  | (0.57  | )%
|Other permanent items                   |  |        | 65,000      |   |         |  | 0.35   | %      |  |   |            |   |  |        | 0.00   | %  |         |   |            |   |  |  | 0.00   | % 
|Foreign rate difference                 |  |        | 374,907     |   |         |  | 2.02   | %      |  |   | 112,871     |   |  |        | 0.42   | %  |         |   | 228,741     |   |  |  | 0.71   | % 
|Permanent net operating loss impairment |  |        | 14,576,877  |   |         |  | 78.44  | %      |  |   |            |   |  |        | 0.00   | %  |         |   |            |   |  |  | 0.00   | % 
|Other                                   |  |        | 67,143      |   |         |  | 0.36   | %      |  |   | 13,562      |   |  |        | 0.05   | %  |         |   | 780,598     |   |  |  | 2.43   | % 
|                                        |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  
|Provision for income taxes              |  | $      | 569         |   |         |  | 0.00   | %      |  | $ | 562         |   |  |        | 0.00   | %  |         | $ | 25,840      |   |  |  | (0.08  | )%
|                                        |  |        |             |   |         |  |        |        |  |   |             |   |  |        |        |    |         |  

10. 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, 2003 are:

|                                 |  |   |         | 
|-------------------------------- |  | - | ------- | 
|For the Year Ending December 31, |  |  
|                                 |  |  
|2004                             |  | $ | 605,077 | 
|2005                             |  |   | 270,562 | 
|2006                             |  |   |        | 
|2007                             |  |   |        | 
|2008                             |  |   |        | 
|                                 |  |   |        
|                                 |  | $ | 875,639 | 
|                                 |  |   |        

Total rental expense charged to operations for
the years ended December 31, 2003, 2002 and 2001 was $718,862,
$820,679 and $778,108, respectively.

F-21



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



10. Commitments and Contingencies,
continued:


Inventory
Commitments

From time to time, the Company has commitments to
purchase inventory, tooling and/or engineering and other
services from its suppliers and manufacturers related to its
current and future hardware product lines. The Companys
commitments are typically highest during periods of product
design and when the Company is procuring inventory related to
anticipated sales. The Company expects that it will continue to
enter into such commitments during 2004 and thereafter as it
designs, develops and procures future wearable computer product
lines.

During 2003, the Company entered into an
agreement with IBM under which the Company agreed to purchase
approximately $4,900,000 in MA V computing units, FPDs,
peripherals and component parts. During 2003 the Company
received all of this inventory and made payments of $4,363,458.
During January 2004, the Company made the final payments
required by this agreement. As of January 31, 2004, the Company
had paid all amounts owed under this agreement.

At December 31, 2003, the Company had
commitments to purchase approximately $2,000,000 in inventory,
related primarily to pending orders for the Atigo product line.

Legal and
Other Proceedings

The Company is involved in litigation with
Zykronix, Inc. in the District Court of Denver Colorado and in
the Circuit Court of Fairfax Virginia. The Colorado suit is
against the Companys Chairman and Chief Executive Officer
based on a personal guarantee that he provided to Zykronix for
payment of fees alleged by Zykronix to be owed by the Company.
The Virginia suit is against the Company for the same $238,000
in fees alleged under the guarantee. The Company believes that
it has substantive defenses to these claims and that the alleged
fees are not owed. The Company is defending, and expects to
continue to defend, against both suits.

In December 2003, the Company filed a lawsuit
against Viewsonic Corporation (Viewsonic) in the
United States District Court for the Eastern District of
Virginia. The suit alleges that Viewsonic infringed one of the
Companys Dual-Use Computing Device patents. The suit
requests unspecified damages and an injunction against Viewsonic
from infringing the patent.

In December 2003, the IRS filed a tax lien
against the Company totaling $1,132,198. This lien covers taxes,
penalties and interest that the IRS alleges that the Company
owes related to certain payroll tax filings during 2000. The
Company believes that all such taxes were remitted to the IRS
during 2000 and does not believe that such taxes are still owed
to the IRS. The Company is in ongoing discussions with the IRS
related to this matter and has formally requested that the lien
be withdrawn. The Company believes that the probability of
future payment of the taxes is remote and therefore the Company
has not accrued any liability or charges. The Company believes
that any related interest or penalties will not be material.

The Company is involved in routine legal and
administrative proceedings and claims of various types. The
Company has no material pending legal or administrative
proceedings, other than as discussed above or 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. While any proceeding or claim
contains an element of uncertainty, management does not expect
that any such proceeding or claim will have a material adverse
effect on the Companys results of operations or financial
position.

11. Related Party Transactions

The Company retains a member of its Board of
Directors as its patent counsel. Since August 1, 2002, the
Company and this Director have entered into one-year agreements.
The current agreement expires on July 31,

F-22



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



11. Related Party Transactions,
continued:


2004. Under these and prior agreements, the
Company had cash expenditures of $320,000, $331,112 and $421,333
during 2003, 2002 and 2001, respectively, in legal services
payable to this Director. The Company is also obligated to issue
to this Director 50,000 shares of its common stock for the
one-year period ending July 31, 2004, which had a value of
$37,500 as of the date the agreement was entered into. The
Company issued to this Director 100,000 shares of its common
stock for the one-year period ended July 31, 2003, which
had a value of $50,000 as of the date the agreement was entered
into. Prior to August 1, 2002, the Directors law firm
billed the Company in accordance with its established standard
billing rates used in the past with its other clients. These
cash and stock payments represent gross payments made by the
Company and the Director is responsible for all overhead,
professional, administrative and other expenditures incurred by
his law firm. During 2003, 2002 and 2001, the Company
represented the law firms only significant client. During
approximately half of 2002 and all of 2001, the Director also
served as the Companys primary 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 was paid only the amount that was
passed through to these other law firms and agencies and paid
administrative services related to these services. The Company
made additional payments of $17,656, $274,040 and $485,827
during 2003, 2002 and 2001, respectively, to this
Directors law firm related to services rendered by the
Directors law firm as the Companys processing agent
for foreign patent and trademark filing and prosecution
expenses. The Companys management and Board of Directors
believe 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 billings of $424,574, $464,067
and $392,524 during 2003, 2002 and 2001, 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. The Companys management and Board
of Directors believe that the relationship with this law firm is
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
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, and 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 at both December 31, 2003 and
December 31, 2002.

F-23



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

12. Subsequent Events
(Unaudited)

In February 2004, the Company began actively
marketing its mobile/wearable hardware solutions in the
Peoples Republic of China (the PRC) through
Xybernaut China Limited (Xybernaut China), a joint
venture with Softbank Investment International (Strategic) Ltd.
(Softbank). Xybernaut China has the exclusive right
to manufacture, market, sell and distribute the Companys
products throughout the PRC and is owned 60% by the Company and
40% by Softbank. The Company is assigning all of its existing
agreements and relationships in the PRC to Xybernaut China and
is providing it with intellectual property, know-how and
technical assistance. Softbank is providing the start-up funding
for Xybernaut China and is assisting with its day-to-day
operations. It is expected that Xybernaut China will start up
operations in March or April 2004 and that the Companys
future consolidated financial statements will include the
accounts of Xybernaut China.

During March 2004, the Company received gross
proceeds of $5,000,000 through the private placement of
3,731,343 shares of its common stock to an investor. The shares
were sold at $1.34 per share, representing an approximate 20%
discount to the closing market price of the Companys
common stock. In connection with this private placement, the
Company issued to the investor three-year callable warrants to
purchase 1,865,671 shares of common stock at $1.52 per share and
six-month callable warrants to purchase 1,865,671 shares of
common stock at $1.52 per share..

During March 2004, the Company received gross
proceeds of $1,000,000 through the private placement of 662,252
shares of its common stock to an investor. The shares were sold
at $1.51 per share, representing an approximate 10% discount to
the closing market price of the Companys common stock. In
connection with this private placement, the Company issued to
the investor three-year callable warrants to purchase 331,126
shares of common stock at $1.52 per share and six-month callable
warrants to purchase 331,126 shares of common stock at $1.52 per
share.

F-24



---



##### 



XYBERNAUT CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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 first, third and fourth quarters of 2003 are
charges related to the provision for inventory and tooling of
$1,749,354, $1,500,000 and $1,750,000, respectively. Included in
the second, third and fourth quarters of 2002 are charges
related to the provision for inventory and tooling of $53,958,
$359,217 and $500,000, respectively. 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.

Schedule I  Quarterly
Consolidated Financial Data

|                                       |  |                     |            |   |          |   |            |               |  |   |              |   |  |   |            |  
|-------------------------------------- |  | ------------------- | ---------- | - | -------- | - | ---------- | ------------- |  | - | ------------ | - |  | - | ---------- | -
|                                       |  |                    
|                                       |  | 2003 Quarters Ended |           
|                                       |  |                     |           
|                                       |  | March 31,           |            |   | June 30, |   |            | September 30, |  |   | December 31, |  
|                                       |  |                     |            |   |          |   |            |               |  |   |              |  
|Total revenue                          |  | $                   | 1,786,977  |   |          | $ | 2,788,581  |               |  | $ | 2,703,121    |   |  | $ | 3,721,308  |  
|Gross profit                           |  |                     | (1,196,383 | ) |          |   | 970,475    |               |  |   | (790,367     | ) |  |   | (922,776   | )
|Net loss                               |  |                     | (5,378,478 | ) |          |   | (3,256,866 | )             |  |   | (4,674,239   | ) |  |   | (5,274,646 | )
|Net loss per share (basic and diluted) |  | $                   | (0.04      | ) |          | $ | (0.02      | )             |  | $ | (0.03        | ) |  | $ | (0.03      | )

|                                       |  |                     |            |   |          |   |            |               |  |   |              |   |  |   |            |  
|-------------------------------------- |  | ------------------- | ---------- | - | -------- | - | ---------- | ------------- |  | - | ------------ | - |  | - | ---------- | -
|                                       |  |                    
|                                       |  | 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      | )

F-25



---



##### 



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 19, 2004, which is included in this
Form 10-K, we have also audited Schedule II as of
December 31, 2003, and for each of the three years then
ended. In our opinion, this schedule presents fairly, in all
material respects, the information required to be set forth
therein.

Vienna, VA

February 19, 2004


F-26



---



##### 



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, 2003 |              | $ | 202,911    |            |  | $ | 5,028      |  |         | $       | (260       | ) |  | $ | 207,679    | 
|                                           | 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    | 
|Reserve for inventory                      |                              |              |   |            |            |  |   |            |  |         |         |            |   |  |   |           
|                                           | Year ended December 31, 2003 |              | $ |           |            |  | $ | 4,999,354  |  |         | $       | (1,726,638 | ) |  | $ | 3,272,716  | 
|                                           | Year ended December 31, 2002 |              | $ | 141,280    |            |  | $ |           |  |         | $       | (141,280   | ) |  | $ |           | 
|                                           | Year ended December 31, 2001 |              | $ | 1,370,000  |            |  | $ | 944,214    |  |         | $       | (2,172,934 | ) |  | $ | 141,280    | 
|Reserve for tooling costs                  |                              |              |   |            |            |  |   |            |  |         |         |            |   |  |   |           
|                                           | Year ended December 31, 2003 |              | $ | 250,000    |            |  | $ |           |  |         | $       | (250,000   | ) |  | $ |           | 
|                                           | Year ended December 31, 2002 |              | $ |           |            |  | $ | 299,077    |  |         | $       | (49,077    | ) |  | $ | 250,000    | 
|                                           | Year ended December 31, 2001 |              | $ | 250,000    |            |  | $ | 139,145    |  |         | $       | (389,145   | ) |  | $ |           | 
|Valuation allowance for deferred tax asset |                              |              |   |            |            |  |   |            |  |         |         |            |   |  |   |           
|                                           | Year ended December 31, 2003 |              | $ | 50,035,000 |            |  | $ |           |  |         | $       | (7,957,000 | ) |  | $ | 42,078,000 | 
|                                           | 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 | 

F-27



---



##### 








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

None.






|         |                         
|-------- | ------------------------
|Item 9A. | Controls and Procedures.

As of the end of the fiscal year ended
December 31, 2003, 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, Chief Financial Officer and President, of the
effectiveness of the design and operation of the Companys
disclosure controls and procedures pursuant to Exchange Act
Rule 13a-15. Based upon that evaluation, the Chief
Executive Officer, Chief Financial Officer and President
concluded that the Companys disclosure controls and
procedures are effective, as of such date, to ensure that
required information will be disclosed on a timely basis in its
reports under the Exchange Act.

There were no significant changes in the
Companys internal control over financial reporting during
the last quarter that have materially affected, or are
reasonably likely to materially affect, the Companys
internal control over financial reporting.




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. | 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, 2003 and December 31, 2002. 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.

Fees

During the Companys fiscal year ended
December 31, 2003 and 2002, respectively, Grant
Thornton LLPs fees for audit and audit related
services were as follows:

|                                                                                |  |      |         |  |      |   |         | 
|------------------------------------------------------------------------------- |  | ---- | ------- |  | ---- | - | ------- | 
|                                                                                |  | 2003 |         |  | 2002 |  
|                                                                                |  |      |         |  |      |  
|Audit fees, including review of quarterly
    financial statements on Form 10-Q |  | $    | 127,000 |  |      | $ | 119,000 | 
|Audit related fees(1)                                                           |  | $    | 53,414  |  |      | $ | 53,112  | 
|Tax service fees(2)                                                             |  | $    | 73,908  |  |      | $ | 70,390  | 




|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Audit related fees result from services in
    connection with rendering consents for periodic registration
    statements as a result of several private placement transactions
    in 2003, 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.
|   
|(2) | Tax service fees 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, and assistance with notes from
    taxing authorities.                                                                                                                                                                                                                                                                     

36



---



##### 






PART IV






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

Reports on
Form 8-K

On November 13, 2003, the Company filed a
report on Form 8-K under Items 5, 7 and 12 disclosing
certain comments made during an investor conference call, a
press release that had been issued that announced details
related to the Companys Annual Meeting of Shareholders, a
press release that had been issued that announced results for
the fiscal quarter ended September 30, 2003 and certain
information relating to net operating expenses, a Non-GAAP
Financial Measure as defined in Regulation G.

Exhibits

| |      |  |  |   |  |                                                                                                                                                                                                                   |  |  |      | 
| | ---- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- | 
| | 1.1  |  |  |  |  | Form of Financial Consulting Agreement between
    the Company and the Representative.                                                                                                                            |  |  | (1)  | 
| | 3.1  |  |  |  |  | Certificate of Incorporation of the Company, as
    Amended.                                                                                                                                                      |  |  | (3)  | 
| | 3.2  |  |  |  |  | Bylaws of the Company (as Amended on
    September 24, 1998).                                                                                                                                                     |  |  | (3)  | 
| | 3.3  |  |  |  |  | Form of Amendment to Article Fourth to the
    Companys Certificate of Incorporation.                                                                                                                            |  |  | (15) | 
| | 4.1  |  |  |  |  | Form of specimen certificate for Common Stock.                                                                                                                                                                    |  |  | (1)  | 
| | 4.2  |  |  |  |  | Form of Warrant issued to International Business
    Solutions, Inc.                                                                                                                                              |  |  | (5)  | 
| | 4.3  |  |  |  |  | Form of Warrant issued to Archway Holdings
    Limited.                                                                                                                                                           |  |  | (8)  | 
| | 4.4  |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of April 19, 2001, between Archway
    Holdings Limited and Xybernaut Corporation.                                                              |  |  | (8)  | 
| | 4.5  |  |  |  |  | Form of Registration Rights Agreement, dated as
    of April 19, 2001, between Archway Holdings Limited and
    Xybernaut Corporation.                                                                            |  |  | (8)  | 
| | 4.6  |  |  |  |  | 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. |  |  | (8)  | 
| | 4.7  |  |  |  |  | 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.       |  |  | (8)  | 
| | 4.8  |  |  |  |  | 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.                     |  |  | (8)  | 
| | 4.9  |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of May 4, 2001, between Alpha Capital
    Aktiengesellschaft and Xybernaut Corporation.                                                         |  |  | (8)  | 
| | 4.10 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of May 4, 2001, between Alpha Capital Aktiengesellschaft and
    Xybernaut Corporation.                                                                       |  |  | (8)  | 
| | 4.11 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of May 4, 2001, between Vertical Ventures,
    LLC and Xybernaut Corporation.                                                                   |  |  | (8)  | 
| | 4.12 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of May 4, 2001, between Vertical Ventures, LLC and Xybernaut
    Corporation.                                                                                 |  |  | (8)  | 
| | 4.13 |  |  |  |  | Form of Agreement, dated May 1, 2001, between
    Atlas Capital Services, Inc. and Xybernaut Corporation.                                                                                                         |  |  | (8)  | 
| | 4.14 |  |  |  |  | Form of Warrant issued to Eva Holdings Limited.                                                                                                                                                                   |  |  | (9)  | 
| | 4.15 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of June 30, 2001, between Eva Holdings
    Limited and Xybernaut Corporation.                                                                   |  |  | (9)  | 
| | 4.16 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of June 30, 2001, between Eva Holdings Limited and Xybernaut
    Corporation.                                                                                 |  |  | (9)  | 
| | 4.17 |  |  |  |  | Form of Warrant issued to DaVinci International
    Limited.                                                                                                                                                      |  |  | (9)  | 
| | 4.18 |  |  |  |  | Form of Warrant issued to Texas Instruments
    Incorporated.                                                                                                                                                     |  |  | (9)  | 
| | 4.19 |  |  |  |  | Form of Warrant issued to Holly Investments
    Limited.                                                                                                                                                          |  |  | (10) | 
| | 4.20 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 15, 2001, between Holly
    Investments Limited and Xybernaut Corporation.                                                          |  |  | (10) | 
| | 4.21 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 15, 2001, between Holly Investments Limited and
    Xybernaut Corporation.                                                                        |  |  | (10) | 

37



---



##### 



| |      |  |  |   |  |                                                                                                                                                                                                                              |  |  |      | 
| | ---- |  |  | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- | 
| | 4.22 |  |  |  |  | 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.                                  |  |  | (10) | 
| | 4.23 |  |  |  |  | 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.                                                |  |  | (10) | 
| | 4.24 |  |  |  |  | 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.           |  |  | (10) | 
| | 4.25 |  |  |  |  | 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.                         |  |  | (10) | 
| | 4.26 |  |  |  |  | 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. |  |  | (10) | 
| | 4.27 |  |  |  |  | Agreement, dated November 15, 2001, between Atlas
    Capital Services, LLC and Xybernaut Corporation.                                                                                                                       |  |  | (10) | 
| | 4.28 |  |  |  |  | Agreement for Payment of Account, dated November
    27, 2001, between frog werk, Inc. and Xybernaut Corporation.                                                                                                            |  |  | (10) | 
| | 4.29 |  |  |  |  | Form of Warrant issued to Yeshuah Investments
    Limited.                                                                                                                                                                   |  |  | (11) | 
| | 4.30 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of March 13, 2002, between Yeshuah
    Investments Limited and Xybernaut Corporation.                                                                      |  |  | (11) | 
| | 4.31 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of March 13, 2002, between Yeshuah Investments Limited and
    Xybernaut Corporation.                                                                                    |  |  | (11) | 
| | 4.32 |  |  |  |  | Form of Warrant issued to Alpha Capital
    Aktiengesellschaft.                                                                                                                                                              |  |  | (11) | 
| | 4.33 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of March 13, 2002, between Xybernaut
    Corporation and Alpha Capital Aktiengesellschaft.                                                                 |  |  | (11) | 
| | 4.34 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of March 13, 2002, between Xybernaut Corporation and Alpha
    Capital Aktiengesellschaft.                                                                               |  |  | (11) | 
| | 4.35 |  |  |  |  | Form of Warrant issued to Cranshire Capital, L.P.                                                                                                                                                                            |  |  | (11) | 
| | 4.36 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of March 13, 2002, between Xybernaut
    Corporation and Cranshire Capital, L.P.                                                                           |  |  | (11) | 
| | 4.37 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of March 13, 2002, between Xybernaut Corporation and
    Cranshire Capital, L.P.                                                                                         |  |  | (11) | 
| | 4.38 |  |  |  |  | Form of Letter Agreement, dated as of
    January 1, 2002 between IBS Technologies LLC and Xybernaut
    Corporation.                                                                                                        |  |  | (11) | 
| | 4.39 |  |  |  |  | Form of Agreement for Payment of Account, dated
    March 20, 2002, between Zykronix, Inc. and Xybernaut
    Corporation.                                                                                                    |  |  | (11) | 
| | 4.40 |  |  |  |  | Form of Warrant issued to Alpha Capital
    Aktiengesellschaft.                                                                                                                                                              |  |  | (12) | 
| | 4.41 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of June 30, 2002, between Alpha Capital
    Aktiengesellschaft and Xybernaut Corporation.                                                                  |  |  | (12) | 
| | 4.42 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of June 30, 2002, between Alpha Capital Aktiengesellschaft and
    Xybernaut Corporation.                                                                                |  |  | (12) | 
| | 4.43 |  |  |  |  | Form of Warrant issued to Rema Investments
    Limited.                                                                                                                                                                      |  |  | (12) | 
| | 4.44 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of June 30, 2002, between Xybernaut
    Corporation and Rema Investments Limited.                                                                          |  |  | (12) | 
| | 4.45 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of June 30, 2002, between Xybernaut Corporation and Rema
    Investments Limited.                                                                                        |  |  | (12) | 
| | 4.46 |  |  |  |  | Form of Consulting Agreement, dated as of June
    30, 2002, between Xybernaut Corporation and Libra Finance, S.A.                                                                                                           |  |  | (12) | 
| | 4.47 |  |  |  |  | Form of Consulting Agreement, dated as of June
    30, 2002, between Xybernaut Corporation and Dune Holdings Ltd.                                                                                                            |  |  | (12) | 
| | 4.48 |  |  |  |  | Form of Warrant issued to each of Yeshuah
    Investments Limited, Holly Investments Limited and Eva Holdings
    Limited.                                                                                                   |  |  | (12) | 

38



---



##### 



| |      |  |  |   |  |                                                                                                                                                         |  |  |      | 
| | ---- |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- | 
| | 4.49 |  |  |  |  | Form of Agreement for Payment of Account, dated
    June 4, 2002, between Carlton R. Turner and Xybernaut
    Corporation.                              |  |  | (12) | 
| | 4.50 |  |  |  |  | Form of Sponsorship Agreement, dated May 1, 2002,
    between Alex Job Racing, Inc. and Xybernaut Corporation.                                          |  |  | (12) | 
| | 4.51 |  |  |  |  | Form of Agreement for Payment of Account, dated
    June 24, 2002, between Fathom Creative, Inc. and Xybernaut
    Corporation.                         |  |  | (12) | 
| | 4.52 |  |  |  |  | Form of Warrant issued to Rewell Holdings, Ltd.                                                                                                         |  |  | (13) | 
| | 4.53 |  |  |  |  | Form of Warrant issued to Rewell Holdings, Ltd.                                                                                                         |  |  | (13) | 
| | 4.54 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of August 29, 2002, between Rewell
    Holdings, Ltd. and Xybernaut Corporation.      |  |  | (13) | 
| | 4.55 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of August 29, 2002, between Rewell Holdings, Ltd. and
    Xybernaut Corporation.                    |  |  | (13) | 
| | 4.56 |  |  |  |  | Form of Warrant issued to Sundale Corporation.                                                                                                          |  |  | (13) | 
| | 4.57 |  |  |  |  | Form of Warrant issued to Sundale Corporation.                                                                                                          |  |  | (13) | 
| | 4.58 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of August 29, 2002, between Sundale
    Corporation and Xybernaut Corporation.        |  |  | (13) | 
| | 4.59 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of August 29, 2002, between Sundale Corporation and
    Xybernaut Corporation.                      |  |  | (13) | 
| | 4.60 |  |  |  |  | Form of Separation Agreement, dated as of
    August 1, 2002, between Xybernaut GmbH, Xybernaut
    Corporation and Mr. Daniel J. Butler.               |  |  | (13) | 
| | 4.61 |  |  |  |  | Form of Warrant issued to Greta Holdings, Ltd.                                                                                                          |  |  | (14) | 
| | 4.62 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between Greta
    Holdings, Ltd. and Xybernaut Corporation.      |  |  | (14) | 
| | 4.63 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between Greta Holdings, Ltd. and
    Xybernaut Corporation.                   |  |  | (14) | 
| | 4.64 |  |  |  |  | Form of Warrant issued to Reno Holdings, Ltd.                                                                                                           |  |  | (14) | 
| | 4.65 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between Reno
    Holdings, Ltd. and Xybernaut Corporation.       |  |  | (14) | 
| | 4.66 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between Reno Holdings, Ltd. and
    Xybernaut Corporation.                    |  |  | (14) | 
| | 4.67 |  |  |  |  | Form of Warrant issued to State Street
    Corporation.                                                                                                 |  |  | (14) | 
| | 4.68 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between State
    Street Corporation and Xybernaut Corporation.  |  |  | (14) | 
| | 4.69 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between State Street Corporation and
    Xybernaut Corporation.               |  |  | (14) | 
| | 4.70 |  |  |  |  | Form of Warrant issued to Company Management Ltd.                                                                                                       |  |  | (14) | 
| | 4.71 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of November 6, 2002, between Company
    Management Ltd. and Xybernaut Corporation.   |  |  | (14) | 
| | 4.72 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of November 13, 2002, between Company Management Ltd. and
    Xybernaut Corporation.                |  |  | (14) | 
| | 4.73 |  |  |  |  | Form of Service Agreement, dated as of
    September 10, 2002, by and between Elite Financial
    Communications Group, LLC and Xybernaut Corporation.  |  |  | (14) | 
| | 4.74 |  |  |  |  | Form of Letter Agreement, dated August 7,
    2002, by and between James J. Ralabate and Xybernaut
    Corporation.                                     |  |  | (14) | 
| | 4.75 |  |  |  |  | Settlement Agreement and Release dated as of
    December 31, 2002 by and among IBS Technologies LLC,
    Mr. Benjamin Cohen and Xybernaut Corporation. |  |  | (18) | 
| | 4.76 |  |  |  |  | Form of Warrant issued to Maple Systems, Ltd.                                                                                                           |  |  | (18) | 
| | 4.77 |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of February 8, 2003, between Maple
    Systems, Ltd. and Xybernaut Corporation.       |  |  | (18) | 
| | 4.78 |  |  |  |  | Form of Registration Rights Agreement, dated as
    of February 8, 2003, between Maple Systems, Ltd. and
    Xybernaut Corporation.                     |  |  | (18) | 
| | 4.79 |  |  |  |  | Form of Warrant issued to Sundial Investments,
    Limited.                                                                                             |  |  | (18) | 
| | 4.80 |  |  |  |  | Form of Warrant issued to Sundial Investments,
    Limited.                                                                                             |  |  | (18) | 
| | 4.81 |  |  |  |  | Form of Note and Warrant Purchase Agreement,
    dated as of March 26, 2003, between Sundial Investments,
    Limited and Xybernaut Corporation.        |  |  | (18) | 

39



---



##### 



| |       |  |  |   |  |                                                                                                                                                       |  |  |      | 
| | ----- |  |  | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------- |  |  | ---- | 
| | 4.82  |  |  |  |  | Form of Warrant issued to Capecove International
    Ltd.                                                                                             |  |  | (19) | 
| | 4.83  |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of June 4, 2003, between Capecove
    International Ltd. and Xybernaut Corporation. |  |  | (19) | 
| | 4.84  |  |  |  |  | Form of Registration Rights Agreement, dated as
    of June 4, 2003, between Capecove International Ltd. and
    Xybernaut Corporation.               |  |  | (19) | 
| | 4.85  |  |  |  |  | Form of Warrant issued to London Properties Ltd.                                                                                                      |  |  | (19) | 
| | 4.86  |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of May 30, 2003, between London
    Properties Ltd. and Xybernaut Corporation.      |  |  | (19) | 
| | 4.87  |  |  |  |  | Form of Registration Rights Agreement, dated as
    of May 30, 2003, between London Properties Ltd. and
    Xybernaut Corporation.                    |  |  | (19) | 
| | 4.88  |  |  |  |  | Form of Warrant issued to Sussex Consulting Ltd.                                                                                                      |  |  | (19) | 
| | 4.89  |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of May 30, 2003, between Sussex
    Consulting Ltd. and Xybernaut Corporation.      |  |  | (19) | 
| | 4.90  |  |  |  |  | Form of Registration Rights Agreement, dated as
    of May 30, 2003, between Sussex Consulting Ltd. and
    Xybernaut Corporation.                    |  |  | (19) | 
| | 4.91  |  |  |  |  | Form of Warrant issued to Chesterfield Inc.                                                                                                           |  |  | (20) | 
| | 4.92  |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of September 8, 2003, between
    Chesterfield Inc. and Xybernaut Corporation.      |  |  | (20) | 
| | 4.93  |  |  |  |  | Form of Registration Rights Agreement, dated as
    of September 16, 2003, between Chesterfield Inc. and
    Xybernaut Corporation.                   |  |  | (20) | 
| | 4.94  |  |  |  |  | Form of Warrant issued to Essex Trading Ltd.                                                                                                          |  |  | (20) | 
| | 4.95  |  |  |  |  | Form of Common Stock and Warrant Purchase
    Agreement, dated as of September 16, 2003, between Essex
    Trading Ltd. and Xybernaut Corporation.    |  |  | (20) | 
| | 4.96  |  |  |  |  | Form of Registration Rights Agreement, dated as
    of September 16, 2003, between Essex Trading Ltd. and
    Xybernaut Corporation.                  |  |  | (20) | 
| | 4.97  |  |  |  |  | Letter Agreement, dated as of May 30, 2003,
    between Sundial Investments Limited and Xybernaut Corporation.                                        |  |  | (20) | 
| | 10.1  |  |  |  |  | Form of Indemnification Agreement to be entered
    into between the Company and each officer and director of the
    Company.                        |  |  | (1)  | 
| | 10.2  |  |  |  |  | Form of Employment Agreement between the Company
    and Edward G. Newman.                                                                            |  |  | (17) | 
| | 10.3  |  |  |  |  | Form of Employment Agreement between the Company
    and Steven A. Newman.                                                                            |  |  | (17) | 
| | 10.4  |  |  |  |  | Form of Employment Agreement between the Company
    and Eugene Amobi.                                                                                |  |  | (7)  | 
| | 10.5  |  |  |  |  | Form of Employment Agreement between the Company
    and Thomas D. Davis.                                                                             |  |  | (16) | 
| | 10.6  |  |  |  |  | November 30, 1994 Lease Agreement between
    Hyatt Plaza Limited Partnership and the Company.                                                        |  |  | (1)  | 
| | 10.7  |  |  |  |  | 1996 Omnibus Stock Incentive Plan.                                                                                                                    |  |  | (1)  | 
| | 10.8  |  |  |  |  | 1997 Omnibus Stock Incentive Plan.                                                                                                                    |  |  | (1)  | 
| | 10.9  |  |  |  |  | Multicosm Ltd. Software Licensing Agreement.                                                                                                          |  |  | (1)  | 
| | 10.10 |  |  |  |  | First Amendment to Office Lease Agreement between
    Hyatt Plaza Limited Ptr. and the Company.                                                       |  |  | (2)  | 
| | 10.11 |  |  |  |  | Form of Exclusive Licensing Agreement between
    SBS Vertrieb GmbH and the Company.                                                                  |  |  | (2)  | 
| | 10.12 |  |  |  |  | Form of Software Distribution Agreement between
    Multicosm LTD and the Company.                                                                    |  |  | (2)  | 
| | 10.13 |  |  |  |  | First Amendment to Office Lease Agreement between
    Hyatt Plaza Limited Partnership and Tech International of
    Virginia, L.L.C.                  |  |  | (2)  | 
| | 10.14 |  |  |  |  | Second Amendment to Storage Space Lease Agreement
    between Hyatt Plaza Limited Ptr. and the Company.                                               |  |  | (3)  | 
| | 10.15 |  |  |  |  | Second Amendment to Office Lease Agreement
    between Hyatt Plaza Limited Ptr. and the Company.                                                      |  |  | (3)  | 
| | 10.16 |  |  |  |  | Third Amendment to Office Lease Agreement between
    Hyatt Plaza Limited Ptr. and the Company.                                                       |  |  | (3)  | 
| | 10.17 |  |  |  |  | 1999 Stock Incentive Plan.                                                                                                                            |  |  | (4)  | 
| | 10.18 |  |  |  |  | 2000 Stock Incentive Plan.                                                                                                                            |  |  | (6)  | 
| | 10.19 |  |  |  |  | Form of Amended and Restated Agreement for
    Wholesale Financing (Security Agreement).                                                              |  |  | (15) | 

40



---



##### 



| |       |  |  |   |  |                                                                                                                                            |  |  |      | 
| | ----- |  |  | - |  | ------------------------------------------------------------------------------------------------------------------------------------------ |  |  | ---- | 
| | 10.20 |  |  |  |  | Form of Addendum to Agreement for Wholesale
    Financing Flexible Payment Plan.                                                           |  |  | (15) | 
| | 10.21 |  |  |  |  | Form of Exhibit A (FPP
    Exhibit A) to Addendum to Agreement for Wholesale
    Financing  Flexible Payment Plan (FPP
    Addendum). |  |  | (15) | 
| | 10.22 |  |  |  |  | Form of Promissory Note.                                                                                                                   |  |  | (15) | 
| | 10.23 |  |  |  |  | Form of Pledge Agreement.                                                                                                                  |  |  | (15) | 
| | 23.1  |  |  |  |  | Consent of Grant Thornton LLP.                                                                                                             |  |  | *    | 
| | 31.1  |  |  |  |  | Certification Pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.                                                               |  |  | *    | 
| | 31.2  |  |  |  |  | Certification Pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.                                                               |  |  | *    | 
| | 31.3  |  |  |  |  | Certification Pursuant to Section 302 of the
    Sarbanes-Oxley Act of 2002.                                                               |  |  | *    | 
| | 32    |  |  |  |  | Certification Pursuant to Section 906 of the
    Sarbanes-Oxley Act of 2002.                                                               |  |  | *    | 



---



| |     |                                                                                                                                                                                                                        
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (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 Companys
    1997 Annual Report on Form 10-KSB, No. 0-15086, filed
    on March 3, 1998.                                                                                             
|
| | (3) | Incorporated by reference to the Companys
    1998 Annual Report on Form 10-KSB, No. 0-15086, filed
    on April 15, 1999.                                                                                            
|
| | (4) | Incorporated by reference to the Registration
    Statement on Form S-8, file No. 333-94463, filed on
    January 12, 2000.                                                                                            
|
| | (5) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-33940 filed on
    April 4, 2000.                                                                                                
|
| | (6) | 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.
|
| | (7) | Incorporated by reference to the report on
    Form 10-K, No. 000-21013, filed on March 9, 2001.                                                                                                                       
|
| | (8) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-60556, filed on
    May 9, 2001.                                                                                                 
|
| | (9) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-68832, filed on
    August 31, 2001.                                                                                             



|     |                                                                                                                               
|---- | ------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-74182, filed on
    November 29, 2001.  
|    
|(11) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-85188, filed on
    March 29, 2002.     
|    
|(12) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-92348, filed on
    July 12, 2002.      
|    
|(13) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-99041, filed on
    August 20, 2002.    
|    
|(14) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-101257, filed on
    November 15, 2002. 
|    
|(15) | Incorporated by reference to the report on
    Form 10-K, No. 000-21013, filed on March 28, 2002.                             
|    
|(16) | Incorporated by reference to the report on
    Form 10-K, No. 000-21013, filed on March 28, 2003.                             
|    
|(17) | Incorporated by reference to the report on
    Form 10-K/A, No. 000-21013, filed on April 30,
    2003.                       
|    
|(18) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-104223, filed on
    April 1, 2003.     
|    
|(19) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-106266, filed on
    June 19, 2003.     
|    
|(20) | Incorporated by reference to the Registration
    Statement on Form S-3, file No. 333-109201, filed on
    September 29, 2003.



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

41



---



##### 






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                  
| | 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  



| |     |                     
| | --- | --------------------
| | By: | /s/ STEVEN A. NEWMAN

| |                                            
| | -------------------------------------------
| |                                            
| | Steven A. Newman                           
| | President, Chief Operating Officer
    and 
| | Vice Chairman of the Board of
    Directors

Date: March 12, 2004

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         |  | Chief Executive Officer and Chairman of the Board
    of Directors                 |  | March 12, 2004
|                                            
|/s/ STEVEN A. NEWMANSteven A. Newman         |  | President, Chief Operating Officer and Vice
    Chairman of the Board of Directors |  | March 12, 2004
|                                            
|/s/ KAZUYUKI TOYOSATOKazuyuki Toyosato       |  | Executive Vice President and Director                                              |  | March 12, 2004
|                                            
|/s/ THOMAS D. DAVISThomas D. Davis           |  | Senior Vice President and Chief Financial Officer                                  |  | March 12, 2004
|                                            
|/s/ EUGENE J. AMOBIEugene J. Amobi           |  | Vice President and Director                                                        |  | March 12, 2004
|                                            
|/s/ MARTIN ERIC WEISBERGMartin Eric Weisberg |  | Secretary and Director                                                             |  | March 12, 2004
|                                            
|/s/ MARC GINSBERGMarc Ginsberg               |  | Director                                                                           |  | March 12, 2004

42



---



##### 



|                                                       |  |          |  |               
|------------------------------------------------------ |  | -------- |  | --------------
|Signature                                              |  | Title    |  | Date          
|                                                       |  |          |  |               
|                                                      
|/s/ PHILLIP E. PEARCEPhillip E. Pearce                 |  | Director |  | March 12, 2004
|                                                      
|/s/ JAMES J. RALABATEJames J. Ralabate                 |  | Director |  | March 12, 2004
|                                                      
|/s/ LT. GEN. HARRY E. SOYSTERLt. Gen. Harry E. Soyster |  | Director |  | March 12, 2004
|                                                      
|/s/ EDWIN VOGTEdwin Vogt                               |  | Director |  | March 12, 2004
|                                                      
|/s/ NORITSUGU YAMAOKANoritsugu Yamaoka                 |  | Director |  | March 12, 2004

43