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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    FORM 10-K

              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

                        COMMISSION FILE NUMBER 000-21129

                                   AWARE, INC.
                                   -----------
             (Exact Name of Registrant as Specified in Its Charter)

           MASSACHUSETTS                              04-2911026
  (State or Other Jurisdiction of         (I.R.S. Employer Identification No.)
  Incorporation or Organization)

               40 MIDDLESEX TURNPIKE, BEDFORD, MASSACHUSETTS 01730
               ---------------------------------------------------
                    (Address of Principal Executive Offices)
                                   (Zip Code)

                                 (781) 276-4000
                                 --------------
              (Registrant's Telephone Number, Including Area Code)

        Securities registered pursuant to Section 12(b) of the Act: NONE
           Securities registered pursuant to Section 12(g) of the Act:
                     COMMON STOCK, PAR VALUE $.01 PER SHARE
                                (Title of class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of 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. [ ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2). YES _X_ NO ___

The aggregate market value of the voting stock held by non-affiliates of the
registrant as of June 30, 2004, based on the closing price of the common stock
on June 30, 2004 as reported on the Nasdaq National Market, was approximately
$86,720,338.

The number of shares outstanding of the registrant's common stock as of March 4,
2005 was 22,976,863.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement to be delivered to
shareholders in connection with the registrant's Annual Meeting of Shareholders
to be held on May 25, 2005 are incorporated by reference into Part III of this
                          Annual Report on Form 10-K.
================================================================================

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                                                AWARE, INC.
                                                 FORM 10-K
                                   FOR THE YEAR ENDED DECEMBER 31, 2004


                                             TABLE OF CONTENTS


                                                  PART I

Item 1.     Description of the Business...............................................................   3
Item 2.     Properties................................................................................  10
Item 3.     Legal Proceedings.........................................................................  11
Item 4.     Submission of Matters to a Vote of Security Holders.......................................  11

                                                  PART II

Item 5.     Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases
            of Equity Securities......................................................................  12
Item 6.     Selected Financial Data...................................................................  12
Item 7.     Management's Discussion and Analysis of Financial Condition and Results
            of Operations.............................................................................  13
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk................................  25
Item 8.     Consolidated Financial Statements and Supplementary Data..................................  26
Item 9.     Changes in and Disagreements with Accountants on Accounting and Financial
            Disclosure................................................................................  44
Item 9A.    Controls and Procedures...................................................................  44
Item 9B.    Other Information.........................................................................  44

                                                 PART III

Item 10.    Directors and Executive Officers of the Registrant........................................  44
Item 11.    Executive Compensation....................................................................  45
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
            Matters...................................................................................  45
Item 13.    Certain Relationships and Related Transactions............................................  45
Item 14.    Principal Accountant Fees and Services....................................................  45

                                                  PART IV

Item 15.    Exhibits and Financial Statement Schedules................................................  46


Signatures............................................................................................  48
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                                     PART I

ITEM 1. DESCRIPTION OF THE BUSINESS

COMPANY OVERVIEW

We are a worldwide leader in the development and marketing of intellectual
property for broadband communications. We license our intellectual property to
semiconductor companies that build integrated circuits based on our technology.
Our principal offering is Asymmetric Digital Subscriber Line ("ADSL") technology
for the telecommunications industry based upon the International
Telecommunication Union ("ITU") industry standards. ADSL enables telephone
companies to use their existing copper telephone lines to offer broadband
services. Numerous ADSL standards have been adopted by the ITU since 1999,
including G.992.1 ADSL and G.992.2 G.lite as well as G.992.3 ADSL2 and G.992.5
ADSL2plus which were adopted by the ITU in 2002 and 2003, respectively. The
newer standards enable higher speeds, greater reach and broader functionality
and are poised to emerge in worldwide deployments over the next several years.

Our technology enables semiconductor companies to manufacture and sell chipsets
that support ADSL, ADSL2 and ADSL2plus ITU standards. These standards underlie
high-speed Internet access services that telephone companies provide to
residential customers. Increasingly, telephone companies are adding new services
to their offerings including video and television. New ADSL2 and ADSL2plus
technologies are improving telephone companies' ability to offer triple-play
services (data, voice and video) over common telephone lines.

In addition to our ADSL intellectual property offerings, we develop and market
ADSL test and diagnostics hardware and software products to the automated test
equipment industry. These products aim to improve the set-up and maintenance of
broadband services based upon ADSL, ADSL2 and ADSL2plus.

We also sell software products for the enrollment of biometric information in
security systems as well as for biometric transaction processing. In addition,
we sell software products for medical and digital imaging applications.

We have projects underway to develop new forms of broadband and imaging
technologies. We play an active role at standards setting bodies so that we can
anticipate and influence changes in industry requirements.

During 2003 and 2004, approximately 57% and 67%, respectively, of our revenue
came from licensing ADSL, ADSL2 and ADSL2plus intellectual property. We license
our intellectual property worldwide through our direct sales force. Our largest
semiconductor customers in 2003 and 2004 were Analog Devices, Inc. and Infineon
Technologies, AG. The remainder of our revenue came from the sale of hardware
and software products. Our hardware products include printed circuit boards for
the ADSL automated test equipment industry. Our software products include
fingerprint compression and biometric transaction processing software tools for
law enforcement agencies as well as ADSL test and diagnostics software for
automated test equipment.

We are headquartered in Bedford, Massachusetts. Our telephone number is (781)
276-4000, and our website is www.aware.com. Incorporated in Massachusetts in
1986, we employed 103 people as of December 31, 2004. Our stock is traded on the
Nasdaq National Market under the symbol AWRE.

Our website provides a link to a third-party website through which our annual,
quarterly and current reports, and amendments to those reports, are available
free of charge. We believe these reports are made available as soon as
reasonably practicable after we electronically file them with, or furnish them
to, the SEC. We do not maintain or provide any information directly to the
third-party website, and we do not check its accuracy.

INDUSTRY BACKGROUND

ADSL INDUSTRY BACKGROUND. ADSL technology allows telephone companies to offer
high-speed data services over their existing telephone wires. Telephone
companies began tests and trials of ADSL technology in the mid 1990s. Commercial
deployment of ADSL services began in modest volumes in 1999, and during the last
five years, the rate of deployment of ADSL services accelerated dramatically,
particularly outside of the United States. According to

                                       3
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announcements by major telephone companies and information compiled by Point
Topic Ltd., a company that provides analysis of broadband access to the
Internet, approximately 12 million, 17 million, 28 million, and 36 million new
ADSL subscribers were added in 2001, 2002, 2003, and 2004, respectively. As of
December 31, 2004, there were approximately 97 million global ADSL subscribers
worldwide, of which approximately 16 million were in North America. There were
approximately 34 million in Europe/Middle East/Africa, approximately 43 million
were in the Asia Pacific region and the remainder were in Latin America.

Some of the largest providers of ADSL service in North America are telephone
companies such as SBC, Verizon, BellSouth, Qwest, and Bell Canada. In Europe,
major providers include Deutsche Telekom, France Telecom, Belgacom, British
Telecom, Telefonica, Telecom Italia, and Telia. Large Asian providers include
Korea Telecom and Hanaro in Korea, NTT and Yahoo Broadband in Japan, Chunghwa in
Taiwan, and China Telecom.

In order to activate ADSL service, one end of a telephone wire must be connected
to ADSL equipment in a central office or remote location controlled by telephone
companies and the other end must be connected to a device in the customer's
premises. ADSL central office and remote location equipment includes DSL access
multiplexers ("DSLAMs"), next generation digital loop carriers ("NGDLCs"), and
broadband loop carriers ("BLCs"). These are available from numerous
telecommunications equipment suppliers. Some of the leading suppliers of ADSL
equipment include Alcatel Alsthom S.A. ("Alcatel"), Huawei, ECI Telecom, Lucent
Technologies, Inc., NEC Corporation, Siemens AG, Sumitomo Corporation, and
UTStarcomm. Devices in the customer's premise are known as ADSL customer
premises equipment ("CPE") and include modems, routers and integrated access
devices (modems and routers that support integrated voice and data). Thomson
Multimedia, Siemens, D-Link, Sumitomo, Sagem, Westell, Zyxel and Cisco are
leading manufacturers of ADSL CPE.

Manufacturers are able to purchase ADSL integrated circuits for telephone
company equipment or CPE from a number of suppliers, including Analog Devices
Inc. ("ADI"), Broadcom Corporation ("Broadcom"), Centillium Communications, Inc.
("Centillium"), Conexant Systems, Inc. ("Conexant"), Infineon Technologies AG
("Infineon"), ST Microelectronics N.V. ("ST"), and Texas Instruments
Incorporated ("TI").

In the United States, at the end of September 2004, there were nearly 14
million(1) DSL subscribers and nearly 19 million(1) cable subscribers. In the
recent past, telephone companies were provisioning DSL subscribers nearly as
fast as cable companies were adding broadband customers. Regulatory relief in
2004 from the FCC has given ownership to both fiber-to-the-premise ("FTTP") and
fiber-to-the node/neighborhood ("FTTN") investments, meaning that phone
companies do not need to provide open access to these networks. During the past
year, SBC, Verizon and BellSouth have all announced plans for FTTP or FTTN
deployments.

Outside North America, DSL growth was slow until 2002 but has accelerated
through 2003 and increased in 2004. At the end of June 2004, there were 25
million(1) DSL subscribers in Europe and 3.3 million(1) cable subscribers.

The Asia Pacific region has the largest number of DSL subscribers with 29.2
million(1) as of the end of June 2004. Cable subscribers numbered 1.8
million(1). Competition in this region is greater than in other parts of the
world. A mix of government regulation and incentives has had a positive
influence on this region's broadband rollouts.

With over 1 billion phone lines installed worldwide, ADSL has only penetrated
approximately 10% of the available market today. According to estimates by
Infonetics Research:

        |X|     Telephone companies will add 59 million, 61 million and 64
                million new DSL ports to their networks in 2005, 2006 and 2007,
                respectively.

        |X|     67 million, 81 million and 96 million new DSL CPE units will be
                sold in 2005, 2006 and 2007, respectively.

As the demand for residential broadband service continues to grow, telephone
companies are upgrading their networks to increase the data rates that are
delivered to their residential customers. These upgrades require large financial
expenditures and often involve the use of fiber optic-based communications to
points deeper in the access networks (i.e. closer to residential customers than
today's central office locations). The resulting


-------------------------------
(1) SOURCE: INFONETICS RESEARCH 2004, DSL AGGREGATION HARDWARE, DSL CPE REPORTS.

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FTTN networks require new equipment platforms to be installed at fiber-fed
points. These equipment platforms then utilize the existing telephone wire
infrastructure for access over the remaining distance to the customer's
premises, and leverage their closer proximity to the end user and new ADSL2plus
or emerging VDSL2 standards to provide increased data rates.

ADSL TECHNOLOGY BACKGROUND. ADSL technology expands the usable bandwidth of
copper wire so that telephone companies can offer high-speed data services over
their existing telephone networks. ADSL is a point-to-point technology that
connects the end user to a central location in the telephone company's network
such as a central office or remote location controlled by the telephone company.
ADSL equipment is required at each end of the telephone line. New ADSL2,
ADSL2plus and VDSL2 technologies will enable transmit speeds between multiple
megabits ("Mbps") and 100 Mbps. Actual transmission speeds depend on the length
and condition of the existing wire.

An ADSL system typically divides the bandwidth on a copper wire into three
segments. The first segment is usually used for plain old telephone service
("POTS"). The second segment is used to transmit data "upstream" from the user
to a central location in the phone network. The third segment is used to
transmit data to the user (the "downstream" direction).

The ADSL industry relies on international standards bodies to specify the
technology used for ADSL services. Standards bodies that contribute
specifications include the American National Standards Institute ("ANSI"), the
ITU, the European Telecommunications Standards Institute ("ETSI") and other
organizations. The prevalence and influence of industry standards on the ADSL
industry make it similar to other communications and networking technologies
such as Code Division Multiple Access ("CDMA"), Universal Serial Bus ("USB"),
Global System for Mobile telecommunications ("GSM"), Global Positioning System
("GPS"), Wireless Local Area Networking ("WLAN"), and chip-connection technology
for Dynamic Random Access Memory ("DRAM"). For applications and services that
use these technologies, standards and patents play a significant role in the
formation of the commercial landscape.

Full-rate ADSL was first standardized in 1995 by ANSI as T1.413, and then by the
ITU in 1999 as G.992.1. Full-rate ADSL can transmit data at speeds up to 8 Mbps
downstream and up to 640 Kbps upstream.

In 1999, the ITU also standardized a lower speed version of ADSL, known as
G.Lite or G.992.2. G.Lite can transmit data at speeds up to 1.5 Mbps downstream
and up to 512 Kbps upstream without using special filtering equipment required
by full-rate ADSL. G.Lite was intended to make the installation of ADSL faster
and less expensive for telephone companies, however, most ADSL service offerings
today are based on full-rate ADSL.

In 2002, the ITU approved a new set of ADSL standards known as ADSL2 or G.992.3
and G.992.4. These standards provide numerous improvements over previous ADSL
standards, including line diagnostics, power management, power down and power
cutback, reduced framing and on-line configuration. In 2003, the ITU approved
ADSL2plus or G.992.5. ADSL2plus builds upon the ADSL2 standard by increasing
achievable data rates to speeds up to 24 Mbps upstream on phone lines as long as
3,000 feet (20 Mbps out to 5,000 feet). While the signal bandwidth of previous
ADSL standards was about 1MHz, ADSL2plus specifies signals with more than 2 MHz
of bandwidth.

A new series of ITU standards, G.998.1 and G.998.2, were approved in January
2005. These standards specify multi-pair ADSL bonding technology for residential
and business services. Data rates are increased by a factor equal to the number
of lines that are bonded. If two pairs are bonded, upstream and downstream data
rates are doubled.

In addition, VDSL2 standards are being developed at the ITU that will specify
data rates up to 100 Mbps. These standards will specify the transmission of
signals with as much as 30 MHz of bandwidth onto a telephone line. These VDSL2
signals will be divided into multiple upstream segments and multiple downstream
segments.

ADSL TEST AND DIAGNOSTICS INDUSTRY BACKGROUND. Automated test equipment ("ATE")
is typically used for testing and diagnosing the services that are offered by
telephone companies to consumers and businesses. An ATE infrastructure has been
in place for telephone companies' traditional voice services for many years. The
deployment of an ATE infrastructure for ADSL service began several years ago.

The ADSL ATE infrastructure typically involves the use of a centrally located
equipment platform, often referred to as a test head. The test head is used to
gather information from the telephone network for setting up or maintaining ADSL
service. Information about the telephone network is also gathered at remote
locations using hand-held testers. The information gathered in test heads is
generally made available to telephone companies' operations organizations
through a software network. This information assists telephone companies in
troubleshooting and

                                       5
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diagnosing problems encountered during service deployment or during operation.
Leading suppliers of ATE hardware and software, hand held devices and operations
software include Spirent, Teradyne, Tollgrade, Acterna, Sunrise, Fluke, and
others. There is an opportunity to improve ADSL service providers' ability to
troubleshoot and diagnose their networks as they continue to expand their user
base or deliver value-added services, such as video, television and triple play
services.

BIOMETRICS INDUSTRY BACKGROUND. Biometric security systems have typically used
fingerprints as the primary biometric to identify individuals. Electronic
identification systems for government and commercial applications based upon
fingerprints are pervasive. These systems gather fingerprints at enrollment
stations, and utilize transaction processing hardware and software and matching
systems for identification. The emergence of digital fingerprint compression and
formatting over the last decade has transformed these to electronic systems
capable of faster transaction processing and matching. These electronic systems
are also capable of being upgraded to utilize biometrics other then digital
fingerprints, such as facial image and iris based biometrics.

Electronic identification systems based upon digital fingerprints are widely
utilized by government agencies such as law enforcement, federal agencies, and
the Department of Defense ("DoD"). The use of these systems by international
governments has increased in the past several years. New government programs are
underway to increase the use of biometric information in documents such as
passports and personal identification cards. The use or contemplation of use of
biometric security systems by regulated segments of the financial,
transportation and healthcare industries has increased in the recent past.

Vendors of the hardware and/or software component of enrollment stations include
Lockheed Martin, Crossmatch, Unisys, SAIC, Identix, Northrop Grumman, Heimann
Biometrics and NEC. Fingerprint matching and/or biometric transaction management
systems are provided by companies such as Motorola, Sagem, NEC, Cogent, Identix,
and numerous system integrators. As biometric security systems gain acceptance
in new areas, the market opportunity for suppliers of hardware and software
solutions is expected to grow. The biometrics security systems market is also
expected to grow as the use of new biometrics, other than fingerprints, gain
favor.

AWARE ADSL INTELLECTUAL PROPERTY

Aware has been a pioneer of DSL technology since the mid 1990s. We license our
StratiPHY2+(TM) technology to semiconductor companies to manufacture and sell
chipsets that are compliant with the ITU standards for ADSL, ADSL2 and
ADSL2plus. We have been first to market with an intellectual property offering,
including a complete digital silicon solution (i.e. chip) that supports ADSL2
and ADSL2plus standards. We have also been first to demonstrate bonded ADSL2plus
that doubles ADSL data rates as well as reach-extended ADSL2 that increases the
distance over which phone companies can deliver service by 20% or more.

The intellectual property in StratiPHY2+ includes patent rights, copyrighted
materials and trade secrets. Copyrighted materials include digital chip design
technology, available in Verilog or VHDL languages, and software, available in
assembly and C-code. We license our copyrighted materials in source code as well
as object code form. We also have available digital silicon that embodies our
intellectual property. Our StratiPHY2+ chip supports all legacy and new ADSL
standards in a single integrated circuit.

Customers develop integrated circuits based upon our technology for fabrication
in their own or third party manufacturing processes. Customers manufacture our
digital chip or integrate our technology into chips that also contain other
functionality. We also offer engineering services to our customers for the
development and support of their chips or chipsets. Our largest ADSL
intellectual property customers are ADI and Infineon.

AWARE TEST AND DIAGNOSTICS PRODUCTS

We have developed test and diagnostics hardware and software products based upon
our Dr. DSL(R) technology. These products are primarily sold to OEMs in the
automated test equipment industry. These products are designed to assist service
providers with provisioning, monitoring, and maintaining DSL services by
enabling them to collect important information and diagnose problems regarding
their service offerings. The primary goal of these products is to reduce the
costs associated with service set-up and maintenance. Specific product features
include loop length measurement, bridged tap measurement, crosstalk disturber
detection and management, subscriber self-installation, and in-home diagnostics.

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Customers use our ADSL test printed circuit boards for connectivity within ADSL
service networks. With these boards, customers can interoperate with a broad
array of telephone company ADSL equipment as well as ADSL CPE. Customers use our
software products to troubleshoot and diagnose problems encountered during
service provisioning and for service maintenance.

We sell our hardware products to original equipment manufacturers ("OEMs") in
the automated test equipment market. We also sell hardware products to support
our customers' developments and sales. Our principal hardware products include:

|X|     DSL MODULES - Printed circuit boards that perform all connectivity
        aspects of ADSL.
|X|     ADSL TEST AND DEVELOPMENT SYSTEMS - System-level products that provide a
        means to conduct performance and interoperability testing during chipset
        development, marketing and production.

We primarily sell our software products, including Dr. DSL CPE and CO, as well
as Technician Dr. DSL diagnostics software to OEMs to perform single-ended and
double-ended testing to troubleshoot and diagnose problems encountered during
ADSL service provisioning and for service maintenance.

Our largest customer for test and diagnostics products has been Spirent
Communications, Inc. ("Spirent").

AWARE BIOMETRICS AND IMAGING PRODUCTS

Aware has been a pioneer in the development of wavelet-based image compression
technology since the late 1980s.

Aware provides standards-compliant biometrics software tools that enable
integrators, solution providers, and government agencies to compress, analyze,
optimize, format, and transport biometric images and data according to
international standards.

We have developed software products for digital fingerprint compression and
transaction processing that are widely used in the industry. These products
include:

|X|     WSQ BY AWARE, to compress digital fingerprint data for use by law
        enforcement agencies such as the Federal Bureau of Investigation.
|X|     NISTPACK, SEGMENTER, CJIS WEB, ACCUPRINT, AND ACCUSCAN, used by law
        enforcement agencies for transaction processing such as to format, edit,
        validate, store, and print fingerprint and facial images.

We sell our biometrics software primarily to OEMs that provide biometric
enrollment systems and to systems integrators.

We have also developed and sell the JPEG 2000 CODEC BY AWARE. This software
product provides a solution for the compression and decompression of still
images using the high-quality, wavelet-based method defined by the JPEG 2000
standard and has been primarily sold to medical imaging OEMs.

AWARE STRATEGY

Our objective is to establish StratiPHY2+ as the market leading broadband
wide-area network ("WAN") silicon-level interface. Key elements of our strategy
include:

DEVELOP HIGH PERFORMANCE, EASY-TO-USE, INTEROPERABLE, FLEXIBLE DSL SILICON
INTERFACE TECHNOLOGY. Our StratiPHY2+ technology supports multiple ADSL
standards in a single cost effective intellectual property offering. Our
StratiPHY2+ technology meets or exceeds industry performance and functionality
requirements. We have established interoperability agreements with leaders in
the ADSL equipment and semiconductor industries to achieve and maintain high
levels of interoperability across multiple vendors' solutions. We have also
developed chips, reference designs and development platforms to allow rapid
evaluation and testing of our technology.

LEVERAGE THE ALIGNMENT OF TECHNOLOGY ADVANCEMENTS AND SERVICE PROVIDER
REQUIREMENTS IN THE NEXT WAVE OF DSL ROLLOUTS. ADSL2 and ADSL2plus are
technologies that enable higher speed, broader functionality services. Telephone
companies worldwide are expanding their ADSL service offerings to include a
bundle of voice and data

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as well as value-added services such as video. The alignment of new capabilities
enabled by new standards and new requirements from service providers has created
an increased demand for our technology from communications, networking, consumer
electronics and multimedia semiconductor suppliers. We expect that support for
ADSL2 and ADSL2plus will rapidly become a requirement in new deployments of ADSL
chipsets and equipment.

LEAD IN THE DEVELOPMENT OF NEXT-GENERATION DSL STANDARDS-BASED TECHNOLOGIES. We
are developing new VDSL2 technologies to deliver speeds up to 100Mbps over
telephone wires. We are active at standards bodies and present our technology
innovations with the goal of including them in new specifications. We have R&D
activities focused on enhancing our intellectual property offerings to include
VDSL2 functionality. With these efforts, we believe we will be able to deliver
leading edge, next-generation technology to our customers.

COMMERCIALIZE OUR DSL TECHNOLOGY THROUGH A LICENSING BUSINESS MODEL. By
licensing our technology, our customers leverage our StratiPHY2+ developments,
reduce their R&D and support costs and economically deliver ADSL functionality
in their products. We generate revenue that is a combination of license fees,
engineering fees and royalties. As a licensor, we are able to leverage our
customers' sales, distribution and manufacturing capabilities. Our objective is
to establish StratiPHY2+ as a predominant broadband WAN silicon-level interface
through the success of our customers' products.

Our ADSL test and diagnostics product strategy is to provide hardware and
software products that address the challenges encountered by telephone companies
as they increase the number of lines and types of services provisioned through
their ADSL networks.

In biometrics, our strategy is to capitalize on the expanded use of biometric
security systems both within and outside the US Government.

RESEARCH AND DEVELOPMENT

DSL semiconductor technology must track the rapidly changing requirements of the
DSL industry. In order to accomplish this, we make substantial investments in
the design and development of new technologies, and for significant improvement
of existing technologies. Our research and development activities are focused on
shrinking the size of integrated circuits based upon our technology, improving
performance and functionality and incorporating new industry standards that we
expect will be adopted.

We also have research and development activities focused on further development
of our ADSL test and diagnostics hardware and software products as well as on
expanding our software products in biometrics, medical and digital imaging
applications.

As of December 31, 2004, we had an engineering staff of 74 employees,
representing 72% of our total employee staff. During the years ended December
31, 2004, 2003, and 2002, research and development expenses charged to
operations were $10.0 million, $12.1 million, and $14.0 million, respectively.
In addition, because our license agreements often call for us to provide
engineering development services to our customers, a portion of our total
engineering costs has been allocated to cost of contract revenue. We expect that
we will continue to invest substantial funds in research and development
activities.

SALES AND MARKETING

Our principal sales and marketing strategy is to license our ADSL intellectual
property to semiconductor manufacturers. We believe that decisions involving the
selection of our technology are frequently made at senior levels within a
prospective customer's organization. Consequently, we rely significantly on
presentations by our senior management to key employees at prospective
customers. As of December 31, 2004, we had eleven people in our ADSL and test
and diagnostics sales and marketing organization.

Customers who are selling or developing integrated circuits based upon our
technology are: ADI, Atmel Corporation ("Atmel"), Infineon, Thomson SA
("Thomson"), and a customer we have not yet named.

In 2004, we derived approximately 28% and 28% of our total revenue from ADI and
Infineon, respectively. In 2003, we derived approximately 27%, 17%, and 14% of
our total revenue from ADI, Infineon, and Spirent,

                                       8
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respectively. In 2002, we derived approximately 32%, 15%, and 12% of our total
revenue from ADI, Infineon and Intel Corporation ("Intel"), respectively. All
revenue in 2004, 2003, and 2002 was derived from unaffiliated customers.

We sell our biometrics and digital imaging software products primarily to OEMs
and systems integrators. As of December 31, 2004, there were two people in our
biometrics and digital imaging software sales organization.

COMPETITION

We compete by offering comprehensive packages of standards-based broadband
technology. Our success as an intellectual property supplier depends on the
willingness and ability of semiconductor manufacturers to design, build and sell
integrated circuits based on our intellectual property. The semiconductor
industry is intensely competitive and has been characterized by:

        |X|     rapid price erosion;

        |X|     rapid technological change;

        |X|     short product life cycles;

        |X|     cyclical market patterns; and

        |X|     increasing foreign and domestic competition.

As an intellectual property supplier to the semiconductor industry, we face
competition from internal development teams within potential semiconductor
customers. We must convince potential licensees to license from us rather than
develop technology internally. Furthermore, semiconductor customers, who have
licensed our intellectual property, may choose to abandon joint development
projects with us and develop chipsets themselves without using our technology.
In addition to competition from internal development teams, we may compete
against other independent suppliers of intellectual property for DSL.

The market for ADSL chipsets is also intensely competitive. Our success within
the ADSL industry requires that ADSL equipment manufacturers buy chipsets from
our semiconductor licensees, and that telephone companies buy ADSL equipment
from those equipment manufacturers. Our customers' chipsets compete with
products from other vendors of standards-based ADSL chipsets, including
Broadcom, Centillium, Conexant, ST and TI.

ADSL services compete with alternative DSL technologies that can also transport
high-speed data over telephone lines. These technologies include symmetric high
speed DSL (also known as HDSL, SDSL and G.SHDSL), and very high speed DSL, also
known as VDSL and VDSL2. We cannot give you assurances that these alternative
broadband technologies will not be more successful than ADSL or that we will be
able to participate in markets involving these alternative broadband
technologies.

ADSL services also compete with broadband technologies that use other network
architectures to provide high-speed data service. These technologies include
cable modems using cable networks, and wireless solutions using wireless
networks. To date, ADSL services have been more successful than high-speed cable
services outside of the United States; however cable services serve a larger
number of broadband subscribers than ADSL inside the United States. We cannot
give you assurances that these alternative network architectures will not be
more successful than ADSL.

Many of our current and prospective ADSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Broadcom,
Conexant, ST and TI, have significantly greater financial, technological,
manufacturing, marketing and personnel resources than we do. We cannot give you
assurances that we will be able to compete successfully or that competitive
pressures will not seriously harm our business.

The markets for our test and diagnostics hardware and software products are
competitive. We cannot assure you that we will be able to compete effectively or
that competitive pressures will not seriously harm our business.

The markets for our biometrics, medical and digital imaging software products
are competitive, and are expected to become increasingly more competitive in the
near future. We cannot assure you that we will be able to compete effectively or
that competitive pressures will not seriously harm our business.

                                       9
<PAGE>

PATENTS AND INTELLECTUAL PROPERTY

We rely on a combination of nondisclosure agreements and other contractual
provisions, as well as patent, trademark, trade secret and copyright law to
protect our proprietary rights. We have an active program to protect our
proprietary technology through the filing of patents. As of December 31, 2004,
we had 30 issued patents and 54 pending patent applications pertaining to
telecommunications and signal processing technology. We also had 12 issued
patents and 5 pending patent applications pertaining to image compression, video
compression, audio compression, seismic data compression and optical
applications.

Although we have patented certain aspects of our technology, we rely primarily
on trade secrets to protect our intellectual property. We attempt to protect our
trade secrets and other proprietary information through agreements with our
licensees, suppliers, employees and consultants, and through security measures.
Each of our employees is required to sign a non-disclosure and non-competition
agreement. Although we intend to protect our rights vigorously, we cannot assure
you that these measures will be successful. In addition, effective intellectual
property protection may be unavailable or limited in certain foreign countries.

Third parties may assert exclusive patent, copyright and other intellectual
property rights to technologies that are important to us. In the past, we have
received letters from third parties suggesting that we may be obligated to
license such intellectual property rights. If we were found to have infringed
any third party's patents, we could be subject to substantial damages and an
injunction preventing us from conducting our business.

MANUFACTURING

Sales of hardware products constitute a relatively small portion of our total
revenue. We do not intend to produce hardware products in any material quantity
for the foreseeable future. Consequently, we rely on third party contract
manufacturers to assemble and test substantially all of our products. Our
internal manufacturing capacity is limited to final test and assembly of certain
products. Other than ADSL chipsets, which are available from ADI, we believe
that other components for our hardware products are available from a number of
suppliers.


EMPLOYEES

At December 31, 2004, we employed 103 people, including 74 in engineering, 13 in
sales and marketing, 3 in manufacturing and 13 in finance and administration. Of
these employees, 101 were based in Massachusetts. None of our employees is
represented by a labor union. We consider our employee relations to be good.

We believe that our future success will depend in large part on the service of
our technical and senior management personnel and upon our ability to retain
highly qualified technical, sales and marketing and managerial personnel. We
cannot assure you that we will be able to retain our key managerial and
technical employees or that we will be able to attract and retain additional
highly qualified personnel in the future.

ITEM 2. PROPERTIES

We believe that our existing facilities are adequate for our current needs and
that additional space sufficient to meet our needs for the foreseeable future
will be available on reasonable terms. We currently occupy:

1.      72,000 square feet of office space in Bedford, Massachusetts, which
        serves as our headquarters. This site is used for our research and
        development, sales and marketing, and administrative activities. We own
        this facility.

2.      530 square feet of research and development space in Lafayette,
        California. This facility is currently leased for a 3-year term, which
        expires on August 31, 2007.

                                       10
<PAGE>

ITEM 3. LEGAL PROCEEDINGS

From time-to-market we are involved in litigation incidental to the conduct of
our business. We are not party to any lawsuit or proceeding that, in our
opinion, is likely to seriously harm our business.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the fourth
quarter ended December 31, 2004.







                                       11
<PAGE>

                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is the only class of stock we have outstanding, and it trades
on the Nasdaq National Market under the symbol AWRE. The following table sets
forth the high and the low sales prices of our common stock as reported on the
Nasdaq National Market from January 1, 2003 to December 31, 2004.

                                FIRST        SECOND       THIRD      FOURTH
                               QUARTER      QUARTER      QUARTER    QUARTER
    ------------------------------------------------------------------------
    2004
      High................       $4.69        $5.18       $4.07       $5.35
      Low.................        2.80         2.70        2.32        2.29

    2003
      High................       $2.48        $2.75       $3.29       $4.06
      Low.................        1.60         1.62        1.98        2.73

As of March 4, 2005, we had approximately 155 shareholders of record. This
number does not include shareholders from whom shares were held in a "nominee"
or "street" name. We have never paid cash dividends on our common stock and we
anticipate that we will continue to reinvest any earnings to finance future
operations.

We did not sell any equity securities that were not registered under the
Securities Act of 1933 during the three months ended December 31, 2004.

ITEM 6. SELECTED FINANCIAL DATA

In the table below, we provide you with our selected consolidated financial
data. We have prepared this information using our audited financial statements
for the years ended December 31, 2004, 2003, 2002, 2001, and 2000. When you read
this selected financial data, it is important that you read it along with
Management's Discussion and Analysis of Financial Condition and Results of
Operations, our historical consolidated financial statements, and the related
notes to the financial statements, which can be found in Item 8.

<TABLE>
<CAPTION>
Year ended December 31,                         2004         2003         2002        2001       2000
--------------------------------------------------------------------------------------------------------
                                                        (in thousands, except per share data)
<S>                                          <C>          <C>          <C>         <C>          <C>
STATEMENTS OF OPERATIONS DATA
Revenue..................................    $16,485      $10,843      $13,844     $18,547      $30,667
Income (loss) from operations............     (1,925)      (8,635)     (12,529)     (4,823)       9,490
Cumulative effect of change in
   accounting principle (1)..............          -            -            -           -       (1,618)
Net income (loss)........................     (1,367)      (8,038)     (18,728)     (2,520)      13,414
Net income (loss) per share - basic......     ($0.06)      ($0.35)      ($0.83)     ($0.11)       $0.60
Net income (loss) per share - diluted....     ($0.06)      ($0.35)      ($0.83)     ($0.11)       $0.56

BALANCE SHEET DATA
Cash and short-term investments..........    $34,965      $35,051      $33,302     $57,284      $57,503
Working capital..........................     37,168       36,727       33,481      59,608       67,146
Total assets.............................     50,183       51,024       59,237      78,103       81,450
Total liabilities........................      1,427        1,384        1,659       1,947        3,117
Total stockholders' equity...............     48,756       49,640       57,578      76,156       78,333
</TABLE>

(1)     Effective January 1, 2000, we adopted Securities and Exchange Commission
        Staff Accounting Bulletin No. 101, Revenue Recognition in Financial
        Statements ("SAB 101") and recorded the impact in 2000.

                                       12
<PAGE>

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

RESULTS OF OPERATIONS

The following table sets forth, for the years indicated, certain line items from
our consolidated statements of operations stated as a percentage of total
revenue:

<TABLE>
<CAPTION>
                                                              Year ended December 31,
                                                    ------------------------------------------
   Revenue:                                               2004         2003         2002
                                                    ------------------------------------------
<S>                                                       <C>          <C>          <C>
      Product sales..............................          29 %         40 %         33 %
      Contract revenue...........................          46           26           49
      Royalties..................................          25           34           18
                                                    ------------------------------------------
        Total revenue............................         100          100          100

   Costs and expenses:
      Cost of product sales......................           5           10            7
      Cost of contract revenue...................          16           14           35
      Research and development...................          61          111          101
      Selling and marketing......................          14           22           21
      General and administrative.................          15           22           26
                                                    ------------------------------------------
         Total costs and expenses................         111          179          190

   Loss from operations..........................         (11)         (79)         (90)

   Interest income...............................           3            5            6
                                                    ------------------------------------------

   Loss before provision for income taxes........          (8)         (74)         (84)
   Provision for income taxes....................           -            -          (51)
                                                    ------------------------------------------
   Net loss......................................          (8)%        (74) %      (135) %
                                                    ==========================================
</TABLE>

PRODUCT SALES

Product sales consist primarily of revenue from the sale of hardware and
software products. Hardware products include ADSL test and development systems,
modules, and modems. Software products consist of standard off-the-shelf
software products for biometric, medical imaging and digital imaging
applications, as well as DSL test and diagnostics software.

Product sales increased 10% from $4.3 million in 2003 to $4.8 million in 2004.
As a percentage of total revenue, product sales decreased from 40% in 2003 to
29% in 2004. The dollar increase was primarily due to a $0.9 million increase in
revenue from the sale of software products, which was partially offset by a $0.4
million decrease in revenue from the sale of hardware products.

Product sales decreased 5% from $4.5 million in 2002 to $4.3 million in 2003. As
a percentage of total revenue, product sales increased from 33% in 2002 to 40%
in 2003. The dollar decrease was primarily due to a $0.5 million decrease in
revenue from the sale of software products, which was partially offset by a $0.3
million increase in revenue from the sale of hardware products.

CONTRACT REVENUE

Contract revenue consists primarily of license and engineering service fees that
we receive under agreements with our customers to develop ADSL (including ADSL2,
ADSL2plus or VDSL2) chipsets.

Contract revenue increased 167% from $2.8 million in 2003 to $7.6 million in
2004. As a percentage of total revenue, contract revenue increased from 26% in
2003 to 46% in 2004. The dollar increase in 2004 was from new agreements with
existing customers and new customers.

                                       13
<PAGE>

Contract revenue decreased 58% from $6.8 million in 2002 to $2.8 million in
2003. As a percentage of total revenue, contract revenue decreased from 49% in
2002 to 26% in 2003. The dollar decrease in contract revenue in 2003 was a
result of a difficult environment for licensing intellectual property for
communications integrated circuits. Both existing and prospective ADSL chipset
licensees were reluctant to begin new development projects given: (i) generally
weak worldwide economic conditions, (ii) a difficult and uncertain environment
in the semiconductor and telecommunications industries, and (iii) intense ADSL
chipset competition and falling chipset prices. During the last several years,
customers and potential customers cautiously evaluated new chipset projects or
delayed or cancelled projects in the face of such conditions.

ROYALTIES

Royalties consist of royalty payments that we receive under licensing
agreements. We receive royalties from customers for the right to use our
technology in their chipsets or solutions.

Royalties increased 12% from $3.7 million in 2003 to $4.2 million in 2004. As a
percentage of total revenue, royalties decreased from 34% in 2003 to 25% in
2004. The dollar increase in royalties was due to a $0.3 million increase in
ADSL royalties and a $0.2 million increase in biometrics and medical imaging
royalties.

Royalties increased 47% from $2.5 million in 2002 to $3.7 million in 2003. As a
percentage of total revenue, royalties increased from 18% in 2002 to 34% in
2003. The dollar increase was due to an increase in ADSL royalties.

Our royalty revenue comes predominantly from ADSL chipset sales by Analog
Devices, Inc. ("ADI"), and Infineon Technologies AG ("Infineon"). Despite steady
growth of worldwide ADSL subscribers over the last several years, the
availability of ADSL chipsets from a number of suppliers and intense competition
among those suppliers has caused chipset prices to steadily decline. We are
uncertain how quickly sales of our customers' chipsets will increase and whether
such increases will contribute meaningful royalties to us.

COST OF PRODUCT SALES

Since the cost of software product sales is minimal, cost of product sales
consists primarily of the cost of hardware product sales.

Cost of product sales decreased 17% from $1.0 million in 2003 to $0.9 million in
2004. As a percentage of product sales, cost of product sales decreased from 24%
in 2003 to 18% in 2004. Cost of product sales decreased in 2004 due to a
decrease in hardware product sales. The increase in overall product margins was
due to a larger proportion of software sales in the product sales revenue mix.

Cost of product sales was essentially the same at $1.0 million in 2002 and 2003.
As a percentage of product sales, cost of product sales increased from 21% in
2002 to 24% in 2003. Although cost of product sales was essentially unchanged
during 2003 and 2002, there were two offsetting factors that caused this result.
Cost of product sales increased in 2003 primarily due to an increase in ADSL
module sales, which was offset by a decrease in cost of product sales that was
primarily due to lower sales of ADSL test and development systems. The decline
in overall product margins was primarily due to a smaller proportion of software
sales in the product sales revenue mix.

COST OF CONTRACT REVENUE

Cost of contract revenue consists primarily of salaries for engineers and
expenses for consultants, technology licensing fees, recruiting, supplies,
equipment, depreciation and facilities associated with customer development
projects. Our total engineering costs are allocated between cost of contract
revenue and research and development expense. In a given period, the allocation
of engineering costs between cost of contract revenue and research and
development is a function of the level of effort expended on each.

Cost of contract revenue increased 71% from $1.6 million in 2003 to $2.7 million
in 2004. As a percentage of contract revenue, cost of contract revenue decreased
from 55% in 2003 to 35% in 2004. The dollar increase in cost of contract revenue
was due to more customer contracts and higher contract revenue in 2004 as
compared to 2003.

                                       14
<PAGE>

Cost of contract revenue decreased 68% from $4.9 million in 2002 to $1.6 million
in 2003. As a percentage of contract revenue, cost of contract revenue decreased
from 72% in 2002 to 55% in 2003. The dollar decrease in cost of contract revenue
was due to fewer customer contracts and lower contract revenue in 2003 as
compared to 2002.

RESEARCH AND DEVELOPMENT EXPENSE

Research and development expense consists primarily of salaries for engineers
and expenses for consultants, recruiting, supplies, equipment, depreciation and
facilities related to engineering projects to improve our broadband intellectual
property offerings, as well as our software and hardware product technology.
Research and development expense decreased 17% from $12.1 million in 2003 to
$10.0 million in 2004. As a percentage of total revenue, research and
development expense decreased from 111% in 2003 to 61% in 2004. The dollar
decrease was primarily from $0.7 million decreased spending resulting from a
shift of engineers to customer projects, where spending is classified as cost of
contract revenue. This shift occurred because we had more customer projects in
2004 than in 2003. The dollar decrease in spending was also attributable to $0.5
million lower compensation and fringe benefit costs and $0.4 million lower
depreciation expense. Our research and development spending was principally
focused on improving our ADSL, ADSL2 and ADSL2plus StratiPHY2+(TM) technology
and chips, developing VDSL2 technology and chips, developing test and
diagnostics hardware and software and developing imaging and biometrics
software.

Research and development expense decreased 13% from $14.0 million in 2002 to
$12.1 million in 2003. As a percentage of total revenue, research and
development expense increased from 101% in 2002 to 111% in 2003. The dollar
decrease was primarily due to a decrease of approximately $1.0 million per
quarter in salaries and related expenses due to the reduction in force we
implemented in October 2002 and salary reductions we imposed on January 1, 2003.
This was partially offset by increased spending resulting from a shift of
engineers from customer projects, where spending is classified as cost of
contract revenue, to internal research and development projects, where spending
is classified as research and development expense. This shift occurred because
we had fewer customer projects in 2003 than in 2002, and we changed our
technology offering such that it requires less engineering support.

In October 2002, we terminated 35 employees to reduce our operating costs. Of
the 35 employees who were terminated, 32 were engineers. The cost of severance
and other employee benefits for terminated employees was approximately $0.7
million. The cost was recorded in the fourth quarter of 2002, and it
approximated our historical quarterly costs for these employees as if they were
active employees. Therefore, the reduction in force had a minimal effect on
research and development spending in 2002. As of December 31, 2002, accrued
severance costs were approximately $0.1 million, and were paid in the first half
of 2003.

In connection with the October reduction in force, we informed remaining
employees that effective January 1, 2003 their salaries would be reduced by 5%
and that senior management's salaries would be reduced by 10%. This reduction in
force and salary reduction lowered total 2003 engineering expenses by $3.7
million, and lowered total 2003 company expenses by $4.1 million. Total
engineering expenses include cost of contract revenue and research and
development expense.

SELLING AND MARKETING EXPENSE

Selling and marketing expense consists primarily of salaries for sales and
marketing personnel, travel, advertising and promotion, recruiting, and
facilities expense. Sales and marketing expense was approximately $2.4 million
in both 2003 and 2004. As a percentage of total revenue, sales and marketing
expense decreased from 22% in 2003 to 14% in 2004. The percentage decrease was
primarily due to higher revenue in 2004 as compared to 2003.

Sales and marketing expense decreased 19% from $3.0 million in 2002 to $2.4
million in 2003. As a percentage of total revenue, sales and marketing expense
increased from 21% in 2002 to 22% in 2003. The dollar decrease was primarily due
to $0.4 million lower spending on compensation and fringe benefit costs. Of this
amount, approximately $0.2 million was related to the reduction in force and
salary reductions we implemented in October 2002 and January 2003, respectively.

                                       15
<PAGE>

GENERAL AND ADMINISTRATIVE EXPENSE

General and administrative expense consists primarily of salaries for
administrative personnel, facility costs, bad debt, audit, legal, stock exchange
and insurance expenses. General and administrative expense increased 4% from
$2.4 million in 2003 to $2.5 million in 2004. As a percentage of total revenue,
general and administrative expense decreased from 22% in 2003 to 15% in 2004.
The dollar increase was primarily due to a $0.1 million lower provision for bad
debts in 2004 compared with 2003, and a $0.1 million increase in professional
fees and insurance. These increases were reduced by a $0.1 million decrease in
depreciation expense.

General and administrative expense decreased 34% from $3.6 million in 2002 to
$2.4 million in 2003. As a percentage of total revenue, general and
administrative expense decreased from 26% in 2002 to 22% in 2003. The dollar
decrease was primarily due to a $0.9 million reduction in our provisions for bad
debts and $0.1 million lower professional fees and insurance, as well as the
reduction in force and salary reductions we implemented in October 2002 and
January 2003, respectively. The reduction in force and salary reductions lowered
general and administrative expenses by approximately $0.2 million in 2003.

INTEREST INCOME

Interest income decreased 7% or $39,000 in 2004 and was approximately $0.6
million in both 2003 and 2004. The dollar decrease was primarily due to lower
cash balances.

Interest income decreased 33% from $0.9 million in 2002 to $0.6 million in 2003.
The dollar decrease was primarily due to lower interest rates earned on our cash
balances and lower cash balances.

INCOME TAXES

We evaluate, on a quarterly basis, the positive and negative evidence affecting
the realizability of our deferred tax assets. As a result of incurring operating
losses since 2001, we determined that it is more likely than not that our
deferred tax assets may not be realized, and since the fourth quarter of 2002
have established a full valuation allowance for our net deferred tax assets.
Accordingly, we have not recorded a deferred tax benefit for the operating
losses incurred in the years ended December 31, 2003 and 2004.

In 2002, we determined that due to our continuing operating losses in 2001 and
2002 as well as the uncertainty of the timing of profitability in future
periods, we should fully reserve our deferred tax assets. As a result, we
recorded a tax provision of $7.1 million in 2002 to reserve for our remaining
deferred tax assets.

As of December 31, 2004, we had federal net operating loss and research and
experimentation credit carry forwards of approximately $48.9 million and $9.6
million respectively, which may be available to offset future federal income tax
liabilities and expire at various dates through 2024. In addition, at December
31, 2004, we had approximately $8.8 million and $4.9 million of state net
operating losses and state research and development and investment tax carry
forwards, respectively, which expire at various dates through 2019.

Of the total net operating loss and research and development tax credit
carryforwards for which a valuation allowance was recorded, approximately $22.0
million is attributable to the exercise of stock options and the tax benefit
will be credited to additional paid-in capital, if realized in the future.

LIQUIDITY AND CAPITAL RESOURCES

Since our inception in March 1986, we have financed our activities primarily
through the sale of stock. In the years ended December 31, 2004, 2003 and 2002,
we received net proceeds from the issuance of stock under employee stock plans
of $0.5 million, $0.1 million and $0.2 million, respectively. Our operating
activities used net cash of $0.9 million, $8.1 million, and $9.5 million in the
years ended December 31, 2004, 2003 and 2002, respectively. Cash used in our
operating activities was primarily the result of operating losses and working
capital requirements.

In the years ended December 31, 2004, 2003, and 2002, we made capital
expenditures of $0.3 million, $0.2 million, and $0.8 million, respectively.
Capital expenditures in all three years primarily consisted of spending on
computer hardware and software, laboratory equipment, and furniture used
principally in engineering activities. We have no material commitments for
capital expenditures.

                                       16
<PAGE>

At December 31, 2004, we had cash, cash equivalents, short-term investments and
investments of $38.3 million. While we can not assure you that we will not
require additional financing, or that such financing will be available to us, we
believe that our cash, cash equivalents, short-term investments and investments
will be sufficient to fund our operations for at least the next twelve months.

To date, inflation has not had a material impact on our financial results. There
can be no assurance, however, that inflation will not adversely affect our
financial results in the future.

OFF-BALANCE SHEET ARRANGEMENTS

We do not have any financial partnerships with unconsolidated entities, such as
entities often referred to as structured finance, special purpose entities or
variable interest entities which are often established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. Accordingly, we are not exposed to any financing, liquidity,
market or credit risk that could arise if we had such relationships.

CONTRACTUAL OBLIGATIONS

We have various contractual obligations impacting our liquidity. The following
represents our contractual obligations as of December 31, 2004 (in thousands):

<TABLE>
<CAPTION>
                                                                    Payments Due By Period
                                           -----------------------------------------------------------------
                                                         Less than                               More than
    CONTRACTUAL OBLIGATIONS                  Total        1 year      1-3 years    3-5 years      5 years
    -----------------------                -----------  ------------  -----------  -----------  ------------
<S>                                             <C>          <C>            <C>           <C>           <C>
    Operating leases                            $ 42         $ 15           $27           $-            $-
    Purchase orders                              351          351             -            -             -
                                           -----------  ------------  -----------  -----------  ------------
    Total                                       $393         $366           $27           $-            $-
                                           ===========  ============  ===========  ===========  ============
</TABLE>

CRITICAL ACCOUNTING POLICIES

We consider certain accounting policies related to revenue recognition, income
taxes and the allowance for doubtful accounts to be critical policies.

REVENUE RECOGNITION. We derive our revenue from three sources (i) product
revenue, which includes revenue from the sale of hardware and software products
for the automated test equipment market and software products for the
biometrics, medical and digital imaging markets, (ii) contract revenue, which
includes patent, license and engineering service fees that we receive under
customer agreements, and (iii) royalties that we receive under customer
agreements.

As prescribed by Securities and Exchange Commission Staff Accounting Bulletin
No. 104, Revenue Recognition, we recognize revenue when there is persuasive
evidence of an arrangement, the sales price is fixed or determinable, collection
of the related receivable is reasonably assured, and delivery has occurred or
services have been rendered. We also apply the principles set forth in AICPA
Statement of Position No. 97-2, Software Revenue Recognition, when recognizing
software revenue. Our revenue recognition policies are described more fully in
Note 2, Summary of Significant Accounting Policies, in the Notes to our
Consolidated Financial Statements.

As described below, we make significant judgments and estimates during the
process of determining revenue for any particular accounting period.

In determining revenue recognition, we assess whether fees associated with
revenue transactions are fixed or determinable and whether or not collection is
reasonably assured. We make a judgment whether fees are fixed or determinable
based on the payment terms associated with that transaction. We assess
collection based on a number of factors, including past transaction history with
the customer and the credit-worthiness of the customer. If we

                                       17
<PAGE>

determine that collection of a fee is not reasonably assured, we defer the fee
and recognize revenue at the time collection becomes reasonably assured.

In addition to these general revenue recognition judgments, we make specific
judgments and estimates with respect to the recognition of contract revenue.
When our agreements include the delivery of licensing rights and technology as
well as the provision of engineering services, we combine the total patent,
license and engineering service fees to be paid under the agreement. These total
fees are recognized ratably over the expected product development period,
subject to the limitation that the cumulative revenue recognized through the end
of any period may not exceed cumulative contract payments to date. We review
assumptions regarding the product development period on a regular basis and make
adjustments as required. Consistent with the principles of SAB 104, we believe
that this method represents the appropriate systematic method for revenue
recognition for this type of contract.

After customers enter into development and license agreements, they often engage
us to provide additional engineering work that is beyond the scope of their
original agreement. When customers request additional services, both parties
agree to engineering fees that are based on the level of effort required. We
recognize revenue from these agreements either as engineering services are
performed or as milestones are achieved.

INCOME TAXES. As part of the process of preparing our consolidated financial
statements we are required to estimate our actual current tax expense. We must
also estimate temporary and permanent differences that result from differing
treatment of certain items for tax and accounting purposes. These differences
result in deferred tax assets and liabilities, which are included in our
consolidated balance sheet. We must then assess the likelihood that our deferred
tax assets will be recovered from future taxable income and to the extent that
we believe that recovery is not likely, we must establish a valuation allowance.
To the extent we establish a valuation allowance or increase this allowance in a
period for deferred tax assets, which have been recognized, we must include an
expense with the tax provision in the statement of operations.

Significant management judgment is required in determining our provision for
income taxes, our deferred tax assets, and any valuation allowance recorded
against our net deferred tax assets. Our deferred tax assets relate to net
operating losses and research and development tax credits that we are carrying
forward into future tax periods. As of December 31, 2004, we had a total of
$41.0 million of deferred tax assets for which we had recorded a full valuation
allowance.

Of the total valuation allowance, approximately $22.0 million relates to net
operating loss and research and development tax credit carryforwards that are
attributable to the exercise of stock options and the tax benefit will be
credited to additional paid-in capital, if realized in the future.

ALLOWANCE FOR DOUBTFUL ACCOUNTS. We make judgments as to our ability to collect
outstanding receivables and provide allowances for receivables when collection
becomes doubtful. Provisions are made based upon a specific review of all
significant outstanding invoices. If the judgments we make to determine the
allowance for doubtful accounts do not reflect the future ability to collect
outstanding receivables, additional provisions for doubtful accounts may be
required.


RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based
Payment ("SFAS 123R"). This Statement is a revision to SFAS 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION, and supersedes APB Opinion No. 25, ACCOUNTING FOR
STOCK ISSUED TO EMPLOYEES. SFAS 123R requires the measurement of the cost of
employee services received in exchange for an award of equity instruments based
on the grant-date fair value of the award. The cost will be recognized over the
period during which an employee is required to provide service in exchange for
the award. No compensation cost is recognized for equity instruments for which
employees do not render service. The effective date of SFAS 123R is as of the
beginning of the first interim or annual reporting period that begins after June
15, 2005. We expect that the adoption of SFAS 123R will have a significant
impact on our results of operations. We do not expect the adoption of SFAS 123R
to impact our overall financial position.

                                       18
<PAGE>

FACTORS THAT MAY AFFECT FUTURE RESULTS

SOME OF THE INFORMATION IN THIS FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS
THAT INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE
STATEMENTS BY FORWARD-LOOKING WORDS SUCH AS "MAY," "WILL," "EXPECT,"
"ANTICIPATE," "BELIEVE," "ESTIMATE," "CONTINUE" AND SIMILAR WORDS. YOU SHOULD
READ STATEMENTS THAT CONTAIN THESE WORDS CAREFULLY BECAUSE THEY: (1) DISCUSS OUR
FUTURE EXPECTATIONS; (2) CONTAIN PROJECTIONS OF OUR FUTURE OPERATING RESULTS OR
FINANCIAL CONDITION; OR (3) STATE OTHER "FORWARD-LOOKING" INFORMATION. HOWEVER,
WE MAY NOT BE ABLE TO PREDICT FUTURE EVENTS ACCURATELY. THE RISK FACTORS LISTED
IN THIS SECTION, AS WELL AS ANY CAUTIONARY LANGUAGE IN THIS FORM 10-K, PROVIDE
EXAMPLES OF RISKS, UNCERTAINTIES AND EVENTS THAT MAY CAUSE OUR ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THE EXPECTATIONS WE DESCRIBE IN OUR FORWARD-LOOKING
STATEMENTS. YOU SHOULD BE AWARE THAT THE OCCURRENCE OF ANY OF THE EVENTS
DESCRIBED IN THESE RISK FACTORS AND ELSEWHERE IN THIS FORM 10-K COULD MATERIALLY
AND ADVERSELY AFFECT OUR BUSINESS. WE ASSUME NO OBLIGATION TO UPDATE ANY
FORWARD-LOOKING STATEMENTS.

OUR QUARTERLY RESULTS ARE UNPREDICTABLE AND MAY FLUCTUATE SIGNIFICANTLY

Our quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter-to-quarter. Because our revenue components
fluctuate and are difficult to predict, and our expenses are largely independent
of revenues in any particular period, it is difficult for us to accurately
forecast revenues and profitability. When appropriate, we recognize contract
revenues ratably over the period during which we expect to deliver technology
and provide engineering services. While this means that contract revenues from
certain current agreements are generally predictable, changes can be introduced
by a reevaluation of the length of the development period, or by the termination
of a contract. The initial estimate of this period is subject to revision as the
product being developed under a contract nears completion, and a revision may
result in an increase or decrease to the quarterly revenue for that contract. In
addition, accurate prediction of revenues from new contracts or licensees is
difficult because contract negotiation is a lengthy process, frequently spanning
a year or more, and the fiscal period in which a new license agreement will be
entered into, if at all, and the financial terms of such an agreement are
difficult to predict. Contract revenues also include fees for engineering
services, which are dependent upon the varying level of assistance desired by
licensees and, therefore, the revenue from these services is also difficult to
predict.

It is also difficult for us to make accurate forecasts of royalty revenues.
Royalties are recognized in the quarter in which we receive a report from a
licensee regarding the shipment of licensed integrated circuits in the prior
quarter, and are dependent upon fluctuating sales volumes and/or prices of chips
containing our technology, all of which are beyond our ability to control or
assess in advance.

Our business is subject to a variety of additional risks, which could materially
adversely affect quarterly and annual operating results, including:

        |X|     market acceptance of broadband technologies we supply by
                semiconductor or equipment companies;
        |X|     the extent and timing of new license transactions with
                semiconductor companies;
        |X|     changes in our and our licensees' development schedules and
                levels of expenditure on research and development;
        |X|     the loss of a strategic relationship or termination of a project
                by a licensee;
        |X|     equipment companies' acceptance of integrated circuits produced
                by our licensees;
        |X|     the loss by a licensee of a strategic relationship with an
                equipment company customer;
        |X|     announcements or introductions of new technologies or products
                by us or our competitors;
        |X|     delays or problems in the introduction or performance of
                enhancements or of future generations of our technology;
        |X|     failures or problems in our hardware or software products;
        |X|     delays in the adoption of new industry standards or changes in
                market perception of the value of new or existing standards;
        |X|     competitive pressures resulting in lower contract revenues or
                royalty rates;
        |X|     competitive pressures resulting in lower software or hardware
                product revenues;
        |X|     personnel changes, particularly those involving engineering and
                technical personnel;
        |X|     costs associated with protecting our intellectual property;
        |X|     the potential that licensees could fail to make payments under
                their current contracts;

                                       19
<PAGE>

        |X|     ADSL market-related issues, including lower ADSL chipset unit
                demand brought on by excess channel inventory and lower average
                selling prices for ADSL chipsets as a result of market
                surpluses;
        |X|     regulatory developments; and
        |X|     general economic trends and other factors.

As a result of these factors, we believe that period-to-period comparisons of
our revenue levels and operating results are not necessarily meaningful. You
should not rely on our quarterly revenue and operating results to predict our
future performance.

WE EXPERIENCED NET LOSSES

We had a net loss during 2001, 2002, 2003, and 2004. We may continue to
experience losses in the future if:

        |X|     the semiconductor and telecommunications markets do not improve;
        |X|     our existing customers do not increase their revenues from sales
                of chipsets with our technology;
        |X|     new or existing customers do not choose to license our
                intellectual property for new chipset products; or
        |X|     new or existing customers do not choose to use our software or
                hardware products.

WE HAVE A UNIQUE BUSINESS MODEL

The success of our business model depends upon our ability to license our
technology to semiconductor and equipment companies, and our customers'
willingness and ability to sell products that incorporate our technology so that
we may receive significant royalties that are consistent with our plans and
expectations.

We face numerous risks in successfully obtaining suitable licensees on terms
consistent with our business model, including, among others:

        |X|     we must typically undergo a lengthy and expensive process of
                building a relationship with a potential licensee before there
                is any assurance of a license agreement with such party;
        |X|     we must persuade semiconductor and equipment manufacturers with
                significant resources to rely on us for critical technology on
                an ongoing basis rather than trying to develop similar
                technology internally;
        |X|     we must persuade potential licensees to bear development costs
                associated with our technology applications and to make the
                necessary investment to successfully manufacture chipsets and
                products using our technology; and
        |X|     we must successfully transfer technical know-how to licensees.

Moreover, the success of our business model also depends on the receipt of
royalties from licensees. Royalties from our licensees are often based on the
selling prices of our licensees' chipsets and products, over which we have
little or no control. We also have little or no control over our licensees'
promotional and marketing efforts. They are not prohibited from competing
against us.

Our business could be seriously harmed if:

        |X|     we cannot obtain suitable licensees;
        |X|     our licensees fail to achieve significant sales of chipsets or
                products incorporating our technology; or
        |X|     we otherwise fail to implement our business strategy
                successfully.

THERE HAS BEEN AND MAY CONTINUE TO BE AN OVERSUPPLY OF ADSL CHIPSETS, AND THERE
IS INTENSE COMPETITION FOR ADSL CHIPSETS, WHICH HAS CAUSED OUR ROYALTY REVENUE
TO DECLINE

The royalties we receive are influenced by many of the risks faced by the ADSL
market in general, including reduced average selling prices ("ASPs") for ADSL
chipsets during periods of surplus. In 2000, 2001, and 2002, the ADSL industry
had experienced an oversupply of ADSL chipsets and central office equipment.
Excessive inventory levels led to soft chipset demand, which in turn led to
declining ASPs. ASPs have also been under

                                       20
<PAGE>

pressure because of intense competition in the ADSL chipset marketplace. As a
result of the soft demand and declining ASPs for ADSL chipsets, our royalty
revenue has decreased substantially from the levels we achieved in 2000. Price
decreases for ADSL chipsets, and the corresponding decreases in per unit
royalties received by us, can be sudden and dramatic. Pricing pressures may
continue during the first quarter of 2005 and beyond. Our royalty revenue may
decline over the long term.

WE DEPEND SUBSTANTIALLY UPON A LIMITED NUMBER OF LICENSEES

There are a relatively limited number of semiconductor and equipment companies
to which we can license our broadband technology in a manner consistent with our
business model. If we fail to maintain relationships with our current licensees
or fail to establish a sufficient number of new licensing relationships, our
business could be seriously harmed. In addition, our prospective customers may
use their superior size and bargaining power to demand license terms that are
unfavorable to us and prospective customers may not elect to license from us.

WE DERIVE A SIGNIFICANT AMOUNT OF REVENUE FROM ONE CUSTOMER

In 2002, 2003 and 2004, we derived 32%, 27% and 28%, respectively of our total
revenue from ADI. ADI was the first customer to license ADSL technology from us
in 1993, and their chipsets are the most mature implementations of our
technology in the market. Our royalty revenues to date have been primarily due
to sales of ADI chipsets that use our ADSL technology. Our royalty revenue in
the near term is highly dependent upon ADI's ADSL chipset market share and
pricing. The ADSL market has experienced significant price erosion, which has
adversely affected ADI's ADSL revenue, which in turn has adversely affected our
royalty revenue. To the extent that ADI has lost market share, or loses market
share in the future, is unable to transition its product to support new ADSL2
and ADSL2plus standards, or experiences further price erosion in its ADSL
chipsets, our royalty revenue could decline.

OUR SUCCESS REQUIRES ACCEPTANCE OF OUR TECHNOLOGY BY EQUIPMENT COMPANIES

Due to our business strategy, our success is dependent on our ability to
generate significant royalties from our licensing arrangements with
semiconductor manufacturers. Our ability to generate significant royalties is
materially affected by the willingness of equipment companies to purchase
integrated circuits that incorporate our technology from our licensees. There
are other competitive solutions available for equipment companies seeking to
offer broadband communications products. We face the risk that equipment
manufacturers will choose those alternative solutions. Generally, our ability to
influence equipment companies' decisions whether to purchase integrated circuits
that incorporates our technology is limited.

We also face the risk that equipment companies that elect to use integrated
circuits that incorporate our technology into their products will not compete
successfully against other equipment companies. Many factors beyond our control
could influence the success or failure of a particular equipment company that
uses integrated circuits based on our technology, including:

        |X|     competition from other businesses in the same industry;
        |X|     market acceptance of its products;
        |X|     its engineering, sales and marketing, and management
                capabilities;
        |X|     technical challenges of developing its products unrelated to our
                technology; and
        |X|     its financial and other resources.

Even if equipment companies incorporate chipsets based on our intellectual
property into their products, their products may not achieve commercial
acceptance or result in significant royalties to us.

OUR SUCCESS REQUIRES TELEPHONE COMPANIES TO INSTALL ADSL SERVICE IN VOLUME

The success of our ADSL licensing business depends upon telephone companies
installing ADSL service in significant volumes. Factors that affect the volume
deployment of ADSL service include:

                                       21
<PAGE>

        |X|     the desire of telephone companies to install ADSL service, which
                is dependent on the development of a viable business model for
                ADSL service, including the capability to market, sell, install
                and maintain the service;
        |X|     the pricing of ADSL services by telephone companies;
        |X|     the transition by telephone companies to new ADSL technologies,
                such as ADSL2, ADSL2plus and VDSL2;
        |X|     the quality of telephone companies' networks;
        |X|     deployment by phone companies of fiber-to-the home or broadband
                wireless services;
        |X|     government regulations; and
        |X|     the willingness of residential telephone customers to demand
                ADSL service in the face of competitive service offerings, such
                as cable modems, fiber-based service or broadband wireless
                access.

If telephone companies do not install ADSL service in significant volumes, or if
telephone companies install broadband service based on other technology, our
business will be seriously harmed.

OUR INTELLECTUAL PROPERTY IS SUBJECT TO LIMITED PROTECTION

Because we are a technology provider, our ability to protect our intellectual
property and to operate without infringing the intellectual property rights of
others is critical to our success. We regard our technology as proprietary, and
we have a number of patents and pending patent applications. We also rely on a
combination of trade secrets, copyright and trademark law and non-disclosure
agreements to protect our unpatented intellectual property. Despite these
precautions, it may be possible for a third party to copy or otherwise obtain
and use our technology without authorization.

As part of our licensing arrangements, we typically work closely with our
semiconductor and equipment manufacturer licensees, many of whom are also our
potential competitors, and provide them with proprietary know-how necessary for
their development of customized chipsets based on our ADSL technology. Although
our license agreements contain non-disclosure provisions and other terms
protecting our proprietary know-how and technology rights, it is possible that,
despite these precautions, some of our licensees might obtain from us
proprietary information that they could use to compete with us in the
marketplace. Although we intend to defend our intellectual property as
necessary, the steps we have taken may be inadequate to prevent
misappropriation.

In the future, we may choose to bring legal action to enforce our intellectual
property rights. Any such litigation could be costly and time-consuming for us,
even if we were to prevail. Moreover, even if we are successful in protecting
our proprietary information, our competitors may independently develop
technologies substantially equivalent or superior to our technology. The
misappropriation of our technology or the development of competitive technology
could seriously harm our business.

Our technology, software or products may infringe the intellectual property
rights of others. A large and increasing number of participants in the
telecommunications and compression industries have applied for or obtained
patents. Some of these patent holders have demonstrated a readiness to commence
litigation based on allegations of patent and other intellectual property
infringement. Third parties may assert patent, copyright and other intellectual
property rights to technologies that are important to our business. In the past,
we have received claims from other companies that our technology infringes their
patent rights. Intellectual property rights can be uncertain and can involve
complex legal and factual questions. We may infringe the proprietary rights of
others, which could result in significant liability for us. If we were found to
have infringed any third party's patents, we could be subject to substantial
damages and an injunction preventing us from conducting our business.

OUR BUSINESS IS SUBJECT TO RAPID TECHNOLOGICAL CHANGE

The semiconductor and telecommunications industries, as well as the market for
high-speed network access technologies, are characterized by rapid technological
change, with new generations of products being introduced regularly and with
ongoing evolutionary improvements. We expect to depend on our ADSL technology
for a substantial portion of our revenue for the foreseeable future. Therefore,
we face risks that others could introduce competing technology that renders our
ADSL technology less desirable or obsolete. Also, the announcement of new
technologies could cause our licensees or their customers to delay or defer
entering into arrangements for the use of our existing technology. Either of
these events could seriously harm our business.

                                       22
<PAGE>

We expect that our business will depend to a significant extent on our ability
to introduce enhancements and new generations of our ADSL technology as well as
new technologies that keep pace with changes in the telecommunications and
broadband industries and that achieve rapid market acceptance. We must
continually devote significant engineering resources to achieving technical
innovations. These innovations are complex and require long development cycles.
Moreover, we may have to make substantial investments in technological
innovations before we can determine their commercial viability. We may lack
sufficient financial resources to fund future development. Also, our licensees
may decide not to share certain research and development costs with us. Revenue
from technological innovations, even if successfully developed, may not be
sufficient to recoup the costs of development.

One element of our business strategy is to assume the risks of technology
development failure while reducing such risks for our licensees. In the past, we
have spent significant amounts on development projects that did not produce any
marketable technologies or products, and we cannot assure you that it will not
occur again.

WE FACE INTENSE COMPETITION FROM A WIDE RANGE OF COMPETITORS

Our success as an intellectual property supplier depends on the willingness and
ability of semiconductor manufacturers to design, build and sell integrated
circuits based on our intellectual property. The semiconductor industry is
intensely competitive and has been characterized by price erosion, rapid
technological change, short product life cycles, cyclical market patterns and
increasing foreign and domestic competition.

As an intellectual property supplier to the semiconductor industry, we face
intense competition from internal development teams within potential
semiconductor customers. We must convince potential licensees to license from us
rather than develop technology internally. Furthermore, semiconductor customers,
who have licensed our intellectual property, may choose to abandon joint
development projects with us and develop chipsets themselves without using our
technology. In addition to competition from internal development teams, we
compete against other independent suppliers of intellectual property. We
anticipate intense competition from suppliers of intellectual property for ADSL.

The market for ADSL chipsets is also intensely competitive. Our success within
the ADSL industry requires that ADSL equipment manufacturers buy chipsets from
our semiconductor licensees, and that telephone companies buy ADSL equipment
from those equipment manufacturers. Our customers' chipsets compete with
products from other vendors of standards-based and ADSL chipsets, including
Broadcom, Centillium, Conexant, ST Microelectronics and Texas Instruments.

ADSL services offered over copper telephone networks also compete with
alternative broadband transmission technologies that use the telephone network
as well as other network architectures. Alternative technologies for the
telephone network include symmetric high speed DSL (also known as HDSL, SDSL and
G.SHDSL), and very high speed DSL, also known as VDSL. These DSL technologies
may be based on techniques other than those used by ADSL to transport high-speed
data over telephone lines. While we are actively developing VDSL technology to
meet new VDSL2 standards, we are not certain that we will be able to participate
in future VDSL deployments. Alternative technologies that use other network
architectures to provide high-speed data service include cable modems using
cable networks, wireless solutions using wireless networks, and optical
solutions using fiber optics technology. These alternative broadband
technologies may be more successful than ADSL and we may not be able to
participate in the markets involving these alternative technologies.

Many of our current and prospective ADSL licensees, as well as chipset
competitors that compete with our semiconductor licensees, including Broadcom,
Conexant, ST Microelectronics and Texas Instruments have significantly greater
financial, technological, manufacturing, marketing and personnel resources than
we do. We may be unable to compete successfully, and competitive pressures could
seriously harm our business.

WE MUST MAKE JUDGMENTS IN THE PROCESS OF PREPARING OUR FINANCIAL STATEMENTS

We prepare our financial statements in accordance with generally accepted
accounting principles and certain critical accounting polices that are relevant
to our business. The application of these principles and policies requires us to
make significant judgments and estimates. In the event that judgments and
estimates we make are incorrect, we may have to change them, which could
materially affect our financial position and results of operations.

                                       23
<PAGE>

Moreover, accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years. The implementation of new standards requires us to interpret and apply
them appropriately. If our current interpretations or applications are later
found to be incorrect, our financial position and results of operations could be
materially affected.

OUR STOCK PRICE MAY BE EXTREMELY VOLATILE

Volatility in our stock price may negatively affect the price you may receive
for your shares of common stock and increases the risk that we could be the
subject of costly securities litigation. The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:

        |X|     quarterly fluctuations in our operating results;
        |X|     changes in future financial guidance that we may provide to
                investors and public market analysts;
        |X|     changes in our relationships with our licensees;
        |X|     announcements of technological innovations or new products by
                us, our licensees or our competitors;
        |X|     changes in ADSL market growth rates as well as investor
                perceptions regarding the investment opportunity that companies
                participating in the ADSL industry afford them;
        |X|     changes in earnings estimates by public market analysts;
        |X|     key personnel losses;
        |X|     sales of common stock; and
        |X|     developments or announcements with respect to industry
                standards, patents or proprietary rights.

In addition, the equity markets have experienced volatility that has
particularly affected the market prices of equity securities of many high
technology companies and that often has been unrelated or disproportionate to
the operating performance of such companies. These broad market fluctuations may
adversely affect the market price of our common stock.

OUR BUSINESS MAY BE AFFECTED BY GOVERNMENT REGULATIONS

The extensive regulation of the telecommunications industry by federal, state
and foreign regulatory agencies, including the Federal Communications
Commission, and various state public utility and service commissions, could
affect us through the effects of such regulation on our licensees and their
customers. In addition, our business may also be affected by the imposition of
certain tariffs, duties and other import restrictions on components that our
customers obtain from non-domestic suppliers or by the imposition of export
restrictions on products sold internationally and incorporating our technology.
Changes in current or future laws or regulations, in the United States or
elsewhere, could seriously harm our business.

                                       24
<PAGE>

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to market risk relates primarily to our investment portfolio, and
the effect that changes in interest rates would have on that portfolio. Our
investment portfolio has included:

        |X|     Cash and cash equivalents, which consist of financial
                instruments with original maturities of three months or less;
        |X|     Short-term investments, which consist of financial instruments
                with remaining maturities of twelve months or less, and auction
                rate securities that typically have interest reset dates of
                twenty-eight days; and
        |X|     Investments, which consist of financial instruments that mature
                in three years or less.

All of our investments meet the high quality standards specified in our
investment policy. This policy dictates the maturity period and limits the
amount of credit exposure to any one issue, issuer, and type of instrument.

The interest rates on our auction rate securities are typically reset by auction
every twenty-eight days. Although our auction rate securities have been readily
marketable, if an auction were to fail, we may not be able to sell these
securities on the planned reset date thereby increasing our holding period.

We do not use derivative financial instruments for speculative or trading
purposes. As of December 31, 2004, we had invested $35.0 million in cash, cash
equivalents and short-term investments that matured in twelve months or less.
Due to the short duration of these financial instruments, we do not expect that
an increase in interest rates would result in any material loss to our
investment portfolio.

As of December 31, 2004, we had invested $3.3 million in long-term investments
that matured in one to three years. These long-term securities are invested in
high quality corporate securities and U.S. government securities. Despite the
high quality of these securities, they may be subject to interest rate risk.
This means that if interest rates increase, the principal amount of our
investment would probably decline. A large increase in interest rates may cause
a material loss to our long-term investments. The following table (dollars in
thousands) presents hypothetical changes in the fair value of our long-term
investments at December 31, 2004. The modeling technique measures the change in
fair value arising from selected potential changes in interest rates. Movements
in interest rates of plus or minus 50 basis points (BP) and 100 BP reflect
immediate hypothetical shifts in the fair value of these investments.

<TABLE>
<CAPTION>
                                       Valuation of securities                         Valuation of securities
                                        given an interest rate                          given an interest rate
                                             decrease of              No change              increase of
                                       -------------------------     in interest      -------------------------
Type of security                         (100BP)      (50 BP)           rates            100 BP        50 BP
---------------------------------------------------------------------------------------------------------------
<S>                                         <C>         <C>               <C>             <C>          <C>
Long-term investments with
  maturities of one to three years..        $3,355      $3,328            $3,301          $3,249       $3,275
</TABLE>


                                       25
<PAGE>

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Directors and Shareholders of Aware, Inc.:

We have completed an integrated audit of Aware, Inc.'s 2004 consolidated
financial statements and of its internal control over financial reporting as of
December 31, 2004 and audits of its 2003 and 2002 consolidated financial
statements in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Our opinions, based on our audits, are
presented below.

CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE

In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) present fairly, in all material respects, the
financial position of Aware, Inc. and its subsidiary at December 31, 2004 and
2003, and the results of their operations and their cash flows for each of the
three years in the period ended December 31, 2004 in conformity with accounting
principles generally accepted in the United States of America. In addition, in
our opinion, the financial statement schedule listed in the index appearing
under Item 15(a)(2) presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements. These financial statements and financial statement
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and financial statement
schedule based on our audits. We conducted our audits of these statements in
accordance with the standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit of financial statements includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

INTERNAL CONTROL OVER FINANCIAL REPORTING

Also, in our opinion, management's assessment, included in Management's Report
on Internal Control Over Financial Reporting appearing under Item 9A, that the
Company maintained effective internal control over financial reporting as of
December 31, 2004 based on criteria established in INTERNAL CONTROL - INTEGRATED
FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), is fairly stated, in all material respects, based on those
criteria. Furthermore, in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2004, based on criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK
issued by the COSO. The Company's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express opinions on management's assessment and on the
effectiveness of the Company's internal control over financial reporting based
on our audit. We conducted our audit of internal control over financial
reporting in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. An audit of internal control over financial reporting includes
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinions.

A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable

                                       26
<PAGE>

assurance regarding prevention or timely detection of unauthorized acquisition,
use, or disposition of the company's assets that could have a material effect on
the financial statements.

Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.


/s/ PricewaterhouseCoopers LLP

PricewaterhouseCoopers LLP
Boston, Massachusetts
March 15, 2005







                                       27
<PAGE>
<TABLE>
<CAPTION>
                                                 AWARE, INC.
                                         CONSOLIDATED BALANCE SHEETS
                               (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

                                                                                         DECEMBER 31,
                                                                               -----------------------------
                                                                                    2004            2003
                                                                               -------------   -------------
<S>                                                                                <C>             <C>
ASSETS
Current assets:
  Cash and cash equivalents.............................................            $7,482          $2,304
  Short-term investments................................................            27,483          32,747
  Accounts receivable (less allowance for doubtful......................
     accounts of $110 in 2004 and $927 in 2003)                                      3,070           2,449
  Inventories...........................................................               143              48
  Prepaid expenses and other current assets.............................               417             563
                                                                               -------------   -------------
        Total current assets............................................            38,595          38,111
                                                                               -------------   -------------

Property and equipment, net................................................          8,287           8,921
Investments................................................................          3,301           3,913
Other assets, net..........................................................              -              79
                                                                               -------------   -------------
           Total assets....................................................        $50,183         $51,024
                                                                               =============   =============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable......................................................              $361            $261
  Accrued expenses......................................................               157             136
  Accrued compensation..................................................               625             439
  Accrued professional..................................................               169              77
  Deferred revenue......................................................               115             471
                                                                               -------------   -------------
          Total current liabilities.....................................             1,427           1,384
                                                                               -------------   -------------

Commitments and contingent liabilities (Note 7)

Stockholders' equity:
  Preferred stock, $1.00 par value; 1,000,000 shares authorized,
       none outstanding ................................................                 -               -
   Common stock, $.01 par value; shares authorized,
          70,000,000 in 2004 and 2003; issued
          and outstanding, 22,908,818 in 2004 and 22,750,294 in 2003....               229             228
   Additional paid-in capital...........................................            77,882          77,400
   Retained earnings (accumulated deficit)..............................           (29,355)        (27,988)
                                                                               -------------   -------------
          Total stockholders' equity....................................            48,756          49,640
                                                                               -------------   -------------
          Total liabilities and stockholders' equity....................           $50,183         $51,024
                                                                               =============   =============


            The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>

                                       28
<PAGE>
<TABLE>
<CAPTION>
                                           AWARE, INC.
                              CONSOLIDATED STATEMENTS OF OPERATIONS
                              (IN THOUSANDS, EXCEPT PER SHARE DATA)

                                                                  YEARS ENDED DECEMBER 31,
                                                          --------------------------------------
                                                               2004        2003         2002
                                                          --------------------------------------
<S>                                                           <C>         <C>         <C>
Revenue:
  Product sales.......................................         $4,759      $4,309       $4,530
  Contract revenue....................................          7,575       2,840        6,797
  Royalties...........................................          4,151       3,694        2,517
                                                          --------------------------------------
      Total revenue...................................         16,485      10,843       13,844
                                                          --------------------------------------

Costs and expenses:
  Cost of product sales...............................            862       1,043          955
  Cost of contract revenue............................          2,683       1,567        4,889
  Research and development............................         10,013      12,074       13,956
  Selling and marketing...............................          2,379       2,407        2,966
  General and administrative..........................          2,473       2,387        3,607
                                                          --------------------------------------
       Total costs and expenses.......................         18,410      19,478       26,373
                                                          --------------------------------------

Loss from operations....................................       (1,925)     (8,635)     (12,529)
Interest income.........................................          558         597          894
                                                          --------------------------------------
Loss before provision for income taxes..................       (1,367)     (8,038)     (11,635)
Provision for income taxes..............................            -           -       (7,093)
                                                          --------------------------------------

Net loss................................................      ($1,367)    ($8,038)    ($18,728)
                                                          ======================================

Net loss per share - basic and diluted..................      ($0.06)     ($0.35)      ($0.83)

Weighted average shares - basic and diluted.............       22,785      22,713       22,679


      The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>

                                               29
<PAGE>
<TABLE>
<CAPTION>
                                              AWARE, INC.
                                 CONSOLIDATED STATEMENTS OF CASH FLOWS
                                             (IN THOUSANDS)

                                                                       YEARS ENDED DECEMBER 31,
                                                               ---------------------------------------
                                                                    2004          2003         2002
                                                               ---------------------------------------
<S>                                                               <C>           <C>         <C>
Cash flows from operating activities:
   Net loss..................................................     ($1,367)      ($8,038)    ($18,728)
   Adjustments to reconcile net loss to net cash
      used in operating activities:
      Depreciation and amortization..........................         969         1,471        1,844
      Provision for doubtful accounts.......................          (50)         (150)         707
      Increase (decrease) from changes in assets and
         liabilities:
      Accounts receivable....................................        (571)       (1,041)        (582)
      Inventories............................................         (95)            2          232
         Deferred tax assets.................................           -             -        7,093
      Prepaid expenses and other current assets..............         146           (33)         265
      Accounts payable.......................................         100           (13)         (79)
      Accrued expenses.......................................         299          (591)        (351)
      Deferred revenue.......................................        (356)          329          142
                                                               ---------------------------------------
           Net cash used in operating activities.............        (925)       (8,064)      (9,457)
                                                               ---------------------------------------

Cash flows from investing activities:
    Purchases of property and equipment......................        (256)         (190)        (807)
    Other assets.............................................           -             -          (52)
    Sales of investments.....................................      33,051        21,775       43,883
    Purchases of investments.................................     (27,175)      (15,185)     (56,805)
                                                               ---------------------------------------
           Net cash provided by (used in) investing
              activities                                            5,620         6,400      (13,781)
                                                               ---------------------------------------

Cash flows from financing activities:
    Proceeds from issuance of common stock ..................         483           100          150
                                                               ---------------------------------------
           Net cash provided by financing activities.........         483           100          150
                                                               ---------------------------------------

Increase (decrease) in cash and cash equivalents.............       5,178        (1,564)     (23,088)
Cash and cash equivalents, beginning of year.................       2,304         3,868       26,956
                                                               ---------------------------------------

Cash and cash equivalents, end of year ......................      $7,482        $2,304       $3,868
                                                               =======================================


         The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>

                                                  30
<PAGE>
<TABLE>
<CAPTION>

                                                AWARE, INC.
                              CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                               (IN THOUSANDS)


                                                                                 Retained
                                               Common Stock        Additional    Earnings        Total
                                          -----------------------    Paid-In   (Accumulated   Stockholders'
                                            Shares       Amount      Capital      Deficit)       Equity
                                          -----------------------------------------------------------------
<S>                                          <C>            <C>       <C>         <C>           <C>
Balance at December 31, 2001............     22,658         $227      $77,151      ($1,222)     $76,156

    Exercise of common stock options ...         10            -           63                        63
    Issuance of common stock under
       employee stock purchase plan.....         30            -           87                        87
    Net loss............................                                           (18,728)     (18,728)
                                          -----------------------------------------------------------------

Balance at December 31, 2002............     22,698          227       77,301      (19,950)      57,578

    Exercise of common stock options ...          3            -           10                        10
    Issuance of common stock under
       employee stock purchase plan.....         49            1           89                        90
    Net loss............................                                            (8,038)      (8,038)
                                          -----------------------------------------------------------------

Balance at December 31, 2003............     22,750          228       77,400      (27,988)      49,640

    Exercise of common stock options ...        110            1          349                       350
    Issuance of common stock under
       employee stock purchase plan.....         49            -          133                       133
    Net loss............................                                            (1,367)      (1,367)
                                          -----------------------------------------------------------------

Balance at December 31, 2004............     22,909         $229      $77,882     ($29,355)     $48,756
                                          =================================================================


           The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>

                                                    31
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.      NATURE OF BUSINESS

        We are a leader in the development and marketing of intellectual
        property for broadband communications. Our principal offering to date
        has been Asymmetric Digital Subscriber Line ("ADSL") technology for the
        telecommunications industry. ADSL enables telephone companies to use
        their existing copper telephone lines to offer broadband services. We
        license our broadband technology on a nonexclusive and worldwide basis
        to semiconductor companies that manufacture and sell integrated circuits
        that incorporate our technology to equipment companies who incorporate
        those integrated circuits into their products. We also offer ADSL
        hardware and software products and biometrics, medical and digital
        imaging software products.

2.      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

        BASIS OF PRESENTATION - The consolidated financial statements include
        the accounts of Aware, Inc. and its subsidiary. All significant
        intercompany transactions have been eliminated.

        CASH AND CASH EQUIVALENTS - Cash and cash equivalents consist primarily
        of demand deposits, money market funds, commercial paper, and discount
        notes in highly liquid short-term instruments with original maturities
        of three months or less from the date of purchase and are stated at
        cost, which approximates market.

        REVISION IN THE CLASSIFICATION OF CERTAIN SECURITIES -In connection with
        the preparation of this report, we concluded that it was appropriate to
        classify our auction variable rate notes as current investments.
        Previously, such investments had been classified as cash and cash
        equivalents. Accordingly, we have revised the classification to report
        these securities as current investments in the short-term investments
        line item on our Consolidated Balance Sheet as of December 31, 2003. We
        have also made corresponding adjustments to our Consolidated Statements
        of Cash Flows for the periods ended December 31, 2003 and 2002, to
        reflect the gross purchases and sales of these securities as investing
        activities rather than as a component of cash and cash equivalents. This
        change in classification does not affect previously reported cash flows
        from operations or from financing activities in our previously reported
        Consolidated Statements of Cash Flows, or our previously reported
        Consolidates Statements of Operations for any period presented.

        As of December 31, 2003, $17.2 million of these current investments were
        classified as cash and cash equivalents on our Consolidated Balance
        Sheet.

        For the fiscal years ended December 31, 2003 and 2002, net cash provided
        by (used in) investing activities related to these current investments
        of $17.2 million and $21.4 million, respectively, were included in cash
        and cash equivalents in our Consolidated Statements of Cash Flows

        INVESTMENTS - At December 31, 2004 and 2003, we categorized all
        securities as "available-for-sale," since we may liquidate these
        investments currently. In calculating realized gains and losses, cost is
        determined using specific identification. Unrealized gains and losses on
        available-for-sale securities are excluded from earnings and reported in
        a separate component of stockholders' equity. At December 31, 2004 and
        2003, unrealized gains and losses were not material. Gross realized
        gains on available for sale securities were $665 in 2004 and $11,912 in
        2003. There were no gross realized losses during those periods.

        At December 31, 2004 and December 31, 2003, we held $15.8 million and
        $17.2 million, respectively, of auction variable rate notes classified
        as available-for-sale securities. Our investments in these securities
        are recorded at cost, which approximates fair market value due to their
        variable interest rates, which typically reset every 28 days, and,
        despite the long-term nature of their stated contractual maturities, we
        have the ability to quickly liquidate these securities. As a result, we
        had no cumulative gross unrealized holding gains (losses) or gross
        realized gains (losses) from these investments. All income generated
        from these investments was recorded as interest income.

                                       32
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

        The amortized cost of securities, which approximates fair value,
        consists of the following at December 31, 2004 and 2003 (in thousands):

        Short-term Investments                       2004             2003
        ----------------------                   ------------     ------------
          Auction variable rate notes........        $15,750          $17,200
          Corporate debt securities..........          2,586            1,393
          U.S. agency securities.............          9,147           14,154
                                                 ------------     ------------
            Total............................        $27,483          $32,747
                                                 ============     ============

        Investments                                  2004             2003
        -----------                              ------------     ------------
          Corporate debt securities..........         $    -           $1,709
          U.S. agency securities.............          3,301            2,204
                                                 ------------     ------------
            Total............................         $3,301           $3,913
                                                 ============     ============

        Short-term investments mature within three to twelve months, and
        investments mature within one to three years.

        ALLOWANCE FOR DOUBTFUL ACCOUNTS - Accounts are charged to the allowance
        for doubtful accounts as they are deemed uncollectible based on a
        periodic review of the accounts.

        INVENTORIES - Inventories are stated at the lower of cost or market with
        cost being determined by the first-in, first-out ("FIFO") method.

        PROPERTY AND EQUIPMENT - Property and equipment are stated at cost.
        Depreciation and amortization of property and equipment is provided
        using the straight-line method over the estimated useful lives of the
        assets. Upon retirement or sale, the costs of the assets disposed of and
        the related accumulated depreciation are removed from the accounts and
        any resulting gain or loss is included in the determination of income or
        loss. The estimated useful lives of assets used by us are:

           Building and improvements.........................    30 years
           Building improvements.............................    5 to 20 years
           Furniture and fixtures............................    5 years
           Computer, office & manufacturing equipment........    3 years
           Purchased software................................    3 years

        IMPAIRMENT OF LONG-LIVED ASSETS - We review long-lived assets for
        impairment whenever events or changes in business circumstances indicate
        that the carrying amount of the assets may not be fully recoverable or
        that the useful lives of these assets are no longer appropriate. Each
        impairment test is based on a comparison of the undiscounted cash flows
        to the recorded value of the asset. If an impairment is indicated, the
        asset is written down to its estimated fair value on a discounted cash
        flow basis. The cash flow estimates used to determine the impairment, if
        any, reflect our best estimates using appropriate assumptions and
        projections at that time. We believe that no significant impairment of
        our long-lived assets has occurred as of December 31, 2004 and 2003.

        REVENUE RECOGNITION - Effective January 1, 2000, we adopted Securities
        and Exchange Commission Staff Accounting Bulletin No. 101, Revenue
        Recognition in Financial Statements ("SAB 101"), which was superseded by
        SAB 104 effective December 2003 and was adopted by us at that time.
        Accordingly, our general revenue recognition policy is to recognize
        revenue when there is persuasive evidence of an arrangement, the sales
        price is fixed or determinable, collection of the related receivable is
        reasonably assured, and delivery has occurred or services have been
        rendered.

        We derive our revenue from three sources (i) product revenue, which
        includes revenue from the sale of ADSL hardware and software products
        and biometrics medical and digital imaging software products, (ii)

                                       33
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

        contract revenue, which includes patent, license and engineering service
        fees that we receive under customer agreements, and (iii) royalties that
        we receive under customer agreements. In addition to the above general
        revenue recognition principles prescribed by SAB 104, our specific
        revenue recognition policies for each revenue source are more fully
        described below.

        PRODUCT SALES. Product sales consist primarily of revenue from the sale
        of: (i) hardware products, and (ii) software products.

        o       Hardware products, including ADSL modules and ADSL test and
                development systems are standalone products that are sold
                independently of our technology licensing products. The terms of
                sales generally do not contain provisions that obligate us to
                provide additional products or services after shipment.
                Additionally, we do not grant return rights other than normal
                warranty rights of return. We recognize revenue: (i) upon
                shipment when products are shipped FOB shipping point, and (ii)
                upon delivery at the customer's location when products are
                shipped FOB destination.

        o       Software products consists of standard off-the-shelf software
                that are generally sold to OEM customers for integration into
                their products. The terms of sale generally do not contain
                provisions that obligate us to provide additional products or
                services after shipment, other than technical telephone support
                for a brief period of time post sale. The cost of providing
                technical support is inconsequential because of the limited
                scope of the support. Additionally, we do not grant return
                rights other than normal warranty rights of return, and we
                generally do not customize software for customers. We also sell
                maintenance contracts that entitle customers to product updates.

                We recognize software revenue by applying the principles set
                forth in SAB 104 and American Institute of Certified Public
                Accountants ("AICPA") Statement of Position No. 97-2, Software
                Revenue Recognition. Accordingly, we recognize revenue for
                software licenses: (i) upon shipment when products are shipped
                FOB shipping point, and (ii) upon delivery at the customer's
                location when products are shipped FOB destination. We recognize
                revenue for maintenance contracts ratably over the related
                contract period.

        CONTRACT REVENUE. We enter into nonexclusive development and license
        agreements with semiconductor licensees that generally require us to
        deliver technology and/or provide engineering services. In return, we
        receive one or more of the following forms of consideration: (i) patent
        and license fees; (ii) engineering service fees; and (iii) royalty
        payments.

        License fees, patent fees or engineering services fees are typically
        paid and the revenue is recognized during the product development period
        as technology is delivered or as engineering services milestones are
        achieved. Engineering milestones have historically been formulated to
        correlate with the estimated level of effort and related costs. We
        classify license, patent and engineering service fees as contract
        revenue.

        When our agreements include both the delivery of licensing rights and
        technology and the provision of engineering services, we combine the
        total patent, license and engineering service fees to be paid under the
        agreement. These total fees are recognized ratably over the expected
        product development period, subject to the limitation that the
        cumulative revenue recognized through the end of any period may not
        exceed cumulative contract payments to date. We review assumptions
        regarding the product development period on a regular basis and make
        adjustments as required. We believe that this method represents the
        appropriate systematic method for revenue recognition for this type of
        contract.

        After customers enter into development and license agreements, they
        often engage us to provide additional engineering work that is beyond
        the scope of their original agreement. When customers request additional
        services, both parties agree to engineering fees that are based on the
        level of effort required. We recognize revenue from these agreements
        either as engineering services are performed or as milestones are
        achieved.

        ROYALTY REVENUE. Royalty revenue is generally recognized in the quarter
        in which a report is received from a licensee detailing the shipments of
        products incorporating our intellectual property. This report is

                                       34
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

        typically received in the quarter following sales of the licensed
        product by the licensee. The terms of our licensing agreements generally
        require licensees to give notification to us and to pay royalties within
        45 to 60 days of the end of the quarter during which sales of licensed
        products take place.

        INCOME TAXES - We compute deferred income taxes based on the differences
        between the financial statement and tax basis of assets and liabilities
        using enacted rates in effect in the years in which the differences are
        expected to reverse. We establish a valuation allowance to offset
        temporary deductible differences, net operating loss carryforwards and
        tax credits when it is more likely than not that the deferred tax assets
        will not be realized.

        CAPITALIZATION OF SOFTWARE COSTS - We capitalize certain internally
        generated software development costs after technological feasibility of
        the product has been established. No software costs were capitalized for
        the years ended December 31, 2004, 2003 and 2002, because such costs
        incurred subsequent to the establishment of technological feasibility,
        but prior to commercial availability, were immaterial.

        CONCENTRATION OF CREDIT RISK - At December 31, 2004 and 2003, we had
        cash and investments, in excess of federally insured deposit limits of
        approximately $38.2 million and $38.9 million, respectively.

        Concentration of credit risk with respect to net accounts receivable
        consists of $1.2 million, $0.6 million, and $0.3 million with three
        customers at December 31, 2004 and $0.5 million, $0.5 million, and $0.4
        million with three customers at December 31, 2003.

        STOCK-BASED COMPENSATION - We grant stock options to our employees and
        directors. Such grants are for a fixed number of shares with an exercise
        price equal to the fair value of the shares at the date of grant. As
        permitted by SFAS No. 123, "Accounting for Stock-Based Compensation", we
        account for stock option grants in accordance with Accounting Principles
        Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees"
        and FASB Interpretation No. 44 ("FIN 44"), "Accounting for Certain
        Transactions Involving Stock Compensation." Accordingly, we have adopted
        the provisions of SFAS No. 123 through disclosure only.

        At December 31, 2004, we have four stock-based employee compensation
        plans, which are described more fully in Note 6. No stock-based employee
        compensation cost is reflected in net income, as all options granted
        under those plans had an exercise price equal to the fair market value
        of the underlying common stock on the date of grant. The following table
        illustrates the pro forma effect on net loss and earnings per share if
        we had applied the fair value recognition provisions of SFAS No. 123 and
        SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and
        Disclosure - An Amendment of SFAS No. 123", to stock-based employee
        compensation (in thousands, except per share data):

<TABLE>
<CAPTION>
                                                                               Year ended December 31,
                                                                   ---------------------------------------------
                                                                         2004            2003           2002
                                                                   ---------------------------------------------
<S>                                                                     <C>            <C>            <C>
        Net loss - as reported.................................         ($1,367)        ($8,038)      ($18,728)
        Deduct: Total stock-based employee compensation
          expense determined under fair value based method
          for all awards.......................................           8,277          21,107         21,207
                                                                   ---------------------------------------------
        Net loss - pro forma...................................         ($9,644)       ($29,145)      ($39,935)

        Basic loss per share - as reported.....................          ($0.06)         ($0.35)        ($0.83)
        Basic loss per share - pro forma.......................          ($0.42)         ($1.28)        ($1.76)

        Diluted loss per share - as reported...................          ($0.06)         ($0.35)        ($0.83)
        Diluted loss per share - pro forma.....................          ($0.42)         ($1.28)        ($1.76)
</TABLE>

        The fair value of options on their grant date was measured using the
        Black-Scholes option pricing model. Key assumptions used to apply this
        pricing model are as follows:

                                       35
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                   Year ended December 31,
                                                        ------------------------------------------
                                                            2004           2003           2002
                                                        -------------  -------------  -------------
<S>                                                          <C>           <C>            <C>
        Average risk-free interest rate.............           3.74%         2.97%          3.82%
        Expected life of option grants..............         5 years       5 years        5 years
        Expected volatility of underlying stock.....             93%           95%            99%
        Expected dividend yield.....................               -             -              -
</TABLE>

        COMPUTATION OF EARNINGS PER SHARE - Basic earnings per share is computed
        by dividing income available to common shareholders by the weighted
        average number of common shares outstanding. Diluted earnings per share
        is computed by dividing income available to common shareholders by the
        weighted average number of common shares outstanding plus additional
        common shares that would have been outstanding if dilutive potential
        common shares had been issued. For the purposes of this calculation,
        stock options are considered common stock equivalents in periods in
        which they have a dilutive effect. Stock options that are antidilutive
        are excluded from the calculation.

        USE OF ESTIMATES - The preparation of our financial statements in
        conformity with generally accepted accounting principles requires us 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
        amount of revenues and expenses during the reporting period. Significant
        estimates include revenue recognition, reserves for doubtful accounts,
        reserves for excess and obsolete inventory, useful lives of fixed
        assets, valuation allowance for deferred income tax assets, and accrued
        liabilities. Actual results could differ from those estimates.

        FAIR VALUE OF FINANCIAL INSTRUMENTS - The carrying amounts of cash and
        cash equivalents, short-term investments, accounts receivable, accounts
        payable and accrued expenses approximate fair value because of their
        short-term nature.

        COMPREHENSIVE INCOME (LOSS) - Comprehensive income (loss) is defined as
        the change in equity of a business enterprise during a period from
        transactions and other events and circumstances from non-owner sources,
        including foreign currency translation adjustments and unrealized gains
        and losses on marketable securities. For the years ended December 31,
        2004, 2003 and 2002, comprehensive income (loss) was not materially
        different from net income (loss).

        ADVERTISING COSTS - Advertising costs are expensed as incurred and were
        not material for 2004, 2003 and 2002.

        RECENT ACCOUNTING PRONOUNCEMENTS - In December 2004, the Financial
        Accounting Standards Board ("FASB") issued Statement of Financial
        Accounting Standard No. 123 (revised 2004), Share-Based Payment ("SFAS
        123R"). This Statement is a revision to SFAS 123, ACCOUNTING FOR
        STOCK-BASED COMPENSATION, and supersedes APB Opinion No. 25, ACCOUNTING
        FOR STOCK ISSUED TO EMPLOYEES. SFAS 123R requires the measurement of the
        cost of employee services received in exchange for an award of equity
        instruments based on the grant-date fair value of the award. The cost
        will be recognized over the period during which an employee is required
        to provide service in exchange for the award. No compensation cost is
        recognized for equity instruments for which employees do not render
        service. The effective date of SFAS 123R is as of the beginning of the
        first interim or annual reporting period that begins after June 15,
        2005. We expect that the adoption of SFAS 123R will have a significant
        impact on our results of operations. We do not expect the adoption of
        SFAS 123R to impact our overall financial position.

        SEGMENTS - We organize ourselves as one segment reporting to the chief
        operating decision-maker. We have sales outside of the United States,
        which are described in Note 8. All long-lived assets are maintained in
        the United States.

                                       36
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3.      INVENTORIES

        Inventories consisted of the following at December 31 (in thousands):

                                                  2004              2003
                                             ---------------    --------------
         Raw materials..................               $143               $48
                                             ===============    ==============

4.      PROPERTY AND EQUIPMENT

        Property and equipment consisted of the following at December 31 (in
        thousands):

<TABLE>
<CAPTION>
                                                                         2004            2003
                                                                    --------------  ---------------
<S>                                                                      <C>             <C>
        Land.....................................................         $1,080          $1,080
        Building and improvements................................          8,837           8,837
        Computer equipment.......................................          5,931           5,688
        Purchased software.......................................          2,839           2,827
        Furniture and fixtures...................................            937             936
        Office equipment.........................................            346             346
        Manufacturing equipment..................................            268             268
                                                                    --------------  ---------------
           Total.................................................         20,238          19,982
        Less accumulated depreciation and amortization...........        (11,951)         (11,061)
                                                                    --------------  ---------------
           Property and equipment, net...........................         $8,287          $8,921
                                                                    ==============  ===============
</TABLE>

        Depreciation expense amounted to $0.9 million, $1.3 million and $1.7
        million in each of the years ended December 31, 2004, 2003, and 2002,
        respectively.

5.      INCOME TAXES

        Deferred tax assets are attributable to the following at December 31 (in
        thousands):

<TABLE>
<CAPTION>
                                                                              2004           2003
                                                                          -------------  -------------
<S>                                                                           <C>            <C>
        Federal net operating loss carryforwards........................      $16,625        $16,560
        Research and development and other tax credit carryforwards.....       12,818         11,822
        State net operating loss carryforwards..........................          554          2,582
        Capitalized research and development costs......................       10,305          9,872
        Other ..........................................................          659            935
                                                                          -------------  -------------
           Total........................................................       40,961         41,771
        Less valuation allowance........................................      (40,961)       (41,771)
                                                                          -------------  -------------
           Deferred tax assets, net.....................................      $     -        $     -
                                                                          =============  =============
</TABLE>

        A reconciliation of the U.S. federal statutory rate to the effective tax
        rate is as follows:

<TABLE>
<CAPTION>
                                                                      Year ended December 31,
                                                           ------------------------------------------
                                                                2004          2003           2002
                                                           -------------  ------------  -------------
<S>                                                             <C>            <C>           <C>
        Federal statutory rate............................      (34%)          (34%)         (34%)
        State rate, net of federal benefit................       (7)            (6)           (6)
        Tax credits.......................................      (77)           (14)          (14)
        Change in valuation allowance.....................       98             50           111
        Other                                                    20              4             4
                                                           -------------  ------------  -------------
           Effective tax rate.............................        0%             0%           61%
                                                           =============  ============  =============
</TABLE>

                                       37
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

        During 2002, we recorded a valuation allowance of $38.1 million against
        all of our deferred tax assets and in 2003 we increased the valuation
        allowance by $3.7 million to $41.8 million. The valuation allowance was
        recorded against deferred tax assets because we determined that it was
        more likely than not that all of the deferred tax assets may not be
        realized. In 2004, we increased the valuation allowance by $0.5 million
        primarily as a result of additional operating losses and tax credits,
        and reduced the valuation allowance by $1.4 million as a result of
        expiring state net operating loss carryforwards.

        We have incurred operating losses in 2004, 2003 and 2002. At December
        31, 2004 and 2003, these cumulative factors resulted in our decision
        that it is more likely than not that all of our deferred tax assets may
        not be realized. If we generate sustained future taxable income against
        which these tax attributes may be applied, some portion or all of the
        valuation allowance would be reversed. If the valuation allowance is
        reversed approximately $22.0 million would be recorded as a credit to
        additional paid in capital reflecting the benefit of deductions from the
        exercise of stock options.

        As of December 31, 2004, we had federal net operating loss and research
        and experimentation credit carryforwards of approximately $48.9 million
        and $9.6 million respectively, which may be available to offset future
        federal income tax liabilities and expire at various dates through 2024.
        In addition, at December 31, 2004, we had approximately $8.8 million and
        $4.9 million of state net operating losses and state research and
        development and investment tax carryforwards, respectively, which expire
        at various dates through 2019.

6.      EQUITY AND STOCK COMPENSATION PLANS

        At December 31, 2004, we have four stock-based compensation plans, which
        are described below.

        FIXED STOCK OPTION PLANS - We have three fixed option plans. Under the
        1990 Incentive and Nonstatutory Stock Option Plan ("1990 Plan"), we may
        grant incentive stock options or nonqualified stock options to our
        employees and directors for up to 2,873,002 shares of common stock.
        Under the 1996 Stock Option Plan ("1996 Plan"), we may grant incentive
        stock options or nonqualified stock options to our employees and
        directors for up to 6,100,000 shares of common stock. Under the 2001
        Nonqualified Stock Plan ("2001 Plan"), we may grant nonqualified stock
        options to our employees and directors for up to 8,000,000 shares of
        common stock. Under all three plans, options are granted at an exercise
        price as determined by the Board of Directors and have a maximum term of
        ten years. Our options generally vest over three to five years, although
        we have granted options that are 50% or fully vested on the date of
        grant. As of December 31, 2004, there were 6,293,809 shares available
        for grant under the 2001 Plan, 1,178,570 shares available for grant
        under the 1996 Plan, and no shares available under the 1990 Plan. In
        February 2005, we granted fully vested stock options to our directors
        and certain of our officers to purchase an aggregate of 1,658,500 shares
        of our common stock. The options were granted with exercise prices equal
        to the fair market value of our common stock on the dates of grant.

        A summary of the transactions of our three fixed stock option plans for
        the years ended December 31, 2004, 2003, and 2002 are presented below:

<TABLE>
<CAPTION>
                                                2004                         2003                        2002
                                      --------------------------  ---------------------------  -------------------------
                                                     Weighted                    Weighted                    Weighted
                                                      Average                     Average                     Average
                                                     Exercise                    Exercise                    Exercise
                                         Shares        Price         Shares        Price          Shares       Price
                                      --------------------------  ---------------------------  -------------------------
<S>                                      <C>              <C>        <C>              <C>         <C>            <C>
Outstanding at beginning of year...      3,467,929        $4.38      6,842,546        $17.47      6,268,208      $20.63
Granted............................      1,305,500         2.96      2,993,963          3.22      1,521,100        3.50
Exercised..........................       (110,087)        3.18         (2,937)         3.54         (9,736)       6.48
Forfeited or cancelled.............       (153,534)        5.83     (6,365,643)        17.91       (937,026)      16.00
                                      --------------------------  ---------------------------  -------------------------
Outstanding at end of year.........      4,509,808        $3.95      3,467,929         $4.38      6,842,546      $17.47
                                      ==========================  ===========================  =========================

Options exercisable at year end....      3,409,927        $4.23      2,356,254         $4.84      4,265,956      $21.01
</TABLE>

                                       38
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

        The weighted average grant date fair values of options granted during
        the years ended December 31, 2004 2003 and 2002 were $2.16, $2.37 and
        $2.65, respectively.

        The following table summarizes information about stock options
        outstanding at December 31, 2004:

<TABLE>
<CAPTION>
                                         Options Outstanding                               Options Exercisable
                       ----------------------------------------------------------  -------------------------------------
                           Number          Weighted-Avg.                                 Number
       Range of        Outstanding at  Remaining Contractual     Weighted-Avg.         Exercisable       Weighted-Avg.
   Exercise Prices        12/31/04              Life            Exercise Price         At 12/31/04       Exercise Price
   ---------------    -----------------------------------------------------------  -------------------------------------
<S>                        <C>                 <C>                   <C>                 <C>                 <C>
  $0 to 5...........       4,287,391           9.0 years              $3.15              3,192,262            $3.19
   5 to 10..........          84,750           6.4                    $7.27                 80,185            $7.33
  10 to 20..........          46,417           3.2                   $10.59                 46,230           $10.59
  20 to 30..........          21,750           5.8                   $20.38                 21,750           $20.38
  30 to 40..........          45,000           4.5                   $33.56                 45,000           $33.56
  40 to 50..........          14,500           5.2                   $44.02                 14,500           $44.02
  50 to 70..........          10,000           4.8                   $58.06                 10,000           $58.06
                       -----------------------------------------------------------  -------------------------------------
                           4,509,808           8.8                    $3.95              3,409,927            $4.23
                       ===========================================================  =====================================
</TABLE>

        EMPLOYEE STOCK PURCHASE PLAN - In June 1996, we adopted an Employee
        Stock Purchase Plan (the "ESPP Plan") under which eligible employees may
        purchase common stock at a price equal to 85% of the lower of the fair
        market value of the common stock at the beginning or end of each
        six-month offering period. Participation in the ESPP Plan is limited to
        6% of an employee's compensation, may be terminated at any time by the
        employee and automatically ends on termination of employment. A total of
        350,000 shares of common stock have been reserved for issuance. As of
        December 31, 2004 there were 172,680 shares available for future
        issuance under the ESPP Plan. We issued 48,437, 49,186 and 30,694 common
        shares under the ESPP Plan in 2004, 2003 and 2002, respectively.

        STOCKHOLDER RIGHTS PLAN - In October 2001, our board of directors
        adopted a stockholder rights plan and declared a dividend distribution
        of one share purchase right (a "Right") for each outstanding share of
        our common stock to stockholders of record at the close of business on
        October 15, 2001. Each share of common stock issued after that date also
        will carry with it one Right, subject to certain exceptions. Each Right,
        when it becomes exercisable, will entitle the record holder to purchase
        from us one ten-thousandth of a share of series A preferred stock at an
        exercise price of $40.00 subject to adjustment.

        The Rights become exercisable upon the earliest of the following dates:
        (i) the date on which we first publicly announce that a person or group
        has become an acquiring person, or (ii) the date, if any, that our board
        of directors may designate following the commencement of, or first
        public disclosure of an intent to commence, a tender or exchange offer
        which could result in the potential buyer becoming a beneficial owner of
        15% or more of our outstanding common stock. Under these circumstances,
        holders of Rights will be entitled to purchase, for the exercise price,
        the preferred stock equivalent of common stock having a market value of
        two times the exercise price. The Rights expire on October 2, 2011, and
        may be redeemed by us for $.001 per Right.

        EMPLOYEE STOCK OPTION EXCHANGE PROGRAM - On March 3, 2003, we commenced
        an offer to exchange outstanding stock options with eligible employees.
        Under the terms of the program, eligible employees had the right to
        tender for cancellation all stock options that they held with an
        exercise price above $3.00 per share by April 1, 2003. We accepted for
        exchange options to purchase an aggregate of 6,162,952 shares of our
        common stock. Subject to the terms and conditions of the offer, we were
        obligated to issue new options to purchase an aggregate of up to
        3,081,563 shares of our common stock. On October 14, 2003, we granted
        options to purchase an aggregate of 2,854,213 shares of our common stock
        at the then current market value of $3.27 per share in connection with
        the offer to exchange. The replacement options were granted more than
        six months and one day after the cancellation of the old options. As a
        result, the new options were considered a fixed award and did not result
        in any compensation expense.

                                       39
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

7.      COMMITMENTS AND CONTINGENT LIABILITIES

        LEASE COMMITMENTS - We own our principal office and research facility in
        Bedford, Massachusetts, which we have occupied since November 1997. We
        conduct a portion of our activities in leased facilities in Lafayette,
        California under a non-cancelable operating lease that expires in 2007.
        The following is a schedule of future minimum rental payments (in
        thousands):

         YEAR ENDED DECEMBER 31,
         2005................................         $15
         2006................................          16
         2007................................          11
                                               -----------
            Total minimum lease payments.....         $42
                                               ===========

        Rental expense was approximately $35,000, $45,000 and $44,000 in 2004,
        2003 and 2002, respectively.

        LITIGATION - There are no material pending legal proceedings to which we
        are a party or to which any of our properties are subject which, either
        individually or in the aggregate, are expected to have a material
        adverse effect on our business, financial position or results of
        operations.

        GUARANTEES AND INDEMNIFICATION OBLIGATIONS - We enter into licensing
        agreements in the ordinary course of business that require us: i) to
        perform under the terms of the contracts, ii) to protect the
        confidentiality of our customers' intellectual property, and iii) to
        indemnify customers, including indemnification against third party
        claims alleging infringement of intellectual property rights. We also
        have agreements with each of our directors and executive officers to
        indemnify such directors or executive officers, to the extent legally
        permissible, against all liabilities reasonably incurred in connection
        with any action in which such individual may be involved by reason of
        such individual being or having been a director or officer of Aware.

        Given the nature of the above obligations and agreements, we are unable
        to make a reasonable estimate of the maximum potential amount that we
        could be required to pay. Historically, we have not made any significant
        payments on the above guarantees and indemnifications and no amount has
        been accrued in the accompanying consolidated financial statements with
        respect to these guarantees and indemnifications.

8.      BUSINESS SEGMENTS AND MAJOR CUSTOMERS

        We manage the business as one segment and conduct our operations in the
        United States.

        We sell our products and technology to domestic and international
        customers. Revenues were generated from the following geographic regions
        (in thousands):

<TABLE>
<CAPTION>
                                                                Year ended December 31,
                                                    -----------------------------------------------
                                                         2004             2003            2002
                                                    ---------------  --------------  --------------
<S>                                                       <C>               <C>            <C>
        United States..............................       $10,101           $8,049         $11,045
        Germany....................................         4,910            1,990           2,271
        Rest of world..............................         1,474              804             528
                                                    ---------------  --------------  --------------
                                                          $16,485          $10,843         $13,844
                                                    ===============  ==============  ==============
</TABLE>

        The portion of total revenue that was derived from major customers was
        as follows:

<TABLE>
<CAPTION>
                                                                Year ended December 31,
                                                  -----------------------------------------------
                                                       2004            2003            2002
                                                  ---------------  --------------  --------------
<S>                                                          <C>             <C>             <C>
        Customer A................................           28%             27%             32%
        Customer B................................           28%             17%             15%
        Customer C................................            7%             14%              7%
        Customer D................................            -%              9%             12%
</TABLE>

                                       40
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

9.      EMPLOYEE BENEFIT PLAN

        In 1994, we established a qualified 401(k) Retirement Plan (the "Plan")
        under which employees are allowed to contribute certain percentages of
        their pay, up to the maximum allowed under Section 401(k) of the
        Internal Revenue Code. Our contributions to the Plan are at the
        discretion of the Board of Directors. Our contributions were $274,000,
        $284,000 and $340,000 in 2004, 2003 and 2002, respectively.

10.     NET INCOME (LOSS) PER SHARE

        Net income (loss) per share is calculated as follows (in thousands,
        except per share data):

<TABLE>
<CAPTION>
                                                                           Year ended December 31,
                                                             ------------------------------------------------
                                                                  2004            2003             2002
                                                             ---------------  --------------  ---------------
<S>                                                                <C>              <C>             <C>
         Net income (loss).................................       ($1,367)         ($8,038)       ($18,728)

         Weighted average common shares outstanding........        22,785           22,713          22,679
         Additional dilutive common stock equivalents .....             -                -               -
                                                             ---------------  --------------  ---------------
         Diluted shares outstanding .......................        22,785           22,713          22,679
                                                             ===============  ==============  ===============

         Net income (loss) per share - basic...............        ($0.06)          ($0.35)          ($0.83)
         Net income (loss) per share - diluted.............        ($0.06)          ($0.35)          ($0.83)
</TABLE>

        For the years ended December 31, 2004, 2003 and 2002, potential common
        stock equivalents of 356,411, 10,525 and 226,303, respectively, were not
        included in the per share calculation for diluted EPS, because we had a
        net loss and the effect of their inclusion would be anti-dilutive. For
        the years ended December 31, 2004, 2003 and 2002, options to purchase
        280,605, 3,352,283 and 4,770,052 shares of common stock at average
        weighted prices of $16.06, $4.45 and $23.54 per share, respectively,
        were outstanding, but were not included in the computation of diluted
        EPS because the options' exercise prices were greater than the average
        market price of the common shares and thus would be anti-dilutive.

11.     QUARTERLY RESULTS OF OPERATIONS - UNAUDITED

        The following table presents unaudited quarterly operating results for
        each of our quarters in the two-year period ended December 31, 2004 (in
        thousands, except per share data):

<TABLE>
<CAPTION>
                                                                      2004 Quarters Ended
                                                  -------------------------------------------------------
                                                     March 31     June 30     September 30   December 31
                                                  -------------------------------------------------------
<S>                                                     <C>         <C>            <C>           <C>
        Revenue.................................        $3,602      $3,725         $4,561        $4,597
        Gross profit............................         2,598       2,877          3,687         3,778
        Income (loss) from operations...........        (1,270)       (923)            21           247
        Net income (loss).......................        (1,147)       (808)           164           424

        Net income (loss) per share - basic.....        ($0.05)     ($0.04)         $0.01         $0.02
        Net income (loss) per share - diluted ..        ($0.05)     ($0.04)         $0.01         $0.02
</TABLE>

                                       41
<PAGE>

                                   AWARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                      2003 Quarters Ended
                                                  -------------------------------------------------------
                                                     March 31     June 30     September 30   December 31
                                                  -------------------------------------------------------

<S>                                                     <C>         <C>            <C>           <C>
        Revenue.................................        $1,947      $2,817         $3,055        $3,024
        Gross profit............................         1,539       2,339          2,315         2,040
        Loss from operations....................        (3,132)     (2,001)        (1,882)       (1,620)
        Net loss................................        (2,963)     (1,844)        (1,746)       (1,485)

        Net loss per share - basic..............        ($0.13)     ($0.08)        ($0.08)       ($0.07)
        Net loss per share - diluted ...........        ($0.13)     ($0.08)        ($0.08)       ($0.07)
</TABLE>









                                       42
<PAGE>

<TABLE>
<CAPTION>

                                     FINANCIAL STATEMENT SCHEDULE


    SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS - YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002
                                            (IN THOUSANDS)

-----------------------------------------------------------------------------------------------------
       COL. A                 COL. B        COL. C(1)       COL. C(2)      COL. D         COL. E
-----------------------------------------------------------------------------------------------------
                                                   ADDITIONS
                                           -------------------------
                            BALANCE AT      CHARGED TO      CHARGED       DEDUCTIONS      BALANCE
                             BEGINNING       COSTS AND      TO OTHER      CHARGED TO       AT END
                             OF PERIOD       EXPENSES       ACCOUNTS       RESERVES      OF PERIOD
-----------------------------------------------------------------------------------------------------
<S>                             <C>            <C>               <C>          <C>          <C>
Allowance for doubtful
accounts receivable:
   2004.................          $927          ($50)            -            $767           $110
   2003.................        $1,077         ($150)            -               -           $927
   2002.................          $380          $707             -             $10         $1,077


Inventory reserves:
   2004.................          $284             -             -               -           $284
   2003.................          $284             -             -               -           $284
   2002.................          $284             -             -               -           $284
</TABLE>




                                                  43
<PAGE>

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

Not applicable.


ITEM 9A.  CONTROLS AND PROCEDURES

CONCLUSION REGARDING THE EFFECTIVENESS OF DISCLOSURE CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including
our chief executive officer and chief financial officer, we conducted an
evaluation of our disclosure controls and procedures, as such term is defined
under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as
amended (the Exchange Act). Based on this evaluation, our chief executive
officer and chief financial officer concluded that our disclosure controls and
procedures were effective as of the end of the period covered by this annual
report.

EVALUATION OF CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING

Under the supervision and with the participation of our management, including
our chief executive officer and chief financial officer, we concluded that there
were no changes in our internal control over financial reporting that occurred
during the quarterly period ended December 31, 2004 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.

MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Our management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act Rule
13a-15(f). Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
conducted an evaluation of the effectiveness of our internal control over
financial reporting based on the framework in INTERNAL CONTROL - INTEGRATED
FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway
Commission. Based on our evaluation under the framework in INTERNAL CONTROL --
INTEGRATED FRAMEWORK, our management concluded that our internal control over
financial reporting was effective as of December 31, 2004.

Our management's assessment of the effectiveness of the Company's internal
control over financial reporting as of December 31, 2004 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting firm, as
stated in their report which is included herein.

ITEM 9B. OTHER INFORMATION

None.


                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by Item 10 of Form 10-K is incorporated by reference
from the information contained in the sections captioned "DIRECTORS AND
EXECUTIVE OFFICERS", "CORPORATE GOVERNANCE" and "SECTION 16(A) BENEFICIAL
OWNERSHIP REPORTING COMPLIANCE" in the Proxy Statement that will be delivered to
our shareholders in connection with our May 25, 2005 Annual Meeting of
Shareholders.

                                       44
<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

The information required by Item 11 of Form 10-K is incorporated by reference
from the information contained in the section captioned "COMPENSATION OF
DIRECTORS AND EXECUTIVE OFFICERS" in the Proxy Statement that will be delivered
to our shareholders in connection with our May 25, 2005 Annual Meeting of
Shareholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS

The information required by Item 12 of Form 10-K is incorporated by reference
from the information contained in the section captioned "SECURITY OWNERSHIP OF
CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS" in the
Proxy Statement that will be delivered to our shareholders in connection with
our May 25, 2005 Annual Meeting of Shareholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information, if any, required by Item 13 of Form 10-K is incorporated by
reference from the information contained in the section captioned "CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS" in the Proxy Statement that will be
delivered to our shareholders in connection with our May 25, 2005 Annual Meeting
of Shareholders.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by Item 14 of Form 10-K is incorporated by reference
from the information contained in the section captioned "INDEPENDENT
ACCOUNTANTS" in the Proxy Statement that will be delivered to our shareholders
in connection with our May 25, 2005 Annual Meeting of Shareholders.


                                       45
<PAGE>

                                     PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

The following documents are filed as part of this report:

(A) Financial Statements and Exhibits:
                                                                           PAGE
  (1) Report of Independent Registered Public Accounting Firm.............  26
  Consolidated Balance Sheets as of December 31, 2004 and 2003............  28
  Consolidated Statements of Operations for each of the three
      years in the period ended December 31, 2004.........................  29
  Consolidated Statements of Cash Flows for each of the
      three years in the period ended December 31, 2004...................  30
  Consolidated Statements of Stockholders' Equity for each of
       the three years in the period ended December 31, 2004..............  31
  Notes to Consolidated Financial Statements..............................  32
  (2) Schedule II - Valuation and Qualifying Accounts.....................  43

  (3) Exhibits:

      Exhibits have been filed separately with the United States Securities and
      Exchange Commission in connection with this Annual Report on Form 10-K or
      have been incorporated into this Report by reference. Copies of such
      exhibits may be obtained from us upon request.

EXHIBIT NO.     DESCRIPTION OF EXHIBIT

3.1             Amended and Restated Articles of Organization (filed as Exhibit
                3.2 to the Company's Registration Statement on Form S-1, File
                No. 333-6807 and incorporated herein by reference).
3.2             Articles of Amendment to the Articles of Organization (filed as
                Exhibit 3.3 to the Company's Form 10-Q for the quarter ended
                September 30, 2002 and incorporated herein by reference).
3.3             Amended and Restated By-Laws (filed as Exhibit 3.3 to the
                Company's Form 10-Q for the quarter ended June 30, 1996 and
                incorporated herein by reference).
4.1             Rights Agreement dated as of October 2, 2001 between Aware, Inc.
                and Equiserve Trust Company, N.A., as Rights Agent (filed as
                Exhibit 4(a) to the Company's Form 8-K filed with the Securities
                and Exchange Commission on October 3, 2001 and incorporated
                herein by reference).
4.2             Terms of Series A Participating Cumulative Preferred Stock of
                Aware, Inc. (attached as Exhibit A to the Rights Agreement filed
                as Exhibit 4.1 hereto).
4.3             Form of Right Certificate (attached as Exhibit B to the Rights
                Agreement filed as Exhibit 4.1 hereto).
10.1            1990 Incentive and Non-Statutory Stock Option Plan (filed as
                Exhibit 10.2 to the Company's Registration Statement on Form
                S-1, File No. 333-6807 and incorporated herein by reference).
10.2            1996 Stock Option Plan, as amended and restated (filed as Annex
                A to the Company's Definitive Proxy Statement filed with the
                Securities and Exchange Commission on April 11, 2000 and
                incorporated herein by reference).
10.3            1996 Employee Stock Purchase Plan, as amended and restated
                (filed as Annex A to the Company's Definitive Proxy Statement
                filed with the Securities and Exchange Commission on April 15,
                2003 and incorporated herein by reference).
10.4            Form of Director and Officer Indemnification Agreement (filed as
                Exhibit 10.4 to the Company's Form 10-K for the year ended
                December 31, 2002 and incorporated herein by reference).
10.5            2001 Nonqualified Stock Plan (filed as Exhibit 99(d)(4) to the
                Company's Schedule TO filed with the Securities and Exchange
                Commission on March 3, 2003 and incorporated herein by
                reference).

                                       46
<PAGE>

21.1            Subsidiaries of Registrant.
23.1            Consent of Independent Registered Public Accounting Firm.
31.1            Certification of Chief Executive Officer pursuant to Section 302
                of the Sarbanes-Oxley Act of 2002.
31.2            Certification of Chief Financial Officer pursuant to Section 302
                of the Sarbanes-Oxley Act of 2002.
32.1            Certification of Chief Executive Officer and Chief Financial
                Officer pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.







                                       47
<PAGE>

                                   SIGNATURES

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

                                        AWARE, INC.


                                        By: /s/ Michael A. Tzannes
                                            ------------------------------------
                                        Michael A. Tzannes, Chief Executive
                                        Officer

                                        Date: March 16, 2005

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities indicated on the 16th day of March 2005.

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

            SIGNATURE                                             TITLE

/s/ Michael A. Tzannes                           Chief Executive Officer and Director
------------------------------------
Michael A. Tzannes                               (Principal Executive Officer)


/s/ Edmund C. Reiter                             President and Director
------------------------------------
Edmund C. Reiter


/s/ Robert J. Weiskopf                           Chief Financial Officer
------------------------------------             (Principal Financial and Accounting Officer)
Robert J. Weiskopf


/s/ John K. Kerr                                 Chairman of the Board of Directors
------------------------------------
John K. Kerr


/s/ Frederick D. D'Alessio                       Director
------------------------------------
Frederick D. D'Alessio


/s/ David Ehreth                                 Director
------------------------------------
David Ehreth

/s/ G. David Forney, Jr.                         Director
------------------------------------
G. David Forney, Jr.


/s/ Adrian F. Kruse                              Director
------------------------------------
Adrian F. Kruse
</TABLE>

                                       48