##### Table of Contents



FORM 10-Q

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

[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACTS OF 1934



|For the Quarter ended SEPTEMBER 30, 2002 | Commission file number: 0-16641
|---------------------------------------- | -------------------------------

RAINBOW TECHNOLOGIES, INC.
(Exact name of Registrant as specified in its charter)

|                         |  |                                     
|------------------------ |  | ------------------------------------
|DELAWARE                 |  | 95-3745398                          
|(State of incorporation) |  | (I.R.S. Employer Identification No.)

|                                         |  |           
|---------------------------------------- |  | ----------
|50 TECHNOLOGY DRIVE, IRVINE, CALIFORNIA  |  | 92618     
|(Address of principal executive offices) |  | (Zip Code)

Indicate by check mark whether the Registrant (i) 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 (ii) has been subject to
such filing requirements for the past 90 days.

Yes [X]    No [   ]

The number of shares of common stock, $.001 par value, outstanding as of
October 31, 2002, was 26,216,249.





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TABLE OF CONTENTS



|                              |                                                                                               |                                                                  |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | Item 1. Condensed Consolidated Financial Statements                                          
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS                           
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                 
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                 
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS            
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                   
|CERTIFICATIONS               
|EXHIBIT INDEX                
|EXHIBIT 10(O)                
|EXHIBIT 99(A)                



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##### Table of Contents



RAINBOW TECHNOLOGIES, INC.

TABLE OF CONTENTS

|                                                                                             |  |                                                                                                                                             |    |  |    |      |  | 
|-------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------- | -- |  | -- | ---- |  | 
|                                                                                             |  |                                                                                                                                             |    |  |    | Page
|                                                                                             |  |                                                                                                                                             |    |  |    |     
|PART I - FINANCIAL INFORMATION                                                               |  |                                                                                                                                             |    | 
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|Item 1.                                                                                      |  | Condensed Consolidated Financial Statements                                                                                                 |    |  |    |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                             |  | Condensed Consolidated Balance Sheets at September 30, 2002 (unaudited) and December 31, 2001                                               |    |  | 4  |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                             |  | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2002and 2001 (unaudited)                  |    |  | 5  |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                             |  | Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and nine months endedSeptember 30, 2002 and 2001 (unaudited) |    |  | 6  |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                             |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2002and 2001 (unaudited)                            |    |  | 7  |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                             |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                                            |    |  | 8  |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|Item 2.                                                                                      |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                                                       |    |  | 14 |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|Item 3.                                                                                      |  | Not applicable                                                                                                                              |    |  |    |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|Item 4.                                                                                      |  | Controls and Procedures                                                                                                                     |    |  | 18 |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|PART II - OTHER INFORMATION                                                                  |  |                                                                                                                                             |    | 
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|Item 1 to 5 - Not applicable                                                                 |  |                                                                                                                                             |    | 
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|Item 6.                                                                                      |  | Exhibits and reports on Form 8K                                                                                                             |    |  | 19 |     
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|SIGNATURES                                                                                   |  |                                                                                                                                             | 21 | 
|                                                                                            
|                                                                                            
|                                                                                            
|                                                                                            
|CERTIFICATIONS OF FINANCIAL REPORTS PURSUANT TO SECTION 302 OF THE SARBANES-OXLEYACT OF 2002 |  |                                                                                                                                             | 22 | 

2



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INTRODUCTORY NOTE

The Quarterly Report on Form 10-Q contains certain forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934 and the Company intends that
such forward-looking statements be subject to the safe harbors created thereby.
These forward-looking statements include (i) the existence and development of
the Companys technical and manufacturing capabilities, (ii) anticipated
competition, (iii) potential future growth in revenues and income, (iv)
potential future decreases in costs, and (v) the need for, and availability of
additional financing.

The forward-looking statements included herein are based on current
expectations that involve a number of risks and uncertainties. These
forward-looking statements are based on the assumption that the Company will
not lose a significant customer or customers or experience increased
fluctuations of demand or rescheduling of purchase orders, that the Companys
markets will continue to grow, that the Companys products will remain accepted
within their respective markets and will not be replaced by new technology,
that competitive conditions within the Companys markets will not change
materially or adversely, that the Company will retain key technical and
management personnel, that the Companys forecasts will accurately anticipate
market demand, that there will be no material adverse change in the Companys
operations or business and that the Company will not experience significant
supply shortages with respect to purchased components, sub-systems or raw
materials. Assumptions relating to the foregoing involve judgments with respect
to, among other things, future economic, competitive and market conditions, and
future business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond the control of the Company. In
addition, the business and operations of the Company are subject to substantial
risks, which increase the uncertainty inherent in the forward-looking
statements. In light of the significant uncertainties inherent in the
forward-looking information included herein, the inclusion of such information
should not be regarded as a representation by the Company or any other person
that the objectives or plans of the Company will be achieved.

3



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##### Table of Contents






PART I. FINANCIAL INFORMATION




Item 1. Condensed Consolidated Financial Statements




RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share amounts)

|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                   |        |   |         | 
|--------------------------------------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------- | ------- | --------------------------------- | ------ | ------------------ | ------- | ----------------- | ------ | - | ------- | 
|                                              |  |                                                                                                                                                     |         |                                   |        | September 30, 2002 |         | December 31, 2001
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  |                                                                                                                                                     |         |                                   |        | (unaudited)        |         |                   |        |  
|ASSETS                                       
|Current assets:                               |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  | Cash and cash equivalents                                                                                                                           |         | $                                 | 42,128 |                    |         | $                 | 28,778 |  
|                                              |  | Marketable available-for-sale and trading securities                                                                                                |         |                                   | 160    |                    |         |                   | 1,195  |  
|                                              |  | Accounts receivable, net of allowance for doubtful accounts of $988 and
$1,858 in 2002 and 2001, respectively                                       |         |                                   | 17,045 |                    |         |                   | 24,492 |  
|                                              |  | Inventories                                                                                                                                         |         |                                   | 10,080 |                    |         |                   | 20,711 |  
|                                              |  | Income tax receivable                                                                                                                               |         |                                   | 5,013  |                    |         |                   | 1,844  |  
|                                              |  | Deferred income taxes                                                                                                                               |         |                                   |       |                    |         |                   | 13,901 |  
|                                              |  | Unbilled costs and fees                                                                                                                             |         |                                   | 1,470  |                    |         |                   | 2,227  |  
|                                              |  | Prepaid expenses and other current assets                                                                                                           |         |                                   | 1,558  |                    |         |                   | 1,634  |  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  |                                                                                                                                                     |         | Total current assets              |        |                    | 77,454  |                   |        |   | 94,782  | 
|Property, plant and equipment, at cost:       |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  | Equipment                                                                                                                                           |         |                                   | 22,167 |                    |         |                   | 20,838 |  
|                                              |  | Buildings                                                                                                                                           |         |                                   | 7,344  |                    |         |                   | 6,655  |  
|                                              |  | Furniture                                                                                                                                           |         |                                   | 2,937  |                    |         |                   | 2,810  |  
|                                              |  | Leasehold improvements                                                                                                                              |         |                                   | 2,941  |                    |         |                   | 2,946  |  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  |                                                                                                                                                     | 35,389  |                                   |        |                    | 33,249  |                  
|                                              |  | Less accumulated depreciation and amortization                                                                                                      |         |                                   | 21,013 |                    |         |                   | 17,336 |  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  |                                                                                                                                                     |         | Net property, plant and equipment |        |                    | 14,376  |                   |        |   | 15,913  | 
|                                              |  | Goodwill, net of accumulated amortization of $35,496 and $22,104 in 2002
and 2001, respectively                                                     |         |                                   | 1,684  |                    |         |                   | 15,638 |  
|                                              |  | Software development costs, net of accumulated amortization of $19,050 and
$11,218 in 2002 and 2001, respectively                                   |         |                                   | 3,945  |                    |         |                   | 10,768 |  
|                                              |  | Product licenses, net of accumulated amortization of $5,094 and $3,537 in
2002 and 2001, respectively                                               |         |                                   | 4,425  |                    |         |                   | 4,030  |  
|                                              |  | Deferred income taxes                                                                                                                               |         |                                   |       |                    |         |                   | 2,421  |  
|                                              |  | Other assets                                                                                                                                        |         |                                   | 1,861  |                    |         |                   | 2,413  |  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  | $                                                                                                                                                   | 103,745 |                                   |        | $                  | 145,965 |                  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|LIABILITIES AND SHAREHOLDERS EQUITY         
|Current liabilities:                          |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  | Accounts payable                                                                                                                                    |         | $                                 | 7,464  |                    |         | $                 | 9,929  |  
|                                              |  | Accrued payroll and related expenses                                                                                                                |         |                                   | 6,039  |                    |         |                   | 5,063  |  
|                                              |  | Accrued restructuring costs                                                                                                                         |         |                                   | 2,326  |                    |         |                   | 3,130  |  
|                                              |  | Warranty reserve                                                                                                                                    |         |                                   | 2,261  |                    |         |                   | 2,417  |  
|                                              |  | Other accrued liabilities                                                                                                                           |         |                                   | 6,024  |                    |         |                   | 5,041  |  
|                                              |  | Long-term debt, due within one year                                                                                                                 |         |                                   | 234    |                    |         |                   | 211    |  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  |                                                                                                                                                     |         | Total current liabilities         |        |                    | 24,348  |                   |        |   | 25,791  | 
|                                              |  | Long-term debt, net of current portion                                                                                                              |         |                                   | 351    |                    |         |                   | 476    |  
|                                              |  | Other liabilities                                                                                                                                   |         |                                   | 2,713  |                    |         |                   | 2,959  |  
|                                              |  | Commitments and contingencies                                                                                                                       |         |                                   |        |                    |         |                   |        |  
|                                              |  | Shareholders equity:                                                                                                                               |         |                                   |        |                    |         |                   |        |  
|                                              |  | Common stock, $.001 par value, 55,000,000 shares authorized, 26,713,270 and
26,157,594 shares issued and outstanding in 2002 and 2001, respectively |         |                                   | 27     |                    |         |                   | 26     |  
|                                              |  | Additional paid-in capital                                                                                                                          |         |                                   | 60,250 |                    |         |                   | 56,885 |  
|                                              |  | Accumulated other comprehensive loss                                                                                                                |         |                                   | (363   | )                  |         |                   | (1,539 | )
|                                              |  | Retained earnings                                                                                                                                   |         |                                   | 18,830 |                    |         |                   | 61,367 |  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  |                                                                                                                                                     | 78,744  |                                   |        |                    | 116,739 |                  
|Less cost of treasury shares (517,000 shares) |  |                                                                                                                                                     | (2,411  | )                                 |        |                    |        |                  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  |                                                                                                                                                     |         | Total shareholders equity        |        |                    | 76,333  |                   |        |   | 116,739 | 
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  
|                                              |  | $                                                                                                                                                   | 103,745 |                                   |        | $                  | 145,965 |                  
|                                              |  |                                                                                                                                                     |         |                                   |        |                    |         |                  

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share amounts)

|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |        |        |         | 
|------------------------------------------------------------ | -------------------------------------- | ----------------------- | ------------------------ | ------ | -------------------------------- | ------ | ------------------------------- | ------ | ------ | ------ | ------- | ------ | ------ | ------- | ------- | ------ | ------ | ------- | 
|                                                             |                                        |                         |                          |        | Three Months Ended September 30, |        | Nine Months Ended September 30,
|                                                             |                                        |                         |                          |        |                                  |        |                                
|                                                             |                                        |                         |                          |        | 2002                             |        | 2001                            |        | 2002   |        | 2001   
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |        
|                                                             |                                        |                         |                          |        | (unaudited)                     
|Revenues:                                                    |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             | eSecurity Products                     |                         | $                        | 11,417 |                                  |        | $                               | 10,305 |        |        | $       | 35,750 |        |         | $       | 43,958 |       
|                                                             | Secure Communications Products         |                         |                          | 18,926 |                                  |        |                                 | 14,855 |        |        |         | 56,758 |        |         |         | 50,640 |       
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        |                         | Total revenues           |        |                                  | 30,343 |                                 |        |        | 25,160 |         |        |        | 92,508  |         |        |        | 94,598  | 
|Operating expenses:                                          |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             | Cost of eSecurity Products             |                         |                          | 3,977  |                                  |        |                                 | 16,092 |        |        |         | 29,339 |        |         |         | 30,928 |       
|                                                             | Cost of Secure Communications Products |                         |                          | 13,877 |                                  |        |                                 | 11,892 |        |        |         | 44,127 |        |         |         | 40,041 |       
|                                                             | Selling, general and administrative    |                         |                          | 7,776  |                                  |        |                                 | 9,786  |        |        |         | 23,867 |        |         |         | 32,589 |       
|                                                             | Research and development               |                         |                          | 2,365  |                                  |        |                                 | 2,664  |        |        |         | 7,095  |        |         |         | 9,076  |       
|                                                             | Goodwill amortization                  |                         |                          |       |                                  |        |                                 | 294    |        |        |         |       |        |         |         | 799    |       
|                                                             | Restructuring costs                    |                         |                          |       |                                  |        |                                 | 5,830  |        |        |         |       |        |         |         | 5,830  |       
|                                                             | Goodwill impairment                    |                         |                          |       |                                  |        |                                 | 1,491  |        |        |         |       |        |         |         | 1,491  |       
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        |                         | Total operating expenses |        |                                  | 27,995 |                                 |        |        | 48,049 |         |        |        | 104,428 |         |        |        | 120,754 | 
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Operating income (loss)                                      |                                        |                         | 2,348                    |        |                                  |        | (22,889                         | )      |        |        | (11,920 | )      |        |         | (26,156 | )     
|Loss on marketable trading securities                        |                                        |                         | (18                      | )      |                                  |        | (14                             | )      |        |        | (108    | )      |        |         | (3,562  | )     
|Foreign currency loss                                        |                                        |                         | (30                      | )      |                                  |        | (2,092                          | )      |        |        | (331    | )      |        |         | (2,373  | )     
|Interest income                                              |                                        |                         | 118                      |        |                                  |        | 88                              |        |        |        | 325     |        |        |         | 453     |       
|Interest expense                                             |                                        |                         | (19                      | )      |                                  |        | (28                             | )      |        |        | (98     | )      |        |         | (96     | )     
|Other income (expense), net                                  |                                        |                         | 56                       |        |                                  |        | (179                            | )      |        |        | 635     |        |        |         | (290    | )     
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Income (loss) from continuing operations before income
taxes |                                        |                         | 2,455                    |        |                                  |        | (25,114                         | )      |        |        | (11,497 | )      |        |         | (32,024 | )     
|Benefit (provision) for income taxes                         |                                        |                         |                         |        |                                  |        | 8,277                           |        |        |        | (13,733 | )      |        |         | 10,903  |       
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Income (loss) from continuing operations                     |                                        |                         | 2,455                    |        |                                  |        | (16,837                         | )      |        |        | (25,230 | )      |        |         | (21,121 | )     
|Loss from discontinued operations, net of applicable taxes   |                                        |                         | (639                     | )      |                                  |        | (3,508                          | )      |        |        | (17,307 | )      |        |         | (4,050  | )     
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Net income (loss)                                            |                                        | $                       | 1,816                    |        |                                  | $      | (20,345                         | )      |        | $      | (42,537 | )      |        | $       | (25,171 | )     
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Basic income (loss) per share:                               |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        | Continuing operations   |                          | $      | 0.09                             |        |                                 | $      | (0.65  | )      |         | $      | (0.95  | )       |         | $      | (0.81  | )      
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        | Discontinued operations |                          | $      | (0.02                            | )      |                                 | $      | (0.13  | )      |         | $      | (0.66  | )       |         | $      | (0.16  | )      
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Net income (loss)                                            |                                        | $                       | 0.07                     |        |                                  | $      | (0.78                           | )      |        | $      | (1.61   | )      |        | $       | (0.97   | )     
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Diluted income (loss) per share:                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        | Continuing operations   |                          | $      | 0.09                             |        |                                 | $      | (0.65  | )      |         | $      | (0.95  | )       |         | $      | (0.81  | )      
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        | Discontinued operations |                          | $      | (0.02                            | )      |                                 | $      | (0.13  | )      |         | $      | (0.66  | )       |         | $      | (0.16  | )      
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Net income (loss)                                            |                                        | $                       | 0.07                     |        |                                  | $      | (0.78                           | )      |        | $      | (1.61   | )      |        | $       | (0.97   | )     
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|Shares used in computing net income (loss) per share:        |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        | Basic                   |                          |        | 26,326                           |        |                                 |        | 26,062 |        |         |        | 26,479 |         |         |        | 26,046 |        
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       
|                                                             |                                        | Diluted                 |                          |        | 26,532                           |        |                                 |        | 26,062 |        |         |        | 26,479 |         |         |        | 26,046 |        
|                                                             |                                        |                         |                          |        |                                  |        |                                 |        |        |        |         |        |        |         |         |       

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(dollars in thousands)

|                                   |                                                                         |   |                                  |      |                                 |   |         |        |      |   |         |       |   |   |         |       |  
|---------------------------------- | ----------------------------------------------------------------------- | - | -------------------------------- | ---- | ------------------------------- | - | ------- | ------ | ---- | - | ------- | ----- | - | - | ------- | ----- | -
|                                   |                                                                         |   | Three Months Ended September 30, |      | Nine Months Ended September 30,
|                                   |                                                                         |   |                                  |      |                                
|                                   |                                                                         |   | 2002                             |      | 2001                            |   | 2002    |        | 2001
|                                   |                                                                         |   |                                  |      |                                 |   |         |        |     
|                                   |                                                                         |   | (unaudited)                     
|Net income (loss)                  |                                                                         | $ | 1,816                            |      |                                 | $ | (20,345 | )      |      | $ | (42,537 | )     |   | $ | (25,171 | )    
|Other comprehensive income (loss): |                                                                         |   |                                  |      |                                 |   |         |        |      |   |         |       |   |   |         |      
|                                   | Foreign currency translation adjustment                                 |   |                                  | 144  |                                 |   |         | 4,196  |      |   |         | 1,628 |   |   |         | 1,959 |  
|                                   | Unrealized loss on securities                                           |   |                                  | (376 | )                               |   |         | (28    | )    |   |         | (452  | ) |   |         | (199  | )
|                                   |                                                                         |   |                                  |      |                                 |   |         |        |      |   |         |       |   |   |         |      
|                                   | Other comprehensive income (loss), before income taxes                  |   |                                  | (232 | )                               |   |         | 4,168  |      |   |         | 1,176 |   |   |         | 1,760 |  
|                                   | Provision for income taxes related to other
comprehensive income (loss) |   |                                  |     |                                 |   |         | (1,583 | )    |   |         |      |   |   |         | (668  | )
|                                   |                                                                         |   |                                  |      |                                 |   |         |        |      |   |         |       |   |   |         |      
|                                   | Other comprehensive income (loss), net of taxes                         |   |                                  | (232 | )                               |   |         | 2,585  |      |   |         | 1,176 |   |   |         | 1,092 |  
|                                   |                                                                         |   |                                  |      |                                 |   |         |        |      |   |         |       |   |   |         |      
|Comprehensive income (loss)        |                                                                         | $ | 1,584                            |      |                                 | $ | (17,760 | )      |      | $ | (41,361 | )     |   | $ | (24,079 | )    
|                                   |                                                                         |   |                                  |      |                                 |   |         |        |      |   |         |       |   |   |         |      

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)

|                                               |                                                                                 |                                           |                                                     |         |                                 |        |        |         |        |        |  
|---------------------------------------------- | ------------------------------------------------------------------------------- | ----------------------------------------- | --------------------------------------------------- | ------- | ------------------------------- | ------ | ------ | ------- | ------ | ------ | -
|                                               |                                                                                 |                                           |                                                     |         | Nine Months Ended September 30,
|                                               |                                                                                 |                                           |                                                     |         |                                
|                                               |                                                                                 |                                           |                                                     |         | 2002                            |        | 2001  
|                                               |                                                                                 |                                           |                                                     |         |                                 |        |       
|                                               |                                                                                 |                                           |                                                     |         | (unaudited)                    
|Cash flows from operating activities:          |                                                                                 |                                           |                                                     |         |                                 |        |        |        
|                                               | Net loss                                                                        |                                           | $                                                   | (42,537 | )                               |        | $      | (25,171 | )     
|                                               | Adjustments to reconcile net loss to net cash provided by
operating activities: |                                           |                                                     |         |                                 |        |        |         |       
|                                               | Amortization                                                                    |                                           |                                                     | 3,281   |                                 |        |        | 6,241   |       
|                                               | Depreciation                                                                    |                                           |                                                     | 2,995   |                                 |        |        | 2,980   |       
|                                               | Change in deferred income taxes                                                 |                                           |                                                     | 16,322  |                                 |        |        | (10,205 | )     
|                                               | Provision (reduction) of allowance for doubtful accounts                        |                                           |                                                     | (898    | )                               |        |        | 1,334   |       
|                                               | Minority interest in subsidiarys earnings                                      |                                           |                                                     | 188     |                                 |        |        | 196     |       
|                                               | Unrealized loss on marketable trading securities                                |                                           |                                                     | 108     |                                 |        |        | 3,562   |       
|                                               | Provision for excess and obsolete inventory                                     |                                           |                                                     | 10,198  |                                 |        |        | 7,414   |       
|                                               | Warranty provision                                                              |                                           |                                                     | 901     |                                 |        |        | 2,440   |       
|                                               | Tax benefit of exercise of common stock options                                 |                                           |                                                     | 295     |                                 |        |        | 138     |       
|                                               | Write-off of long-term investment                                               |                                           |                                                     | 260     |                                 |        |        | 1,206   |       
|                                               | Write-off of capitalized and developed software                                 |                                           |                                                     | 5,436   |                                 |        |        | 2,392   |       
|                                               | Write-off of Spectria goodwill                                                  |                                           |                                                     | 12,840  |                                 |        |        |        |       
|                                               | Provision for impairment of assets on discontinued operations                   |                                           |                                                     | 2,356   |                                 |        |        |        |       
|                                               | Restructuring costs                                                             |                                           |                                                     |        |                                 |        |        | 6,402   |       
|                                               | Goodwill impairment                                                             |                                           |                                                     |        |                                 |        |        | 4,030   |       
|                                               | Foreign currency loss on repayment of loan to foreign subsidiary                |                                           |                                                     |        |                                 |        |        | 1,252   |       
|Changes in operating assets and liabilities:   |                                                                                 |                                           |                                                     |         |                                 |        |        |        
|                                               |                                                                                 | Accounts receivable                       |                                                     |         | 8,803                           |        |        |         | 18,086 |       
|                                               |                                                                                 | Inventories                               |                                                     |         | 573                             |        |        |         | 1,651  |       
|                                               |                                                                                 | Unbilled costs and fees                   |                                                     |         | 757                             |        |        |         | (1,038 | )     
|                                               |                                                                                 | Prepaid expenses and other current assets |                                                     |         | 111                             |        |        |         | (115   | )     
|                                               |                                                                                 | Accounts payable                          |                                                     |         | (2,489                          | )      |        |         | (1,325 | )     
|                                               |                                                                                 | Accrued liabilities                       |                                                     |         | (2,369                          | )      |        |         | (5,236 | )     
|                                               |                                                                                 | Billings in excess of costs and fees      |                                                     |         | 305                             |        |        |         | (935   | )     
|                                               |                                                                                 | Income taxes                              |                                                     |         | (3,169                          | )      |        |         | 2,039  |       
|                                               |                                                                                 |                                           |                                                     |         |                                 |        |        |         |       
|                                               |                                                                                 |                                           | Net cash provided by operating activities           |         |                                 | 14,267 |        |         |        | 17,338 |  
|Cash flows from investing activities:          |                                                                                 |                                           |                                                     |         |                                 |        |        |        
|                                               | Purchases of property, plant and equipment                                      |                                           |                                                     | (1,236  | )                               |        |        | (3,398  | )     
|                                               | Capitalized software development costs                                          |                                           |                                                     | (656    | )                               |        |        | (4,020  | )     
|                                               | Other assets                                                                    |                                           |                                                     | 902     |                                 |        |        | (161    | )     
|                                               | Cash paid for acquisition of Impex Computacion, S.A. de C.V.                    |                                           |                                                     | (297    | )                               |        |        |        |       
|                                               | Additional investment in Rainbow Technologies (Taiwan) Co. Ltd.                 |                                           |                                                     | (225    | )                               |        |        |        |       
|                                               | Cash paid for investment in DataSafe Technologies, China                        |                                           |                                                     |        |                                 |        |        | (231    | )     
|                                               | Investment in Rainbow Technologies K.K., Japan                                  |                                           |                                                     |        |                                 |        |        | (1,357  | )     
|                                               | Additional investment in Rainbow Goldensoft, China                              |                                           |                                                     |        |                                 |        |        | (809    | )     
|                                               |                                                                                 |                                           |                                                     |         |                                 |        |        |         |       
|                                               |                                                                                 |                                           | Net cash used in investing activities               |         |                                 | (1,512 | )      |         |        | (9,976 | )
|Cash flows from financing activities:          |                                                                                 |                                           |                                                     |         |                                 |        |        |        
|                                               | Exercise of common stock options                                                |                                           |                                                     | 3,071   |                                 |        |        | 478     |       
|                                               | Repayment of long-term debt                                                     |                                           |                                                     | (171    | )                               |        |        | (126    | )     
|                                               | Purchase of treasury stock                                                      |                                           |                                                     | (2,411  | )                               |        |        |        |       
|                                               | Cash paid to minority shareholder of Rainbow Technologies K.K., Japan           |                                           |                                                     | (292    | )                               |        |        |        |       
|                                               | Repayment of line of credit                                                     |                                           |                                                     |        |                                 |        |        | (3,129  | )     
|                                               |                                                                                 |                                           |                                                     |         |                                 |        |        |         |       
|                                               |                                                                                 |                                           | Net cash provided by (used in) financing activities |         |                                 | 197    |        |         |        | (2,777 | )
|Effect of exchange rate changes on cash        |                                                                                 |                                           | 398                                                 |         |                                 |        | 945    |        
|                                               |                                                                                 |                                           |                                                     |         |                                 |        |        |         |       
|Net increase in cash and cash equivalents      |                                                                                 |                                           | 13,350                                              |         |                                 |        | 5,530  |        
|Cash and cash equivalents at beginning of year |                                                                                 |                                           | 28,778                                              |         |                                 |        | 19,458 |        
|                                               |                                                                                 |                                           |                                                     |         |                                 |        |        |         |       
|Cash and cash equivalents at end of year       |                                                                                 | $                                         | 42,128                                              |         |                                 | $      | 24,988 |        
|                                               |                                                                                 |                                           |                                                     |         |                                 |        |        |         |       

See accompanying notes.

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RAINBOW TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2002
(Unaudited)

1. Basis of presentation

Rainbow Technologies, Inc. (the Company) develops, manufactures, programs and
markets software and internet security products which prevent the unauthorized
use of intellectual property, including software programs, provides privacy and
security for network communications and develops and manufactures secure
communication products for satellite communications. The accompanying
financial statements consolidate the accounts of the Company and its
wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated. Certain amounts previously reported have
been reclassified to conform to the 2002 presentation.

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the accompanying
financial statements. Actual results could differ from those estimates.
Significant estimates made in preparing these financial statements include the
allowance for doubtful accounts, the reserve for excess and obsolete inventory,
goodwill valuations, accrued warranty costs, restructuring costs, the valuation
allowance for deferred tax assets and total estimated contract costs associated
with billed and unbilled contract revenue.

Management determines the appropriate classification of its investments in
marketable securities at the time of purchase. Securities that are bought and
held principally for the purpose of selling them in the near term are
classified as trading securities and carried at fair value with the unrealized
holding gains and losses included in earnings. Available-for-sale securities
are carried at fair value, with the unrealized gains and losses, net of tax,
reported as a separate component of Accumulated Other Comprehensive Loss within
Shareholders Equity.

In the opinion of the Companys management, the accompanying condensed
consolidated financial statements include all normal recurring adjustments
necessary for a fair presentation of the financial position at September 30,
2002 and results of operations for the three and nine months ended September
30, 2002 and 2001. The condensed consolidated financial statements do not
include footnotes and certain financial information normally presented annually
under accounting principles generally accepted in the United States and,
therefore, should be read in conjunction with the Companys December 31, 2001
Annual Report on Form 10-K. Results of operations for the three and nine months
ended September 30, 2002 are not necessarily indicative of results to be
expected for the full year.

The Company has subsidiaries in the United Kingdom, Germany, France,
Netherlands, India, Australia, China, Taiwan, Japan and Mexico. The Company
utilizes the currencies of the countries where its foreign subsidiaries operate
as the functional currency. Balance sheet accounts denominated in foreign
currency are translated at exchange rates as of the date of the balance sheet
and income statement accounts are translated at average exchange rates for the
period. Translation gains and losses are accumulated as a separate component of
Accumulated Other Comprehensive Loss within Shareholders Equity. The Company
has adopted local currencies as the functional currencies for its subsidiaries
because their principal economic activities are most closely tied to the
respective local currencies.

2. 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 for
the period. Diluted earnings per share for the three months ended September 30,
2002 assumes the conversion of 206,000 stock options. The Company incurred
losses for the three months ended September 30, 2001 and the nine months ended
September 30, 2002 and 2001 and, therefore, all stock options were
anti-dilutive and not included in the computation of diluted earnings per
share.

3. Government Contracts

The Company is both a prime contractor and subcontractor under fixed-price and
cost-reimbursement contracts with the U.S. Government (Government). At the
commencement of each contract or contract modification, the Company submits
pricing proposals to the Government to establish indirect cost rates applicable
to such contracts. These rates, after audit and approval by the Government, are
used to settle costs on completed contracts.

To facilitate interim billings during the performance of its contracts, the
Company establishes provisional billing rates, which are used in recognizing
contract revenue and contract accounts receivable. The provisional billing
rates are adjusted to actual at year-end and are subject to adjustment after
Government audit.

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4. Inventories

Inventoried costs relating to long-term contracts are stated at actual
production costs, including pro-rata allocations of factory overhead and
general and administrative costs incurred-to-date, reduced by amounts
identified with revenue recognized on units delivered. The costs attributed to
units delivered under such long-term contracts are based on the estimated
average cost of all units expected to be produced.

Inventories, other than inventoried costs relating to long-term contracts, are
stated at the lower of cost (first-in, first-out basis) or market.

Inventories consist of the following:(dollars in thousands)

|                                                                                                            |  |                    |         |                   |  |   |        |  
|----------------------------------------------------------------------------------------------------------- |  | ------------------ | ------- | ----------------- |  | - | ------ | -
|                                                                                                            |  | September 30, 2002 |         | December 31, 2001
|                                                                                                            |  |                    |         |                  
|Raw materials                                                                                               |  | $                  | 8,883   |                   |  | $ | 14,016 |  
|Work in process                                                                                             |  |                    | 1,590   |                   |  |   | 2,643  |  
|Finished goods                                                                                              |  |                    | 4,037   |                   |  |   | 5,883  |  
|Inventoried costs relating to long-term contracts, net of
amounts attributed to revenues recognized to date |  |                    | 5,646   |                   |  |   | 4,569  |  
|Reserve for excess and obsolete inventory                                                                   |  |                    | (10,076 | )                 |  |   | (6,400 | )
|                                                                                                            |  |                    |         |                   |  |   |        |  
|                                                                                                            |  | $                  | 10,080  |                   |  | $ | 20,711 |  
|                                                                                                            |  |                    |         |                   |  |   |        |  

5. Goodwill and other intangible assets

Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards (SFAS) No. 141, Business Combinations and No. 142,
Goodwill and other Intangible Assets. SFAS No. 141 addresses financial
accounting and reporting for a business combination and requires all business
combinations to be accounted for using the purchase method. SFAS No. 141 is
effective for any business combinations initiated after June 30, 2001. SFAS
No. 142 addresses the initial recognition and measurement of goodwill and other
intangible assets acquired in a business combination. Goodwill and other
intangible assets with indefinite lives are no longer amortized but instead are
subject to an impairment test at least annually. The impairment test is
comprised of two parts. The first step compares the fair value of a reporting
unit with its carrying amount, including goodwill. If the carrying amount
exceeds the fair value of the reporting unit, the second step of the goodwill
impairment test must be performed. The second step compares the implied fair
value of the reporting units goodwill with the respective carrying amount in
order to determine the amount of impairment loss, if any. In accordance with
SFAS No. 142, the Company performed the first part of the two-step goodwill
impairment test for its business segments with goodwill, excluding the $12.8
million of goodwill related to the Spectria business segment, which was
written-off and included in the loss from discontinued operations in the
consolidated statement of operations for the nine months ended September 30,
2002 (see note 12). For each of the Companys business segments for which
goodwill was recorded, the Company determined that the fair value exceeded the
carrying amount as of January 1, 2002. As a result, the second step of the
impairment test was not required. Additionally, under SFAS No. 142, the
Company ceased amortizing its remaining goodwill balance which will result in
reduced amortization of approximately $0.6 million, net of tax, in fiscal 2002.
Total amortization expense for the three and nine months ended September 30,
2002 for other intangible assets subject to amortization, were $1.0 million and
$3.3 million, respectively.

The following table reconciles the Companys net income (loss) and net income
(loss) per share from continuing operations as reported, to the amounts
adjusted for the exclusion of goodwill amortization, net of the related income
tax effect for the period prior to the adoption of SFAS
No. 142.(dollars in thousands, except per share amounts):

|                                                                    |                                                      |             |   |                                  |       |                                 |   |         |         |      |   |         |         |   |   |         |         |  
|------------------------------------------------------------------- | ---------------------------------------------------- | ----------- | - | -------------------------------- | ----- | ------------------------------- | - | ------- | ------- | ---- | - | ------- | ------- | - | - | ------- | ------- | -
|                                                                    |                                                      |             |   | Three Months Ended September 30, |       | Nine Months Ended September 30,
|                                                                    |                                                      |             |   |                                  |       |                                
|                                                                    |                                                      |             |   | 2002                             |       | 2001                            |   | 2002    |         | 2001
|                                                                    |                                                      |             |   |                                  |       |                                 |   |         |         |     
|Net income (loss) from continuing operations:                       |                                                      |             |   |                                  |       |                                 |   |         |         |      |   |         |         |   |   |        
|                                                                    | As reported                                          |             | $ | 2,455                            |       |                                 | $ | (16,837 | )       |      | $ | (25,230 | )       |   | $ | (21,121 | )      
|                                                                    | eSecurity Products goodwill amortization,
net of tax |             |   |                                 |       |                                 |   | 183     |         |      |   |        |         |   |   | 495     |        
|                                                                    |                                                      |             |   |                                  |       |                                 |   |         |         |      |   |         |         |   |   |        
|                                                                    |                                                      | As adjusted |   | $                                | 2,455 |                                 |   | $       | (16,654 | )    |   | $       | (25,230 | ) |   | $       | (20,626 | )
|                                                                    |                                                      |             |   |                                  |       |                                 |   |         |         |      |   |         |         |   |   |        
|Basic & diluted income (loss) per share from
continuing operations: |                                                      |             |   |                                  |       |                                 |   |         |         |      |   |         |         |   |   |        
|                                                                    | As reported                                          |             | $ | 0.09                             |       |                                 | $ | (0.65   | )       |      | $ | (0.95   | )       |   | $ | (0.81   | )      
|                                                                    | eSecurity Products goodwill amortization,
net of tax |             |   |                                 |       |                                 |   | 0.01    |         |      |   |        |         |   |   | 0.02    |        
|                                                                    |                                                      |             |   |                                  |       |                                 |   |         |         |      |   |         |         |   |   |        
|                                                                    |                                                      | As adjusted |   | $                                | 0.09  |                                 |   | $       | (0.64   | )    |   | $       | (0.95   | ) |   | $       | (0.79   | )
|                                                                    |                                                      |             |   |                                  |       |                                 |   |         |         |      |   |         |         |   |   |        

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The following table presents details of the Companys other intangible assets
that are subject to amortization:

(dollars in thousands):


|                           |       |   |                    |        |                   |   |             |         |       |   |              |       |     |   |        |        |             |   |         |         |   |   |        |        | 
|-------------------------- | ----- | - | ------------------ | ------ | ----------------- | - | ----------- | ------- | ----- | - | ------------ | ----- | --- | - | ------ | ------ | ----------- | - | ------- | ------- | - | - | ------ | ------ | 
|                           |       |   | September 30, 2002 |        | December 31, 2001
|                           |       |   |                    |        |                  
|                           |       |   |                    |        |                   |   | Accumulated |         |       |   |              |       |     |   |        |        | Accumulated |   |         |         |  
|                           |       |   | Gross              |        | Amortization      |   | Net         |         | Gross |   | Amortization |       | Net
|                           |       |   |                    |        |                   |   |             |         |       |   |              |       |    
|Software development costs |       | $ | 22,995             |        |                   | $ | (19,050     | )       |       | $ | 3,945        |       |     | $ | 21,986 |        |             | $ | (11,218 | )       |   | $ | 10,768 |       
|Product licenses           |       |   | 9,519              |        |                   |   | (5,094      | )       |       |   | 4,425        |       |     |   | 7,567  |        |             |   | (3,537  | )       |   |   | 4,030  |       
|                           |       |   |                    |        |                   |   |             |         |       |   |              |       |     |   |        |        |             |   |         |         |   |   |        |       
|                           | Total |   | $                  | 32,514 |                   |   | $           | (24,144 | )     |   | $            | 8,370 |     |   | $      | 29,553 |             |   | $       | (14,755 | ) |   | $      | 14,798 | 
|                           |       |   |                    |        |                   |   |             |         |       |   |              |       |     |   |        |        |             |   |         |         |   |   |        |       

At September 30, 2002, the amortization of the remaining balance of other
intangible assets of $8.4 million will be $0.9 million for the remainder of
2002. The amortization for each of the fiscal years 2003, 2004 and 2005 will
be $3.0 million, $2.8 million and $1.5 million, respectively. At September 30,
2002, the Company had $0.2 million of unamortized software development costs
included in the remaining balance of other intangible assets of $8.4 million,
which had not begun amortization. Amortization of software development costs
commences when the products are available for general release to customers.

6. Software development costs

SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased
or Otherwise Marketed, requires capitalization of certain software development
costs subsequent to the establishment of technological feasibility. Based on
the Companys product development process, technological feasibility is
established upon completion of a working model. Amortization of capitalized
software development costs commences when the products are available for
general release to customers and are determined using the straight-line method
over the expected useful lives of the respective products. These amounts are
written-off if it is determined that the projects cannot be brought to market.

7. Other assets

Other assets primarily represent investments in early stage companies that are
accounted for on the cost basis. The Company periodically reviews these
investments for other-than-temporary declines in fair value and writes down
investments to their fair value when an other-than-temporary decline has
occurred based on the specific identification method. The Company generally
believes an other-than-temporary decline has occurred when the fair value of
the investment is below the carrying value for two consecutive quarters, absent
evidence to the contrary.

8. Industry segments

In June 2002, the Company announced that its Spectria segment had experienced
rapidly deteriorating business prospects due to a severe decline in IT services
infrastructure spending. Consequently, the Company discontinued Spectria and
is closing its facility in Long Beach, California. Spectrias results of
operations are included in the loss from discontinued operations in the
consolidated statement of operations for the three and nine months ended
September 30, 2002 and 2001. The identifiable assets, after applicable
eliminations for Spectria as of September 30, 2002 were $0.3 million as
compared to $16.5 million as of December 31, 2001 (see note 12).

The Company has two business segments comprising continuing operations. The
first segment focuses on commercial security products, including solutions for
reliable identity, secure internet and wireless transaction acceleration,
licensing solutions for software publishers, easy to deploy Web security
solutions and security training and consulting for enterprise IT staff
(eSecurity Products). The second segment provides products and services for
enterprise, government and defense applications for products providing security
for classified information, for products providing personal identity
authentication for government and defense applications, and custom design
services for enterprises, government and defense applications requiring either
extraordinary performance and/or security (Secure Communications Products).
These two business segments are increasingly working closely together. The
identifiable assets, after applicable eliminations, for each segment from
continuing operations as of September 30, 2002, were $81.2 million and $22.2
million, respectively, compared with $101.8 million and $27.7 million as of
December 31, 2001.

Intercompany revenues for the three and nine months ended September 30, 2002
were $1,000 and $18,000, respectively, and $14,000 and $280,000, respectively,
for the corresponding periods in the prior year. Intercompany revenues are
generated by the Secure Communications segment.

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9. Recent accounting pronouncements

In June 2002, the Financial Accounting Standards
Board (FASB) issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities (SFAS 146). This standard addresses
financial accounting and reporting for costs associated with exit or disposal
activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring). The principal difference between SFAS No. 146 and EITF 94-3
relates to SFAS 146s requirements for recognition of a liability for a cost
associated with an exit or disposal activity. SFAS No. 146 requires that a
liability for a cost associated with an exit or disposal activity be recognized
when the liability is incurred. Under EITF 94-3, a liability for an exit costs
as generally defined in EITF 94-3 was recognized at the date of an entitys
commitment to an exit plan. The provisions of SFAS No. 146 are effective for
exit or disposal activities that are initiated after December 31, 2002. The
Company does not expect SFAS No. 146 to have a material impact on its
consolidated results of operations.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. SFAS No. 144 supersedes FASB Statement No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of, and the accounting and reporting provisions of APB
Opinion No. 30, Reporting the Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions, for the disposal of a segment
of a business (as previously defined in that opinion). SFAS No. 144 requires
that one accounting model be used for long-lived assets to be disposed of by
sale, whether previously held and used or newly acquired, and broadens the
presentation of discontinued operations to include more disposal transactions
than were included under the previous standards. Under SFAS No. 144, a
component of a business that either has been disposed of or is classified as
held for sale is reported in discontinued operations if (i) the operations and
cash flows will be, or have been, eliminated from the on-going operations of
the company as a result of the disposal transaction and, (ii) the company will
not have any significant continuing involvement in such operations.

In June 2002, the Company announced that its Spectria segment had experienced
rapidly deteriorating business prospects due to a severe decline in IT services
infrastructure spending. Consequently, the Company discontinued Spectria and
is closing its facility in Long Beach, California. During the second quarter
of 2002, the Company wrote-off Spectrias goodwill balance of $12.8 million and
recorded a $2.1 million provision based on managements estimates of the
amounts to be realized on the disposal of its assets. During the third quarter
of 2002, the Company increased the provision by $0.3 million due to additional
severance and lease obligations related to the discontinuation of Spectria.
The amount the Company will ultimately realize could differ from the
assumptions currently used in arriving at the anticipated loss. Spectrias
results of operations are included in the loss from discontinued operations in
the consolidated statement of operations for the three and nine months ended
September 30, 2002 (see note 12).

10. Litigation

In September 1998, a patent infringement action was filed against the Company
by Globetrotter, Inc., alleging that certain of the Companys products infringe
patents owned by Globetrotter. The complaint seeks unspecified monetary
damages and a permanent injunction banning the use of the products alleged to
infringe the Globetrotter patents. On September 24, 2001, the District Court
granted partial summary judgment in favor of the Company as it relates to
allegations by Globetrotter. The Company has filed a counterclaim alleging
antitrust and unfair competition and has been vigorously prosecuting their
antitrust and other business tort claims. The counterclaims are presently set
for trial on December 2, 2002.

In July 1998, a patent infringement claim was filed against the Company by
Andrew Pickholtz, alleging that certain of the Companys products infringe a
patent owned by Pickholtz. The complaint seeks unspecified monetary damages.
The Company filed a motion for summary judgment of noninfringement that was
decided in favor of the Company in December 2000. In January 2001, Mr.
Pickholtz filed a notice of appeal. After considering legal briefs filed by
the Company and by Mr. Pickholtz, the Court of Appeals for the Federal Circuit
heard oral arguments in the case on November 7, 2001. On April 3, 2002, the
appellate court issued an opinion which reversed the trial courts entry of
summary judgment in favor of the Company, and remanded the case to the trial
court for further proceedings. Mr. Pickholtz filed a petition seeking a
rehearing as to certain issues, which the appellate court denied on April 29,
2002. The Company continues to believe the claims are without merit and
intends to continue to vigorously defend against any infringement claims made
by Mr. Pickholtz.

In June 2002, a breach of contract lawsuit was filed against the Company by a
supplier. The complaint seeks damages of $3.9 million. The Company has
recorded $2.6 million related to this matter that is included in accounts
payable. The Company believes that the additional claim is without merit and
intends to vigorously defend this matter.

The Company is also involved in other legal proceedings and claims arising in
the ordinary course of business. The Company does not believe that any
liabilities related to the legal proceedings to which it is a party are likely
to be, individually or in the aggregate, material to the Companys consolidated
financial condition, results of operations or cash flows.

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11. Restructuring charges

In the third quarter of 2001, the Company restructured and consolidated its
Digital Rights Management and iVEA operations (eSecurity Products), resulting
in a net staff reduction of 97 employees across all employee groups, primarily
in the U.S., and recorded restructuring charges of $6.4 million.

The following table summarizes the Companys restructuring costs and activities
from continuing operations in the restructuring reserves:(dollars in thousands):

|                                                    |  |            |       |           |  |       |       |   |  |   |        |  
|--------------------------------------------------- |  | ---------- | ----- | --------- |  | ----- | ----- | - |  | - | ------ | -
|                                                    |  | Facilities |       |           |  |       |       |   |  |  
|                                                    |  | and        |       |           |  |       |       |   |  |  
|                                                    |  | Equipment  |       | Severance |  | Total
|                                                    |  |            |       |           |  |      
|Charged to costs and expenses at September 30, 2001 |  | $          | 4,699 |           |  | $     | 1,131 |   |  | $ | 5,830  |  
|Cash payments                                       |  |            | (538  | )         |  |       | (931  | ) |  |   | (1,469 | )
|                                                    |  |            |       |           |  |       |       |   |  |   |        |  
|Restructuring balance, December 31, 2001            |  |            | 4,161 |           |  |       | 200   |   |  |   | 4,361  |  
|Cash payments                                       |  |            | (855  | )         |  |       | (200  | ) |  |   | (1,055 | )
|                                                    |  |            |       |           |  |       |       |   |  |   |        |  
|Restructuring balance, September 30, 2002           |  | $          | 3,306 |           |  | $     |      |   |  | $ | 3,306  |  
|                                                    |  |            |       |           |  |       |       |   |  |   |        |  

The following table summarizes the Companys restructuring costs and activities
from discontinued operations in the restructuring reserves:

|                                                    |  |            |      |  
|--------------------------------------------------- |  | ---------- | ---- | -
|                                                    |  | Facilities
|                                                    |  | and       
|                                                    |  | Equipment 
|                                                    |  |           
|Charged to costs and expenses at September 30, 2001 |  | $          | 572  |  
|Cash payments                                       |  |            | (160 | )
|                                                    |  |            |      |  
|Restructuring balance, December 31, 2001            |  |            | 412  |  
|Cash payments                                       |  |            | (209 | )
|                                                    |  |            |      |  
|Restructuring balance, September 30, 2002           |  | $          | 203  |  
|                                                    |  |            |      |  

The current portion of the restructuring reserve of $2.3 million relating to
office space reduction is shown separately under current liabilities while the
long-term portion of the reserve of $1.2 million is recorded in other
liabilities. Exit activities are anticipated to continue through 2002 with
certain lease obligations currently expiring in 2005.

12. Discontinued operations and other charges

In June 2002, the Company announced that its Spectria segment had experienced
rapidly deteriorating business prospects due to a severe decline in IT services
infrastructure spending. Consequently, the Company discontinued Spectria and
is closing its facility in Long Beach, California. During the second quarter
of 2002, the Company wrote-off Spectrias goodwill balance of $12.8 million and
recorded a $2.1 million provision based on managements estimates of the
amounts to be realized on the disposal of its assets. During the third quarter
of 2002, the Company increased the provision by $0.3 million due to additional
severance and lease obligations related to the discontinuation of Spectria.
The amount the Company will ultimately realize could differ from the
assumptions currently used in arriving at the anticipated loss. Spectrias
results of operations are included in the loss from discontinued operations in
the consolidated statement of operations for the three and nine months ended
September 30, 2002.

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The revenues and loss from discontinued operations for the three and nine
months ended September 30, 2002 and 2001 related to the disposal of Spectria
are as follows:

(dollars in thousands)


|                                  |  |                                  |      |                                 |  |      |        |      |  |   |         |   |  |   |        |  
|--------------------------------- |  | -------------------------------- | ---- | ------------------------------- |  | ---- | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                  |  | Three Months Ended September 30, |      | Nine Months Ended September 30,
|                                  |  |                                  |      |                                
|                                  |  | 2002                             |      | 2001                            |  | 2002 |        | 2001
|                                  |  |                                  |      |                                 |  |      |        |     
|Revenues                          |  | $                                | 434  |                                 |  | $    | 2,896  |      |  | $ | 3,179   |   |  | $ | 11,003 |  
|Loss from discontinued operations |  | $                                | (639 | )                               |  | $    | (3,508 | )    |  | $ | (17,307 | ) |  | $ | (4,050 | )

The assets and liabilities of Spectria at September 30, 2002 and December 31,
2001 consisted of the following:

(dollars in thousands)


|                                               |  |                    |       |                   |  |   |        | 
|---------------------------------------------- |  | ------------------ | ----- | ----------------- |  | - | ------ | 
|                                               |  | September 30, 2002 |       | December 31, 2001
|                                               |  |                    |       |                  
|Cash and accounts receivable                   |  | $                  | 298   |                   |  | $ | 2,576  | 
|Prepaid expenses and other current assets      |  |                    | 33    |                   |  |   | 384    | 
|Property, plant and equipment                  |  |                    |      |                   |  |   | 652    | 
|Goodwill, net of accumulated amortization      |  |                    |      |                   |  |   | 12,840 | 
|                                               |  |                    |       |                   |  |   |        | 
|Total assets of discontinued operations        |  | $                  | 331   |                   |  | $ | 16,452 | 
|                                               |  |                    |       |                   |  |   |        | 
|Accounts payable and other
accrued liabilities |  | $                  | 1,363 |                   |  | $ | 1,209  | 
|Accrued payroll and related expenses           |  |                    | 69    |                   |  |   | 598    | 
|Accrued restructuring costs                    |  |                    | 203   |                   |  |   | 412    | 
|Long-term debt                                 |  |                    |      |                   |  |   | 162    | 
|                                               |  |                    |       |                   |  |   |        | 
|Total liabilities of discontinued operations   |  | $                  | 1,635 |                   |  | $ | 2,381  | 
|                                               |  |                    |       |                   |  |   |        | 

13. Income taxes

The Company recorded income tax expense from continuing operations of $13.7
million for the nine months ended September 30, 2002 and income tax benefits of
$8.3 million and $10.9 million for the three and nine months ended September
30, 2001, respectively. There was no income tax expense recognized during the
three months ended September 30, 2002 since the Company expects a tax net
operating loss for the year and any expected tax benefit related to the net
operating loss has been previously recorded. In the second quarter of 2002,
the Company determined that the realization of its net deferred tax asset is
uncertain and, therefore, recorded $11.6 million of valuation allowance in
accordance with SFAS No. 109, Accounting for Income Taxes.

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Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations

The following is managements discussion and analysis of certain significant
factors which have affected the consolidated results of operations, and the
consolidated financial position of the Company during the periods included in
the accompanying condensed consolidated financial statements. This discussion
should be read in conjunction with the related condensed consolidated financial
statements and associated notes.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Companys financial statements are based on the selection and application
of significant accounting policies, which require management to make
significant estimates and assumptions. The Company believes that the following
are some of the more critical judgment areas in the application of its
accounting policies that currently affect its consolidated financial condition
and results of operations.

Revenue Recognition

eSecurity recognizes revenues from product sales at the time of shipment.
Secure Communications recognizes revenue and profit as work progresses on
long-term contracts using the percentage-of-completion method, which relies on
estimates of total expected contract revenue and costs. Catalog product
revenues and revenues under certain fixed-price contracts calling for delivery
of a specified number of units are recognized as deliveries are made. Revenues
under cost-reimbursement contracts are recognized as costs are incurred and
include estimated earned fees in the proportion that costs incurred to date
bear to total estimated costs. Certain contracts are awarded on a fixed-price
incentive fee basis. Incentive fees on such contracts are considered when
estimating revenues and profit rates and are recognized when the amounts can
reasonably be determined. The costs attributed to units delivered under
fixed-price contracts are based on the estimated average cost per unit at
contract completion. Profits expected to be realized on long-term contracts are
based on total revenues and estimated costs at completion. Revisions to
contract profits are recorded in the accounting period in which the revisions
are known. Estimated losses on contracts are recorded when identified. For
research and development and other cost-plus-fee type contracts, the Company
recognizes contract earnings using the percentage-of-completion method in the
proportion that costs incurred to date bear to total estimated costs. Spectria
recognizes revenues from eBusiness consulting fees as services are performed on
a time and materials basis.

Accounts Receivable

The Company is required to estimate the collectibility of its trade receivables
and unbilled costs and fees. A considerable amount of judgment is required in
assessing the ultimate realization of these receivables including the current
credit-worthiness of each customer. Significant changes in required reserves
may occur in the future depending on future market conditions.

Inventory

The Company is required to state its inventories at the lower of cost or
market. In assessing the ultimate realization of inventories, the Company is
required to exercise judgment in its assessment of future demand requirements
and compare that with the current or committed inventory levels. It is possible
that changes in required inventory reserves may continue to occur in the future
due to market conditions.

Income Taxes

The Company had significant deferred tax assets, which were subject to periodic
recoverability assessments. A valuation allowance against the deferred tax
assets is recorded if the Company determines that it is not more likely than
not that these assets will be realized. This is based upon the expectation of
future taxable income and tax planning strategies. The Companys judgment
regarding future taxable income may change due to future market conditions and
its ability to continue to successfully execute its restructuring program and
other factors. These changes, if any, may require possible material
adjustments to these deferred tax asset balances.

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Impairment of Goodwill

The Company performs an annual impairment test of its goodwill, or more
frequently, if certain impairment indicators exist. The Companys judgment
regarding the existence of impairment indicators is based on legal factors,
market conditions and operational performance of acquired businesses. Future
events could cause the Company to conclude that impairment indicators exist and
that goodwill associated with acquired businesses is impaired. Any resulting
impairment loss could have a material adverse impact on the Companys
consolidated financial condition and results of operations.

Capitalized Software Development Costs

The Companys policy on capitalized software costs determines the timing of
recognition of certain development costs. In addition, this policy determines
whether the cost is classified as development expense or cost of license fees.
Management is required to use professional judgment in determining whether
development costs meet the criteria for immediate expense or capitalization.

Statement of Financial Accounting Standards No. 86, Accounting for the Costs
of Computer Software to be Sold, Leased or Otherwise Marketed, requires
capitalization of certain software development costs subsequent to the
establishment of technological feasibility. Based upon the Companys product
development process, technological feasibility is established upon completion
of a working model. Amortization of capitalized software development costs
commences when the products are available for general release to customers and
is determined using the straight-line method over the expected useful lives of
the respective products.

RESULTS OF OPERATIONS(dollars in thousands)

|                                                    |                                |                                                          |   |                                  |        |                                 |   |         |         |      |   |         |         |   |   |         |         |  
|--------------------------------------------------- | ------------------------------ | -------------------------------------------------------- | - | -------------------------------- | ------ | ------------------------------- | - | ------- | ------- | ---- | - | ------- | ------- | - | - | ------- | ------- | -
|                                                    |                                |                                                          |   | Three Months Ended September 30, |        | Nine Months Ended September 30,
|                                                    |                                |                                                          |   |                                  |        |                                
|                                                    |                                |                                                          |   | 2002                             |        | 2001                            |   | 2002    |         | 2001
|                                                    |                                |                                                          |   |                                  |        |                                 |   |         |         |     
|Revenues from continuing operations:                |                                |                                                          |   |                                  |        |                                 |   |         |         |      |   |         |         |   |   |        
|                                                    | eSecurity Products             |                                                          | $ | 11,417                           |        |                                 | $ | 10,305  |         |      | $ | 35,750  |         |   | $ | 43,958  |        
|                                                    | Secure Communications Products |                                                          |   | 18,926                           |        |                                 |   | 14,855  |         |      |   | 56,758  |         |   |   | 50,640  |        
|                                                    |                                |                                                          |   |                                  |        |                                 |   |         |         |      |   |         |         |   |   |        
|                                                    |                                | Total revenues from continuing operations                |   | $                                | 30,343 |                                 |   | $       | 25,160  |      |   | $       | 92,508  |   |   | $       | 94,598  |  
|                                                    |                                |                                                          |   |                                  |        |                                 |   |         |         |      |   |         |         |   |   |        
|Operating income (loss) from continuing operations: |                                |                                                          |   |                                  |        |                                 |   |         |         |      |   |         |         |   |   |        
|                                                    | eSecurity Products             |                                                          | $ | (1,882                           | )      |                                 | $ | (25,659 | )       |      | $ | (22,620 | )       |   | $ | (35,452 | )      
|                                                    | Secure Communications Products |                                                          |   | 4,230                            |        |                                 |   | 2,770   |         |      |   | 10,700  |         |   |   | 9,296   |        
|                                                    |                                |                                                          |   |                                  |        |                                 |   |         |         |      |   |         |         |   |   |        
|                                                    |                                | Total operating income (loss) from continuing
operations |   | $                                | 2,348  |                                 |   | $       | (22,889 | )    |   | $       | (11,920 | ) |   | $       | (26,156 | )
|                                                    |                                |                                                          |   |                                  |        |                                 |   |         |         |      |   |         |         |   |   |        

REVENUES FROM CONTINUING OPERATIONS

On a consolidated basis, revenues from continuing operations for the three and
nine months ended September 30, 2002 increased 21% to $30.3 million and
decreased by 2% to $92.5 million, respectively, from the same periods in the
prior year. Revenues from international markets for the three months ended
September 30, 2002 increased 57% to $5.9 million as compared to the same period
in the prior year. The increase in revenues was primarily due to continued
growth in Asia Pacific primarily due to revenues generated by the Companys
office in Japan, which was opened in the fourth quarter of 2001. Although
revenues from international markets remained the same for the nine months ended
September 30, 2002 as compared to the same period in the prior year, the
decrease in revenues in Europe was offset by the increase in revenues in Asia
Pacific. Revenues from domestic markets for the three and nine months ended
September 30, 2002 increased by 14% to $24.5 million and decreased 3% to $74.7
million, respectively, from the same periods in the prior year. These were
primarily due to decrease in revenues from the eSecurity segment, which was
partially offset by the continued growth in revenues from Secure Communications
segment.

eSecurity revenues for the three and nine months ended September 30,
2002 increased 11% to $11.4 million and decreased 19% to $35.8 million,
respectively, when compared to the same periods in 2001. The increase in
revenues for the three months ended September 30, 2002 was primarily due to
strong growth in software security and authentication product sales in Asia
Pacific. Additionally, declines in the CryptoSwift eCommerce accelerator OEM
business in the quarter were offset by increases in sales of Sentinel software
security products and NetSwift iGate Web security appliances. The Company
expects to see revenue growth from new products and new channel programs for
eSecurity solutions. The decrease in revenues for the nine months ended
September 30, 2002 was primarily attributable to the decline in OEM markets for
Cryptoswift SSL acceleration devices.

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Secure Communications revenues for the three and nine months ended September
30, 2002 increased 27% to $18.9 million and 12% to $56.8 million when compared
to the same periods in 2001. The increase in revenues was primarily
attributable to continued growth demand from the government for network link
encryptors, voice and data security solutions and high assurance commercial
security products. The Secure Communications segment ended the quarter with
record backlog. The Company expects to see increases in government spending on
security.

GROSS PROFIT FROM CONTINUING OPERATIONS

Gross profit from eSecurity products for the three months ended September 30,
2002 increased to 65% of revenues compared to a negative 56% of revenues for
the corresponding period in 2001. The increase was primarily due to higher
cost of revenues in the prior year quarter which included charges of $7.4
million in inventory reserves, $1.8 million in warranty reserves and $2.4
million write-off of capitalized and developed software. Gross profit for the
nine months ended September 30, 2002 decreased to 18% of revenues compared to
30% of revenues for the corresponding period in 2001. The decrease was
primarily due to the other charges recorded in the second quarter of 2002 which
included $8.4 million in inventory reserves, $5.0 million of write-off of
capitalized and developed software, $0.5 million in warranty reserves and $0.4
million in severance and other accruals. Excluding other charges recorded in
the current and prior year, gross profit as a percentage of revenues increased
which was primarily attributable to increased efficiencies in manufacturing
operations and lower overhead costs.

Gross profit from Secure Communications for the three months ended September
30, 2002 increased to 27% of revenues as compared to 20% of revenues for the
corresponding period in 2001. Gross profit for the nine months ended September
30, 2002 increased to 22% of revenues compared to 21% of revenues for the
corresponding period in 2001. The increases in gross profit were primarily due
to a change in mix to more profitable product sales.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative expenses consist primarily of
personnel-related expenses, sales commission, promotional activities, and
professional fees. Selling, general and administrative expenses from continuing
operations for the three months ended September 30, 2002 were $7.8 million or
26% of revenues as compared to $9.8 million or 39% of revenues for the
corresponding period in 2001. The decrease was primarily due to reduced
expenses in the eSecurity segment, as a result of a decrease in staff and a
charge of $1.6 million in provision for bad debts recorded in the prior year.
Selling, general and administrative expenses from continuing operations for the
nine months ended September 30, 2002 were $23.9 million or 26% of revenues as
compared to $32.6 million or 34% of revenues for the corresponding period in
2001. The decrease reflected the overall reduction in expenses primarily in
the eSecurity segment, as a result of a decrease in staff and lower marketing
expenses.

RESEARCH AND DEVELOPMENT

Research and development expenses consist primarily of salaries and other
personnel-related expenses, costs related to engineering development tools, and
subcontracting costs. Research and development expenses from continuing
operations for the three months ended September 30, 2002 was $2.4 million or 8%
of revenues, as compared to research and development expenses of $2.7 million
or 11% of revenues for the corresponding period in 2001. Research and
development expenses from continuing operations for the nine months ended
September 30, 2002 were $7.1 million or 8% of revenues, as compared to research
and development expenses of $9.1 million or 10% of revenues for the
corresponding period in 2001. The decreases in research and development
expenses were primarily due to a decrease in compensation from the Companys
eSecurity segment, as a result of the decrease in staff in the United States
and greater use of research and development resources in India and China. This
decrease was partially offset by higher research and development costs
capitalized in 2001 by eSecurity and higher unfunded research and development
expenses in 2002 from the Companys Secure Communications segment.

MARKETABLE TRADING SECURITIES

At September 30, 2001, the difference between the estimated fair value and the
cost of the trading securities resulted in an unrealized loss of $3.6 million,
which was recognized in earnings for the nine months ended September 30, 2001.
Unrealized losses on the trading securities recognized in earnings during the
nine months ended September 30, 2002 was $108,000.

PROVISION FOR INCOME TAXES

The Company recorded income tax expense from continuing operations of $13.7
million for the nine months ended September 30, 2002 and income tax benefits of
$8.3 million and $10.9 million for the three and nine months ended September
30, 2001, respectively. There was no income tax expense recognized during the
three months ended September 30, 2002 since the Company expects a tax net

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operating loss for the year and any expected tax benefit related to the net
operating loss has been previously recorded. In the second quarter of 2002,
the Company determined that the realization of its net deferred tax assets is
uncertain and, therefore, recorded $11.6 million of valuation allowance in
accordance with SFAS No. 109, Accounting for Income Taxes. The effective tax
rates for the three and nine months ended September 30, 2001 were 33% and 34%,
respectively.

RESULTS OF DISCONTINUED OPERATIONS

Discontinued operations for the three and nine months ended September 30, 2002
reported operating results and net losses of $0.6 million and $17.3 million,
respectively, as compared with losses of $3.5 million and $4.1 million for the
corresponding periods in 2001. Spectrias losses in 2002 included $12.8
million of write-off of goodwill and a $2.4 million provision based on
managements current estimates of the amounts to be realized on the disposal of
its assets. The amount the Company will ultimately realize could differ from
the assumptions currently used in arriving at the anticipated loss. Spectrias
losses in 2001 included $2.5 million of goodwill impairment, $1.2 million
write-off of long-term investment and $0.6 million of restructuring costs.

INVENTORIES

Raw materials decreased approximately $5.1 million to $8.9 million at September
30, 2002 as compared with $14.0 million at December 31, 2001. The decrease was
primarily due to write-off of obsolete inventory and reduced purchases.

LIQUIDITY AND CAPITAL RESOURCES

The Companys principal sources of operating funds have been from operations
and proceeds from exercises of the Companys common stock options. Net cash
provided by operating activities for the nine months ended September 30, 2002
and 2001 were $14.3 million and $17.3 million, respectively. Operating
activities in 2002 included a decrease in accounts receivable of $8.8 million
primarily due to increased collection activities with improvement in days sales
outstanding and non-cash charges of $10.2 million of provision for excess and
obsolete inventory, $5.4 million of write-off of capitalized and developed
software, $15.2 million of write-off of goodwill and provisions for impairment
of assets relating to discontinued operations and $16.3 million in deferred
income taxes primarily due to the Companys valuation allowance for deferred
tax assets. Operating activities in 2001 included a decrease in accounts
receivable of $18.1 million primarily due to the decrease in revenues relating
to the Companys CryptoSwift product line and non-cash charges of $3.6 million
for unrealized loss on marketable trading securities, $7.4 million of provision
for excess and obsolete inventory, $6.4 million in restructuring costs and $4.0
million goodwill impairment.

Net cash used in investing activities for the nine months ended September 30,
2002 and 2001 were $1.5 million and $10.0 million, respectively. Investing
activities in 2002 included $1.2 million on capital expenditures, $0.7 million
in capitalized software development costs primarily related to the Companys
NetSwift iGate product and $0.5 million of net cash paid for acquisition of
Impex Computacion S.A. de C.V. in Mexico and purchase of remaining shares in
the Companys subsidiary in Taiwan. Investing activities in 2001 included $3.4
million on capital expenditures, $4.0 million on development of new products
and $2.4 million of payments for investment in the Companys joint venture in
Japan and purchase of additional shares in the Companys subsidiary in China.
The decrease in capital expenditures in 2002 as compared to the corresponding
period in 2001 was in line with the Companys overall reduction in expenses.

Net cash provided by financing activities for the nine months ended September
30, 2002 was $0.2 million while net cash used in financing activities for the
nine months ended September 30, 2001 was $2.8 million. Financing activities
included in 2002 were $2.4 million in repurchase of the Companys common stock
and $3.1 million received from common stock options exercised while financing
activities in 2001 included a $3.1 million repayment of the line of credit.

The Company intends to use its capital resources to expand its product lines
and for possible acquisitions of additional products and technologies. The
Company has no significant capital commitments or requirements at this time.

At September 30, 2002, the Companys subsidiaries in the United Kingdom,
Germany, France, Netherlands and Japan carried approximately $1.6 million, $1.0
million, $1.4 million, $2.0 million and $1.4 million, respectively, in interest
earning deposits which may result in foreign exchange gains or losses due to
the fact that the functional currency in those subsidiaries is not the U.S.
dollar.

The Company believes that its current working capital of $53.1 million and
anticipated working capital to be generated by future operations will be
sufficient to support the Companys working capital requirements for at least
the next twelve months.

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Item 4. Controls and Procedures

As of September 30, 2002, an evaluation was performed by the Chief Executive
Officer and Chief Financial Officer of the effectiveness of the Companys
disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based
on that evaluation, the Companys Chief Executive Officer and Chief Financial
Officer concluded that the disclosure controls and procedures were effective in
ensuring that all material information required to be filed in this quarterly
report has been made known to them in a timely fashion. There have been no
significant changes in internal controls, or in factors that could
significantly affect internal controls subsequent to the date the Chief
Executive Officer and Chief Financial Officer completed their evaluation.

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PART II. OTHER INFORMATION




Item 6. Exhibits and Reports on Form 8-K

(a)  Exhibits

|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                     
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                                                                                                                                                                                                                                                                                                     
|NUMBER  |  | DESCRIPTION                                                                                                                                                                                                                                                                                                                                                                                                                         
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                     
|2(i)    |  | Agreement and Plan of Reorganization, dated as of January 26, 1995 among the Company, Rainbow Acquisition
Inc., a California corporation and a wholly owned subsidiary of Rainbow, and Mykotronx, Inc., a
California corporation (Mykotronx) (incorporated by reference to the Companys Registration Statement
on Form S-4 under the Securities Act of 1933, as amended, effective on April 20, 1995, Registration No.
33-89918).
|2(ii)   |  | Agreement and Plan of Merger, dated September 30, 1996, by and among the Company, RNBO Acquisition
Corporation, a Nevada corporation and a wholly-owned subsidiary of the Company, and Software Security,
Inc., a Connecticut corporation (incorporated by reference to Exhibit 2(ii) of the Companys 1996 Annual
Report on Form 10-K under the Securities Exchange Act of 1934
filed in March 1997 (the 1996 10-K)).            
|2(iii)  |  | Agreement and Plan of Merger, dated March 6, 1998, by and among the Company, WRS Acquisition Corp., a
California corporation and wholly owned subsidiary of the Company, and Wyatt River Software, Inc.
(incorporated by reference to Exhibit 2(iii) of the Companys 1997 Annual Report on Form 10-K under the
Securities Exchange Act of 1934 filed in March 1998 (the 1997
10-K)).                                             
|3(i)    |  | Articles of Incorporation of Rainbow, as amended (incorporated by reference to Exhibit 3(a) to Rainbows
Registration Statement on Form S-18 under the Securities Act of 1933, as amended, filed on July 20, 1987
- File No. 33-15956-LA (the S-18 Registration
Statement)).                                                                                                                                                      
|3(ii)   |  | By-Laws of Rainbow (incorporated by reference to Exhibit 3(b) to
the S-18 Registration Statement).                                                                                                                                                                                                                                                                                                                                  
|4(a)    |  | See Exhibit 3(i).                                                                                                                                                                                                                                                                                                                                                                                                                   
|4(b)    |  | See Exhibit 3(ii).                                                                                                                                                                                                                                                                                                                                                                                                                  
|10(a)   |  | Agreement, dated October 1996, between the Company and National Semiconductor Corporation (incorporated
by reference to Exhibit 10(b) of the Companys 1998 Annual Report on Form 10-K under the Securities
Exchange Act of 1934 filed in March, 1999 (the 1998
10-K)).                                                                                                                                                           
|10(b)   |  | Agreement, dated December 1998, between the Company and EM Microelectronic  Marin S.A. (incorporated by
reference to Exhibit 10(c) of the 1998 10-K).                                                                                                                                                                                                                                                                              
|10(c)   |  | 1990 Incentive Stock Option Plan as amended (incorporated by
reference to Exhibit 10(j) of the 1991 10-K).                                                                                                                                                                                                                                                                                                                          
|10(d)   |  | Employment Agreement, dated February 16, 1990, between the Company and Walter W. Straub (incorporated by
reference to Exhibit 10(j) of the 1989 10-K).                                                                                                                                                                                                                                                                              
|10(e)   |  | Change of Control Agreement, dated February 16, 1990, between the Company and Walter W. Straub
(incorporated by reference to Exhibit 10(k) of the 1989 10-K).                                                                                                                                                                                                                                                                       
|10(f)   |  | Employment Agreement, dated January 5, 1995, between the Company and Patrick E. Fevery (incorporated by
reference to Exhibit 10(l) of the 1994 10-K).                                                                                                                                                                                                                                                                               
|10(g)   |  | Change of Control Agreement, dated January 5, 1995, between the Company and Patrick E. Fevery
(incorporated by reference to Exhibit 10(m) of the 1994 10-K).                                                                                                                                                                                                                                                                        
|10(h)   |  | Employment Agreement, dated January 1, 1998, between the Company and Laurie Casey (incorporated by
reference to Exhibit 10(q) of the 1997 10-K).                                                                                                                                                                                                                                                                                    
|10(i)   |  | Change of Control Agreement, dated January 1, 1998, between the Company and Laurie Casey (incorporated by
reference to Exhibit 10(r) of the 1997 10-K).                                                                                                                                                                                                                                                                             
|10(j)   |  | Agreement for Design and Product Purchase, dated September 4, 1997, between IBM Microelectronics and
Rainbow Technologies, Inc. and Mykotronx, Inc. (incorporated by reference to Exhibit 10(w) of the 1998
10-K).                                                                                                                                                                                                                  

19



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##### Table of Contents



|        |  |                                                                                                                                                                                                                                                                                                                                                    
|------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                                                                                                                                                                                                                    
|NUMBER  |  | DESCRIPTION                                                                                                                                                                                                                                                                                                                                        
|        |  |                                                                                                                                                                                                                                                                                                                                                    
|10(k)   |  | Leases for premises at 357, 359, and 371 Van Ness Way, Torrance, California, dated September 8, 1993,
September 25, 1996 and October 2, 1997, respectively, between Surf Management Associates, a California
limited partnership, and Mykotronx, Inc., a California Corporation (incorporated by reference to Exhibit
10(x) of the 1999 Form 10-K).
|10(l)   |  | Lease for premises at 111 West Ocean Boulevard, Long Beach, California, between Stevens Creek Associates,
a California general partnership, and the Company (incorporated by reference to Exhibit 10(y) of the 1999
Form 10-K).                                                                                                                    
|10(m)   |  | Lease for premises at 8 Hughes, Irvine, California, between Alton Irvine Partners, LLC, a California
limited liability company, and the Company (incorporated by reference to Exhibit 10(z) of the 2000 Form
10-K).                                                                                                                                
|10(n)   |  | 2000 Incentive Stock Option Plan (incorporated by reference to Rainbows Registration Statement on Form
S-8 filed under the Securities Act of 1933).                                                                                                                                                                                               
|10(o)   |  | Lease for premises at 50 Technology Drive, Irvine, California, dated
April 14, 2000, between The Irvine Company, a California
corporation, and the Company.                                                                                                                                                                                        
|99(a)   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002  Walter W. Straub, President and Chief Executive Officer and Patrick E.
Fevery, Vice President and Chief Financial Officer                                                                                                 



|(b) |  | Reports on Form 8-K
|--- |  | -------------------
|   
|    |  | None               

20



---



##### Table of Contents






SIGNATURES

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

Dated: November 12, 2002

| |                                            |                      
| | ------------------------------------------ | ---------------------
| | RAINBOW TECHNOLOGIES, INC.                
|
| | By:                                        | /s/ Patrick E. Fevery
| |                                           
| | Vice President and
Chief Financial Officer

21



---



##### Table of Contents






CERTIFICATIONS

I, Walter W. Straub, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of Rainbow
Technologies, Inc.;                                                                                                                                                                                                                                             
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;                   
|  
|4. |  | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a14 and 15d14) for the registrant and
we have:                                                                                                     



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



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



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



|6. |  | The registrants other certifying officers and I have indicated in
this quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Dated: November 12, 2002

| |                                       |                     
| | ------------------------------------- | --------------------
| | RAINBOW TECHNOLOGIES, INC.           
|
| | By:                                   | /s/ Walter W. Straub
| |                                      
| | President and
Chief Executive Officer

22



---



##### Table of Contents



CERTIFICATIONS

I, Patrick E. Fevery, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of Rainbow
Technologies, Inc.;                                                                                                                                                                                                                                             
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;                   
|  
|4. |  | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a14 and 15d14) for the registrant and
we have:                                                                                                     



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



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



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



|6. |  | The registrants other certifying officers and I have indicated in
this quarterly report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Dated: November 12, 2002

| |                                            |                      
| | ------------------------------------------ | ---------------------
| | RAINBOW TECHNOLOGIES, INC.                
|
| | By:                                        | /s/ Patrick E. Fevery
| |                                           
| | Vice President and
Chief Financial Officer

23



---



##### Table of Contents






EXHIBIT INDEX

|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                      |  |  |  | 
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  |  |  | 
|EXHIBIT |  |                                                                                                                                                                                                                                                                                                                                                                                                                                      |  |  |  | 
|NUMBER  |  | DESCRIPTION                                                                                                                                                                                                                                                                                                                                                                                                                          |  |  |  | 
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                      |  |  |  | 
|2(i)    |  | Agreement and Plan of Reorganization, dated as of January 26, 1995 among the Company, Rainbow Acquisition
Inc., a California corporation and a wholly owned subsidiary of Rainbow, and Mykotronx, Inc., a
California corporation (Mykotronx) (incorporated by reference to the Companys Registration Statement
on Form S-4 under the Securities Act of 1933, as amended, effective on April 20, 1995, Registration No.
33-89918).
|2(ii)   |  | Agreement and Plan of Merger, dated September 30, 1996, by and among the Company, RNBO Acquisition
Corporation, a Nevada corporation and a wholly-owned subsidiary of the Company, and Software Security,
Inc., a Connecticut corporation (incorporated by reference to Exhibit 2(ii) of the Companys 1996 Annual
Report on Form 10-K under the Securities Exchange Act of 1934
filed in March 1997 (the 1996 10-K)).            
|2(iii)  |  | Agreement and Plan of Merger, dated March 6, 1998, by and among the Company, WRS Acquisition Corp., a
California corporation and wholly owned subsidiary of the Company, and Wyatt River Software, Inc.
(incorporated by reference to Exhibit 2(iii) of the Companys 1997 Annual Report on Form 10-K under the
Securities Exchange Act of 1934 filed in March 1998 (the 1997
10-K)).                                             
|3(i)    |  | Articles of Incorporation of Rainbow, as amended (incorporated by reference to Exhibit 3(a) to Rainbows
Registration Statement on Form S-18 under the Securities Act of 1933, as amended, filed on July 20, 1987
- File No. 33-15956-LA (the S-18 Registration
Statement)).                                                                                                                                                      
|3(ii)   |  | By-Laws of Rainbow (incorporated by reference to Exhibit 3(b) to
the S-18 Registration Statement).                                                                                                                                                                                                                                                                                                                                  
|4(a)    |  | See Exhibit 3(i).                                                                                                                                                                                                                                                                                                                                                                                                                   
|4(b)    |  | See Exhibit 3(ii).                                                                                                                                                                                                                                                                                                                                                                                                                  
|10(a)   |  | Agreement, dated October 1996, between the Company and National Semiconductor Corporation (incorporated
by reference to Exhibit 10(b) of the Companys 1998 Annual Report on Form 10-K under the Securities
Exchange Act of 1934 filed in March, 1999 (the 1998
10-K)).                                                                                                                                                           
|10(b)   |  | Agreement, dated December 1998, between the Company and EM Microelectronic  Marin S.A. (incorporated by
reference to Exhibit 10(c) of the 1998 10-K).                                                                                                                                                                                                                                                                              
|10(c)   |  | 1990 Incentive Stock Option Plan as amended (incorporated by
reference to Exhibit 10(j) of the 1991 10-K).                                                                                                                                                                                                                                                                                                                          
|10(d)   |  | Employment Agreement, dated February 16, 1990, between the Company and Walter W. Straub (incorporated by
reference to Exhibit 10(j) of the 1989 10-K).                                                                                                                                                                                                                                                                              
|10(e)   |  | Change of Control Agreement, dated February 16, 1990, between the Company and Walter W. Straub
(incorporated by reference to Exhibit 10(k) of the 1989 10-K).                                                                                                                                                                                                                                                                       
|10(f)   |  | Employment Agreement, dated January 5, 1995, between the Company and Patrick E. Fevery (incorporated by
reference to Exhibit 10(l) of the 1994 10-K).                                                                                                                                                                                                                                                                               
|10(g)   |  | Change of Control Agreement, dated January 5, 1995, between the Company and Patrick E. Fevery
(incorporated by reference to Exhibit 10(m) of the 1994 10-K).                                                                                                                                                                                                                                                                        
|10(h)   |  | Employment Agreement, dated January 1, 1998, between the Company and Laurie Casey (incorporated by
reference to Exhibit 10(q) of the 1997 10-K).                                                                                                                                                                                                                                                                                    
|10(i)   |  | Change of Control Agreement, dated January 1, 1998, between the Company and Laurie Casey (incorporated by
reference to Exhibit 10(r) of the 1997 10-K).                                                                                                                                                                                                                                                                             
|10(j)   |  | Agreement for Design and Product Purchase, dated September 4, 1997, between IBM Microelectronics and
Rainbow Technologies, Inc. and Mykotronx, Inc. (incorporated by reference to Exhibit 10(w) of the 1998
10-K).                                                                                                                                                                                                                  





---



##### Table of Contents



|        |  |                                                                                                                                                                                                                                                                                                                                                     |  |  |  | 
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  |  |  | 
|EXHIBIT |  |                                                                                                                                                                                                                                                                                                                                                     |  |  |  | 
|NUMBER  |  | DESCRIPTION                                                                                                                                                                                                                                                                                                                                         |  |  |  | 
|        |  |                                                                                                                                                                                                                                                                                                                                                     |  |  |  | 
|10(k)   |  | Leases for premises at 357, 359, and 371 Van Ness Way, Torrance, California, dated September 8, 1993,
September 25, 1996 and October 2, 1997, respectively, between Surf Management Associates, a California
limited partnership, and Mykotronx, Inc., a California Corporation (incorporated by reference to Exhibit
10(x) of the 1999 Form 10-K).
|10(l)   |  | Lease for premises at 111 West Ocean Boulevard, Long Beach, California, between Stevens Creek Associates,
a California general partnership, and the Company (incorporated by reference to Exhibit 10(y) of the 1999
Form 10-K).                                                                                                                    
|10(m)   |  | Lease for premises at 8 Hughes, Irvine, California, between Alton Irvine Partners, LLC, a California
limited liability company, and the Company (incorporated by reference to Exhibit 10(z) of the 2000 Form
10-K).                                                                                                                                
|10(n)   |  | 2000 Incentive Stock Option Plan (incorporated by reference to Rainbows Registration Statement on Form
S-8 filed under the Securities Act of 1933).                                                                                                                                                                                               
|10(o)   |  | Lease for premises at 50 Technology Drive, Irvine, California, dated
April 14, 2000, between The Irvine Company, a California
corporation, and the Company.                                                                                                                                                                                        
|99(a)   |  | Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002  Walter W. Straub, President and Chief Executive Officer and Patrick E.
Fevery, Vice President and Chief Financial Officer