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

                                    FORM 10-K
(Mark One)
( X ) Annual Report  Pursuant to Section 13 or 15(d) of the Securities  Exchange
Act of 1934 For the fiscal year ended December 31, 2001

(   ) Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from
                               -------------------------------------------------

Commission File No.                                  0-5265
                    ------------------------------------------------------------

                                SCAN-OPTICS, INC.
--------------------------------------------------------------------------------
             (Exact name of registrant as specified in its charter)

               Delaware                                06-0851857
--------------------------------------------------------------------------------
 (State or other jurisdiction of        (I.R.S. Employer Identification Number)
  incorporation or organization)

169 Progress Drive, Manchester, CT                            06040
--------------------------------------------------------------------------------
(Address of principal executive offices)                     Zip Code

                                 (860) 645-7878
--------------------------------------------------------------------------------
              (Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:          None
                                                             -------------------

                                                                Common stock,
Securities registered pursuant to Section 12(g) of the Act:    $.02 par value
                                                             -------------------
                                                              (Title of Class)

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

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulation  S-K is not contained  herein,  and will not be contained,  to the
best of registrant's  knowledge,  in definitive proxy or information  statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]

The aggregate  market value of the voting stock (common) held by  non-affiliates
of the registrant: $2,231,920 as of March 26, 2002.

The number of shares of common stock,  $.02 par value,  outstanding  as of March
26, 2002 was 7,439,732.


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<PAGE>


DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive Proxy Statement,  relating to the 2002 Annual Meeting
of  Stockholders,  which  will be  filed  pursuant  to  Regulation  14A with the
Securities and Exchange  Commission not later than 120 days after the end of the
fiscal year, are incorporated by reference and included in the following:

Part III-Item 10 - Directors and Executive Officers of the Registrant

Part III-Item 11 - Executive Compensation

Part  III-Item  12  -  Security  Ownership  of  Certain  Beneficial  Owners  and
Management

Part III-Item 13 - Certain Relationships and Related Transactions















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                                     PART I

ITEM 1 - BUSINESS

Scan-Optics,  Inc. (the "Company") was  incorporated in Delaware in 1968 and has
its principal office at 169 Progress Drive, Manchester, Connecticut 06040.

The Company  designs,  develops,  manufactures  and  services  production  image
scanning systems and designs,  develops and integrates  software-based solutions
that use state of the art  technology  for imaging,  automated data capture with
forms processing, document management, and workflow.

The Company is a leader in applying  technology to solve information capture and
customer service challenges for government  agencies and commercial  businesses.
For 33 years,  the Company has provided  innovative  solutions to its customers,
using  advanced  technology  for  forms  processing,   document  management  and
automated data capture.

The Company was among the first to develop Optical  Character  Recognition (OCR)
technology for data capture and is a leading  provider of image scanning systems
worldwide.  Building on its core  competencies  of  high-speed  paper  handling,
digital image  processing,  optical character  recognition,  and data entry, the
Company has transitioned to become a provider of data management  solutions that
focus on the business needs of its customers.

The Company's  strategy is to provide a "Total Solution" to specific image, data
capture, document  management  and  workflow  needs of a  specific  customer  or
industry.  This  allows  the  Company  to  position  itself as a single  source
provider.

The  Company  has three  distinct  divisions:  Solutions  and  Products,  Access
Services and Manufacturing Services.

The Company's  Solutions and Products Division combines technology and expertise
to  develop  cost-effective   solutions  for  applications  in  the  government,
insurance,  assessment,  commercial  voting  systems  such as proxy  ballot  and
tabulation,  financial and order entry markets.  The Company's  ability to offer
customized and  integrated  system  solutions has helped  customers all over the
world to meet their productivity and profitability objectives.

The Access Services Division of the Company provides third party and proprietary
maintenance services  nationwide,  as well as to the UK and Canada. The division
provides hardware maintenance support for equipment related to scanning, imaging
and automated data capture, as well as supplying  maintenance services for other
manufacturers of electro-mechanical equipment.

The Company's  Manufacturing  Services Division created a contract manufacturing
function in 1998 to provide  electro-mechanical  assembly and test  services for
third party  providers  of  equipment  such as  large-format  scanners and other
electro-mechanical devices.

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<PAGE>


SOLUTIONS AND PRODUCTS DIVISION

Solutions
The Company's solutions employ high speed document handling,  image capture, ink
jet printing,  character recognition,  multi-pocket document sorting, key-entry,
image storage and retrieval products,  as well as software/hardware  integration
services,  application  software  development  services,  and project management
services.

Scan-Optics'  AccuScore,  for the  automatic  scoring of  "bubble"  forms,  uses
electronic  image-capture  technology in  conjunction  with patent pending image
processing  software for performing  the scoring with:

     *    No expensive paper or printing required

     *    No  specialized  LED-array  scanner

     *    Flexible, easy-to-use forms definition tool

     *    Extremely high accuracy rates

     *    Greater flexibility in forms design

Scan-Optics'  AddressBuilder,  automatically  reads customer names and addresses
from incoming documents and prepares the data for the customer's database, using
patented  technology.   AddressBuilder   automatically  corrects  OCR  ("optical
character  recognition")  rejects,  OCR  substitutions,  and erroneous data from
original documents - without operator intervention.

Scan-Optics' DocWise, provides a secure digital information archive. DocWise can
store  virtually  any  type  of  electronic  file:  E-mail,  computer  documents
(Microsoft  Excel and Word),  digital photos,  faxes, XML files and ERM reports.
DocWise  provides  security with Windows NT security with seven levels of access
rights  built in.  DocWise  has the  capacity to import and index  thousands  of
documents per hour in standard Tiff format.

Scan-Optics' ImageEMC++,  developed as a result of the Company's experience with
many of the nation's leading health insurance and other claim payment companies,
is a comprehensive  business solution designed to efficiently  process the paper
forms and other documents these organizations receive. It minimizes the time and
labor involved with processing single and multi-part health claims, enrollments,
and other forms, as well as correspondence,  re-pricing sheets and other general
documents.

Scan-Optics'  ORDERexpress(TM) is an automated image-based data capture solution
for "club"  style  order  solicitation  and order  processing.  ORDERexpress(TM)
provides mark sense, machineprint, and handprint recognition, which are integral
parts of most reply  cards.  It also offers  processing  modules to handle order
reply cards, return non-orders,  and process payments.  This solution eliminates
the need to manually sort and separately process orders from non-orders and name
and address  changes.  Also available are hardware and  application  software to
process mail-out announcements, return order documents and payments.

Scan-Optics'  PayWise, is a turnkey solution designed to increase the efficiency
of an  Accounts  Payable  department  by  integrating  image  processing  of the
supplier invoice to a company's Accounts Payable system.


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<PAGE>


Scan-Optics' PROOFexpress(TM) is an automated image-based solution for delivery,
data  capture,  and storage and  retrieval.  It provides  processing  modules to
process waybills,  delivery tickets, and other billing documents. It applies the
technologies of character  recognition,  data and image capture, data correction
and verification,  and transfer to a host system. As a result,  PROOFexpress(TM)
can achieve the principal goal of most billing  departments in  implementing  an
image-based storage and retrieval system.

Scan-Optics'  TAXexpress(TM),  an automated  image-based tax processing and data
capture solution, consists of processing modules to handle income tax, sales tax
and other tax returns.  It applies the  technologies  of character  recognition,
data and image capture,  data correction,  and verification,  transfer to a host
system, image workflow,  and archive capabilities.  As a result,  TAXexpress(TM)
can  achieve  the  principal  goal  of  most  tax  and  revenue  departments  in
implementing an image-based tax processing system.


Products
In June 1992, the Company  introduced  the Series 9000 scanner.  The Series 9000
integrates character  recognition,  image capture, and paper handling technology
into a high-speed  scanner.  During 1993, the Company introduced several options
for  this  scanner.   These  options  permit  character  recognition  and  image
processing on the "reverse side" of documents,  a special small document stacker
module, and the ability to recognize several industry standard  bar-codes.  With
the  announcement of the 9000M (at 220ppm) in 2000 and the 9000mm (at 100ppm) in
2001,  the  Company  continues  to lead in the high volume  document  processing
systems  market.  The 9000M and the  9000mm  feature  modular  design,  advanced
digital camera technology,  and black and white or grayscale output. Both models
are based on Windows NT operating environment,  and can process intermixed forms
of varying sizes and weights,  and both are available as simplex or duplex, with
an  integrated  image  quality  monitor,   acoustic  double-detect  feeder,  and
recognition rates up to 10,000 characters per second.

In July 1996, the Company introduced a high-speed neural-network based handprint
recognition  system for use in the  Series  9000  scanner.  The  In-Line  Neural
Classifier  operates  at  speeds  of up to 7,500  characters  per  second  while
achieving a 50% reject rate reduction and 10%  substitution  rate reduction over
the previous handprint  recognition engine. The classifier is based on a special
neural network  algorithm that is resistant to over-training  making it an ideal
candidate for character recognition systems.

The Company  has been  involved in  leveraging  the power of neural  recognition
engines to achieve success with each application. The Company's patented Context
Edit  analyzes  data,  conducts  a  database  library  search,  compares  fields
character by character to locate a correct match, and then automatically updates
the data  batch  with the  correct  information.  With an  extensive  electronic
postal/name  library  virtually  every  combination  is considered  but only the
correct value is accepted.

The  Company  released  VistaCapture  in  1998.  VistaCapture  represents  a new
paradigm for creating data entry applications.  The VistaCapture  product suite,
an open-system  solution based on Microsoft's  VisualBasic,  utilizes  Microsoft
ActiveX (OCX)  technology.  VistaCapture  is


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<PAGE>

designed  for  high-speed   key-entry,   key-from-image,   and  state-of-the-art
character recognition (OCR/ICR) applications.

In 1999, the Company announced a document  management tool with Internet access,
DocWise, which was acquired through a licensing agreement with Bluebird Systems.
DocWise provides an environment where users can capture,  index, secure,  store,
access,  distribute,  and use the information  contained in documents simply and
efficiently.  The Docwise product set was enhanced through the addition of dwWEB
and dwINDEX. The dwWEB software product provides access to stored images via the
World Wide Web and the dwINDEX  provides an off-line  indexing  application  for
higher volume forms processing.

The Company  added a new scanner  series to its line in 1999,  the Vision Series
8000, due to the acquisition of product rights and certain assets of Photomatrix
Corporation.  The Vision Series 8000 is targeted at the  mid-range  requirements
for  scanning.  Rated at 100 ppm to 200 ppm,  the  Series  8000  scanner  family
converts large volumes of documents into compressed electronic images.

In 2000,  Gray Scale  Optical Mark Read  (GSOMR) was released, which is a patent
pending  product  with   capabilities  to  more  accurately  detect  mark  sense
information for processing such forms as test scoring and balloting.

SONAR (Scan-Optics Neural Auxiliary  Recognition) is a software product released
in 2001. SONAR  incorporates the Company's patented Context Edit product and ICR
recognition   technology  for  lower  volume  forms/data  capture  applications.
Applications such as address changes are ideally suited for SONAR.

In 2002, the Company intends to continue its aggressive  program of research and
development of enhancements  with additional  options and  capabilities  for its
existing products as well as the development of new products that take advantage
of the Company's core competencies.

Core Competencies

Key product  disciplines utilize integration skills and experience that leverage
the core  competencies  of the Company to provide broad  solution  alternatives.
These core competencies include:

Document Scanning
Image Enhancement Algorithms and Image Quality
Character Recognition (OCR, ICR, Barcode, Mark Sense, OMR, etc.)
Key-From-Image and Key-From-Paper Data Entry
Document Management, Workflow and Access
Line of Business Domain Knowledge
Professional Services (Design, Development, Installation and Support)
Value Added Engineering Services and Solutions


                                       6

<PAGE>

Document Scanning

The Company has addressed the high-speed, high-volume,  page/document-processing
marketplace since its inception.  During 1992, the Company introduced the Series
9000 generation of scanners.  This was followed in 1998 with the 9000T. In 2000,
the Company  announced  the 9000M.  These  systems  provide  full-page  document
scanning,   including   options  for  front  and  back  imaging,   OCR  reading,
serialization, and sorting of documents in a single pass, black and white and/or
Grayscale output as standard components,  Windows NT platform,  resolutions from
200 to 400 dpi,  and  in-line  recognition  speeds up to 10,000  characters  per
second.  In 1999,  the Company added the Vision Series 8000 scanner to its line.
The Series 8000 scanner rated at 100 ppm to 200 ppm,  converts  large volumes of
documents into compressed  electronic  images. In 2001, the Company released the
9000mm, a 100 page per minute scanner based upon the 9000M product.

Image Enhancement Algorithms and Image Quality
Image  enhancement  starts  at the  scanner  capture  system.  Various  embedded
algorithms are utilized to ensure a quality image is taken the first time. These
algorithms  include  code for  straightening  a page,  removing  black  "noise",
adjusting  the  contrast,  and  trimming  the  image  to the  exact  size of the
document.  The Company provides the fastest page capture and image system on the
market  today.  This  processing  is carried  forward  into the  Company's  OCR,
Key-From-Image and image storage and retrieval systems. Management believes that
the Company's image quality is among the best in the industry.  Electronic image
processing and storage  systems have rapidly  overtaken the use of microfilm and
the Company is on the leading  edge of this  technology  with its  hardware  and
application software solutions.

Character Recognition
The Company has developed and provided its own high-speed character  recognition
since 1968. OCR and its related technologies are able to lift data automatically
from  paper  forms,  without  the need for  manual  keying  of the data into the
computer  system.  The  Company's  recognition  technology  has always  included
in-line  recognition  of machine  printed,  handprinted  and mark  sense  forms.
In-line  recognition  occurs at very high speed,  in real-time,  as the paper is
moving down the scanning transport.

With the  introduction  of the Series 9000  system,  the Company  expanded  this
recognition to include  barcode,  patch code,  special  educational test scoring
analysis,  and special  stamp  recognition.  In  addition  to these  recognition
processes,  the Company integrated and developed neural recognition technologies
that support both in-line and post capture recognition.  The Company's character
recognition  technology  was  enhanced in 1999 with its  patented  Context  Edit
capability  that  brings a new  level  of data  purification  to the  integrated
solutions.

Key-From-Image and Key-From-Paper Data Entry
The Company has been providing  complete  hardware and software  solutions using
Key-From-Image  (KFI) and  Key-From-Paper  (KFP) data entry since 1976. This KFI
and KFP  solution  remains  important  today,  using the latest open network and
platform  designs with Windows,  UNIX,  Novell,  TCP/IP,  NT, and other industry
standard  components.  By combining  the  high-speed  scanning  systems with the
flexibility  of KFI and KFP,  customers  are able to lower  their  overall  data
capture and document processing costs while improving the level of data accuracy
and availability.

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<PAGE>

Document Management, Workflow and Access
In 1999, the Company introduced DocWise which extends the value of the digitized
documents to workflow,  storage and retrieval functions. This enables the use of
image technology to research source documents in a customer service environment.

Line of Business Domain Knowledge
The  Company   provides   solutions   that  are  proven,   cost-effective,   and
production-ready.  The  Company  has  the  domain  knowledge  to  provide  total
solutions in the following industries:  government,  insurance,  transportation,
financial  and order  entry.  That domain  knowledge  is utilized in the product
suite  of  applications;  ImageEMC++,  ORDERexpress(TM),   PROOFexpress(TM)  and
TAXexpress(TM).

Professional Services
In order to provide a total solution to the customer, the Company has provided a
consultative  approach to integrate solutions with proven Professional  Services
core competencies in the following areas:

 Application Expertise     Industry Standards         Open Systems
 Archival / Retrieval      Installation               Paper Handling
 Custom Engineering        Microfilming               Project Management
 Development Tools         Networking                 Systems Engineering
 Forms Design              Neural Technology          System Integration
 Imaging                   OCR Technology             Training

The  Company  has  provided  software  solutions  to its  customers  since 1968.
Utilizing  both  Company  developed  products  and  third  party  products,  the
Professional Services group provides turnkey solutions to address the customer's
mission  critical  applications.  The  Company's  scanners and assorted  network
system  products  provide  the  hardware   platforms  for  delivering   advanced
high-volume forms processing, imaging, and document management system solutions,
especially in government, insurance, assessment, transportation,  financial, and
order entry markets.

These targeted solutions are provided through  professional  services offered by
the Company. The Company also provides  individual,  custom software services as
requested  by the  customer.  In this way,  the Company  can either  provide the
entire  package of software  support or simply  provide those  services that the
customer desires.

Value Added Engineering Services and Solutions
The  Company has been  supplying  engineering  services  and  solutions  to meet
customer needs since  introducing its first fully  integrated  solution in 1976.
The  solutions  include  scanning,  recognition,   Key-From-Image,  data  entry,
archival storage and retrieval, and communications. During 1993, the Company was
selected  to  develop  a  prototype  system  to  process  medical  claims  for a
healthcare agency in Japan. This system was designed with 36 stacker pockets for
sorting forms;  expanded paper handling  capabilities for  light-weight,  flimsy
forms;  high resolution image cameras to permit  recognition of complex Japanese
kanji  characters;  and software forms  recognition  for up to 20,000  different
document formats.

The Company has been involved in special recognition techniques to process order
forms that contain stamps.  These stamps are used as an entry into a sweepstakes
contest or to select  ordered items for a record or book club. The stamps are of
a multitude  of colors and are  successfully  processed  through  the  Company's
special  recognition  features.  Similar  techniques  have been used to  provide
quality and fraud control  application  for the indicia from postal  meters.  In
addition  to stamp  processing,  the  Company  has been  engaged in  recognition
analysis for  educational  test scoring.  This process is  accomplished  in full
duplex  mode at a  transport  speed of 50 inches per  second.  Test  scoring and
balloting  includes Optical Mark Read (OMR) and image  presentment of text pages
to knowledge workers for value added analysis and grading.


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<PAGE>

ACCESS SERVICES DIVISION

The  Company has been  offering  service  and  maintenance  support to its broad
customer  base since 1968.  This  support is  available  with  either  leased or
purchased systems in both domestic and international markets.

In June of 1998,  the Company  acquired  the  hardware  maintenance  division of
Access  Corporation  of  Cincinnati,  Ohio.  This  business  was  combined  with
Scan-Optics'  existing hardware  maintenance division to form Access Services, a
separate  division,  dedicated to serving the Scan-Optics  customer base and the
third party maintenance marketplace.

Service is provided through a network of over 140 service centers worldwide. The
Company  provides  on-site service with response times of 2 to 24 hours based on
the service plan selected by the customer.  The Company focuses on comprehensive
diagnostic  routines,  modular designs,  preventive  maintenance  procedures and
customer  surveys  to  provide  its users high  system  availability  to perform
mission critical applications.

The Company's  customers  include  government,  healthcare  organizations,  test
scoring,   transportation,   subscription  and  catalog  fulfillment  companies,
financial  institutions and  manufacturers in the U.S.,  Canada,  Latin America,
Europe and Asia.  The Company  maintains high standards of teamwork and customer
satisfaction.


MANUFACTURING SERVICES DIVISION

The contract manufacturing services function,  within the Manufacturing Services
Division, provides electro-mechanical assembly and test services under contracts
with customers who develop and sell a variety of equipment.

Beginning with the customer's  plans,  Scan-Optics  can manage each project from
concept to completion. The capabilities provided include:


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<PAGE>

Project Management
Engineering and Prototyping
Procurement and Materials Management
Precision Machining, Sheet metal Fabrication and Welding
Networks/System Integration
Systems Testing
Just-in-Time/Kanban Delivery Systems
Professional Services and Training
Worldwide Field Service - through Access Services
Strong Supplier Partnerships with:
           Agency Standards Certification (FCC, UL, LE, CSA, ISO 9001)
           Commercial Painting and Metal Finishing
           Printed Circuit Board Assemblies and Testing
           Wire Harness and Cable Assembly and Testing
           Specialty Packaging
           Worldwide Shipping


SIGNIFICANT CUSTOMERS

In 2001, no customers accounted for more than 10% of total revenue. In 2000, the
Company derived 13% of its total revenue from one customer,  Toyo  Officemation,
Inc., one of the Company's  distributors  in Japan. In 1999, the Company derived
11% of its total  revenue from one customer,  the Kentucky  Revenue  Cabinet,  a
state government taxing authority.


CHANNELS OF DISTRIBUTION

The  Company  sells  directly  to  end-users  and  distributors.  It also  pools
resources  with  selected  system   integration   firms  and  specialized  niche
suppliers.  The cooperative effort with system integrators and other vendors has
introduced  the  Scan-Optics   logo  to  new  markets  both   domestically   and
internationally.


BACKLOG

The backlog for the Company's  products and services as of December 31, 2001 was
approximately   $22.5  million.  As  of  December  31,  2000,  the  backlog  was
approximately  $15.3 million.  The backlog  consists of equipment,  software and
services to be sold and  non-cancelable  rentals and maintenance due on existing
rental and  maintenance  contracts  over the next  year.  The  Company  normally
delivers a system within 30 to 180 days after receiving an order, depending upon
the degree of software customization required.


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<PAGE>


MANUFACTURING

Manufacture of the Company's  products  requires the  fabrication of sheet metal
and mechanical  parts,  the  subassembly of electronic and mechanical  parts and
components,   and   operational  and  quality  control  testing  of  components,
assemblies and completed systems. The Company's products consist of standard and
Company-specified  mechanical and  electronic  parts,  sub-assemblies  and major
components,  including  microcomputers.  A  majority  of  parts  are  purchased,
including many complex electronic and mechanical subassemblies. The Company also
purchases major standard  components,  including low speed scanners,  jukeboxes,
PCs,  printers and servers.  An important aspect of the Company's  manufacturing
activities  is its  quality  control  program,  which  uses  computer-controlled
testing equipment.

The Company has not  experienced  significant  shortages  of any  components  or
subassemblies. Alternate sources for such components and subassemblies have been
developed.  Certain  sole source items have been  evaluated  and the Company has
determined  that a minor  engineering  effort  would be  required  to  qualify a
replacement.  During  2001,  the Company  experienced  delays in the shipment of
components and subassemblies arising from the Company's lack of liquidity.


COMPETITION

The Company's  Solutions and Products  Division  competes with service providers
who  integrate  systems  with  products  from  multiple  vendors.   The  Company
differentiates  its  solutions  by  offering  a  total  system,  including  post
installation support of hardware and software services along with image scanning
and  document  handling  transports.  The Company  focuses on industry  specific
"application"  areas with solutions  utilizing image and data entry/data capture
systems provided by the Company.

A large portion of the revenue generated by the Access Services Division is from
post installation hardware and software services on integrated systems installed
by the Company's Solutions and Products Division.  Due to the proprietary nature
of these  integrated  systems,  this division faces little  competition for this
business.   The   remaining   revenue  is  generated  by  the  field  repair  of
electro-mechanical  devices  manufactured by Original  Equipment  Manufacturers,
primarily  of  scanner  products,  that do not have their own field  staff.  The
division competes with other third party maintenance  providers for this revenue
by using its  reputation for quality and its 32 years of experience in providing
scanner repair.

Contract  Manufacturing,  a function  of the  Manufacturing  Services  Division,
provides  electro-mechanical  assembly and test services  under  contracts  with
customers who develop and sell a variety of equipment.  The primary  competition
for this business is the customers  themselves who can decide to manufacture the
products   instead  of  outsourcing   them.   Competition  from  other  contract
manufacturers is minimal due to the Company's expertise in the electo-mechanical
field as well as the flexibility to handle various order requirements.


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<PAGE>


ISO 9001 CERTIFICATION

On November 12, 1999, the Company received ISO 9001-1994  certification  for its
product development and manufacturing  divisions. The scope of the certification
is  for  the  design  and   production   of  scanning   equipment  and  contract
manufacturing of electronic equipment.

In 2000,  the Company  took the first step in expanding  its quality  program by
bringing the Access Service Division into compliance. The Company also performed
internal audits to test for compliance in the sales,  design,  manufacturing and
service  areas to  continue  to  improve  the  quality  management  system.  The
registering  body performed four  surveillance  audits on the Company's  product
development and manufacturing divisions, all of which were successful.

In 2001,  the Company  maintained  its  quality  systems  and  prepared  for the
transition  to ISO  9001:2000.  The  Company  expects to achieve  ISO  9001:2000
compliance by May 2002.


PATENTS

The Company  currently  has nine  United  States  patents in force which  expire
between  2003 and  2021.  The  patents  are on  mechanical  systems,  electronic
circuits,  electronic systems and software algorithms, which are used throughout
the product lines. The Company values the investments made in new technology and
makes all efforts to protect its intellectual  property.  The Company expects to
continue  to apply for  patents on its new  technological  developments  when it
believes they are  significant.  In November 1997, the Company licensed a patent
to Imaging Business  Machines,  LLC. for use in an image transport  designed for
processing  airline  tickets.  In 1999,  this same  patent was  licensed to Nale
Corporation for use on its paper handling  transports.  In 2000, the engineering
organization  filed  for a  patent  for  gray  scale  OMR  used in test  scoring
applications  and a patent  for an  ultrasonic  overlapping  document  detection
system  for our  scanners.  In 2001,  the  Company  received  the patent for the
ultrasonic-based system.


EMPLOYEES

As of December  31, 2001 the Company  employed  221  persons,  including 23 with
administrative and support  responsibilities,  19 in marketing and sales, 122 in
software  and service  activities,  20 in  engineering  and 37 in  manufacturing
capacities. The Company considers its employee relations to be good. The Company
has not experienced any work stoppages.


FUNDED DEVELOPMENT AGREEMENTS

During 1999,  the Company  entered into four custom  development  agreements for
specific   customers.   A  $125,000   agreement   involved  the  development  of
localization  software for screen displays in Japanese. A $115,000 agreement was
for recognition  enhancements to a current product. A $75,000 agreement involved
enhancements for the reading of Japanese stock certificates. A $58,000 agreement
involved  software  developments  for the  processing  of


                                       12
<PAGE>

mortgage  payments and taxes.  The Company recorded all revenue related to these
development agreements in 1999. These revenues offset the related costs incurred
for this  development.  The  ownership  of these  technologies  remains with the
Company.  No  royalties  or other  considerations  are required as part of these
agreements.

During 2000 and 2001, the Company completed a number of small custom development
contracts for specific customers resulting in revenue of approximately  $200,000
and $110,000, respectively. These revenues offset the related costs incurred for
this development.  The ownership of these technologies remains with the Company.
No royalties or other considerations are required as part of these agreements.


EFFECTS OF ENVIRONMENTAL LAWS

The effect of  federal  and state  environmental  regulations  on the  Company's
operations is insignificant.









                                       13
<PAGE>



BUSINESS SEGMENTS

The Company views its business in three distinct operating  segments:  solutions
and products, Access Services and contract manufacturing services.  Revenues are
used by management as a guide to determine the  effectiveness  of the individual
segment.  The  Company  manages its  operating  expenses  through a  traditional
functional  perspective and accordingly does not report operating  expenses on a
segment basis.
<TABLE>
<CAPTION>
                                                                   Year Ended December 31
(thousands)                                             2001                2000             1999
--------------------------------------------------------------------------------------------------------

Revenues
<S>                                                    <C>               <C>                <C>
  Solutions and products                               $16,667           $ 23,295           $ 36,841
  Access services                                       13,193             12,669             14,083
  Contract manufacturing services                          880              2,338              1,068
                                                      --------           --------           --------
    Total revenues                                      30,740             38,302             51,992

Cost of solutions and products                          13,298             22,806             28,816
Service expenses                                        11,200             11,287             11,657
                                                      --------           --------           --------

    Gross profit margin                                  6,242              4,209             11,519

  Operating expenses, net                               12,522             21,918             19,934
                                                      --------           --------           --------
Loss before income taxes                              $ (6,280)          $(17,709)          $ (8,415)
                                                      ========           ========           ========

Total assets                                          $ 25,279           $ 34,436           $ 55,186

Total  expenditures  for  additions to
long-lived assets                                     $    121           $    109           $    596
</TABLE>

Certain 2000 and 1999 amounts have been  reclassified  to conform to the current
year presentation.

Note: In 2001, no customers  accounted  for more than 10% of total  revenue.  In
2000,  the Company  derived 13% of its total  revenue  from one  customer,  Toyo
Officemation,  Inc., one of the Company's  distributors  in Japan.  In 1999, the
Company derived 11% of its total revenue from one customer, the Kentucky Revenue
Cabinet, a state government taxing authority.

Sales of product to customers in the international market represent an important
source of the Company's  revenues.  The Company has  international  distributors
located in 46 countries and covering six  continents.  All  international  sales
other  than  sales  originating  from  the  UK  and  Canadian  subsidiaries  are
denominated  in United  States  dollars.  Changes in the  economic  climates  of
foreign markets could have an unfavorable impact on future international sales.



                                       14
<PAGE>



Export sales by geographic  area (based on the location of the customer) were as
follows:

<TABLE>
<CAPTION>
(thousands)                                        2001                  2000                 1999
----------------------------------------------------------------------------------------------------------
<S>                                              <C>        <C>      <C>          <C>      <C>         <C>
Latin America                                    $   152    3%       $     152    2%       $    77     2%
Europe                                             3,706   73%           1,667   22%         1,982    41%
Pacific Rim                                        1,220   24%           5,881   76%         2,743    57%
                                                 ---------------------------------------------------------
                                                 $ 5,078             $   7,700             $ 4,802
                                                 =========================================================
</TABLE>

Export sales represented 45%, 43%, and 20% of hardware and software revenues for
the three years ended December 31, 2001, 2000, and 1999, respectively.


ITEM 2 - PROPERTIES

The Company's  world  headquarters  and  manufacturing  facility is located in a
84,000 square foot, one-story building in Manchester,  Connecticut, leased for a
term  expiring in December  2006.  The Company  also leases 1,238 square feet of
office  space,  under a lease  expiring  in July  2002,  in  Dallas,  Texas  for
professional services and sales.

Scan-Optics,  Ltd., a wholly owned subsidiary in the United Kingdom, also leases
office space for sales, service, and equipment demonstration.


ITEM 3 - LEGAL PROCEEDINGS

There are two lawsuits  currently pending against the Company.  The lawsuits are
both in  reaction  to lawsuits  filed by the  Company  against  the  plaintiffs.
Although the ultimate outcome is uncertain,  based on currently known facts, the
Company  believes  that it has strong  defenses  against  both  lawsuits and the
resolution  of these  matters  will not have a  material  adverse  effect on the
Company's financial position or annual operating results.


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

The Company did not submit any  matters  during the fourth  quarter of 2001 to a
vote of the stockholders.





                                       15
<PAGE>


EXECUTIVE AND OTHER OFFICERS OF THE REGISTRANT

Officers of the Company are set forth in the schedule below.
<TABLE>
<CAPTION>
                                                                                             Officer
Name                                Age         Principal Occupation:                          Since
-------------------------------------------------------------------------------------------------------
<S>                                 <C>        <C>                                           <C>
James C. Mavel                      56          Chairman, Chief Executive Officer
                                                and President                                  1996

Joseph P. Crouch                    39          Vice President -
                                                Manufacturing Services Division                1999

Marianna C. Emanuelson              40          Vice President -
                                                Human Resources                                1997

Richard C. Goyette                  50          Vice President -
                                                Sales and Marketing                            1996

Richard D. Harris                   41          Corporate Secretary                            2001

Joel K. Howser                      54          Vice President -
                                                Software Development                           1998

Clarence W. Rife                    62          Vice President -
                                                Access Services Division and
                                                Hardware Engineering                           1975

Michael J. Villano                  42          Chief Financial Officer, Vice
                                                President and Treasurer                        1992

Alan W. Ware                        63          Vice President -
                                                Project and System Integration                 2000

</TABLE>


Mr. Mavel joined the Company in January  1996 as President  and Chief  Operating
Officer.  In June 1996, Mr. Mavel became a Director of the Company.  On December
31, 1996, Mr. Mavel was promoted to Chief  Executive  Officer.  In May 1997, Mr.
Mavel was  elected  Chairman  of the Board of  Directors.  Prior to joining  the
Company,  from 1992  through  1995,  Mr.  Mavel was Vice  President  and General
Manager of the Imaging  Systems  Division of Unisys.  From 1991 to 1992,  he was
Group Vice President of the Financial  Information  Systems Division of National
Data Corporation.

                                       16
<PAGE>



Mr.  Crouch  joined the Company in March 1999 and was elected to the position of
Vice President -  Manufacturing  Services  Division in November  1999.  Prior to
joining the Company,  Mr. Crouch was Director of  Manufacturing  Operations  for
CalComp's Input Technologies Division. Mr. Crouch had over ten years of contract
manufacturing experience before joining the Company.

Ms.  Emanuelson  joined  the  Company  in August  1994,  and was  elected to the
position of Vice  President  in 1997.  She is currently  Vice  President - Human
Resources.

Mr.  Goyette  joined the  Company in March  1996 as Vice  President  - Sales and
Marketing. Prior to joining the Company, from 1993 through 1995, Mr. Goyette was
Vice President of the Imaging Systems Division of Unisys.  From 1992 to 1993, he
was Vice President of the Software  Products Group of Unisys.  From 1990 to 1992
he was Vice President of Corporate  Information  Productivity Systems of Unisys.
He is currently Vice President - Sales and Marketing.

Mr. Harris joined the law firm of Day, Berry and Howard LLP in 1990 and became a
partner in 1998.  He was  elected to the  position  of  Corporate  Secretary  in
January 2001.

Mr. Howser joined the Company in February 1997 as Vice President - Marketing. In
December of 1997,  Mr. Howser  assumed the  responsibility  of Vice  President -
Product  Development.  Prior to joining the Company,  from 1989 through 1996, he
was director of  development  for Unisys in its image  program.  Mr.  Howser had
twenty years of experience in transaction  processing and OCR/image  development
prior to joining Unisys. He is currently Vice President - Software Development.

Mr.  Rife has been  employed  by the  Company  since 1969 and was elected to the
position of Vice  President  in 1975.  He is currently  Vice  President - Access
Services Division and Hardware Engineering.

Mr.  Villano  joined  the  Company  in 1986  and in  1988  was  named  Assistant
Controller.  In 1989 he was promoted to the position of Controller,  in February
1992 was named Vice  President and  Controller and in March 1994 was named Chief
Financial Officer and Vice President. Mr. Villano was appointed Treasurer in May
1997.

                                       17

<PAGE>


Mr.  Ware  joined the  Company in October  2000 as Vice  President - Project and
System Integration.  Prior to joining the Company he was Chief Executive Officer
and Chairman of American OBGYN,  Inc.  (formally  Spectrascan  Imaging Services,
Inc.)  from  1984 to 2000.  He was Vice  President  of Sales and  Marketing  for
Scan-Optics  from 1974 to 1984 and Director of Engineering and Customer  Service
at Recognition Equipment from 1968 to 1974. Mr. Ware is a member of the Board of
Directors of Quality Care Solutions Inc.

The  executive  officers  are  elected  for a one  year  term  effective  at the
conclusion of the Annual Meeting of Stockholders  each year. There are no family
relationships between any of the listed officers.



                                       18
<PAGE>

                                     PART II


ITEM 5 - MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON
              EQUITY AND RELATED STOCKHOLDER MATTERS


COMMON STOCK MARKET PRICES AND DIVIDENDS

The following is a two year history of Common Stock prices for each quarter. The
table sets forth the high and low closing  quotations  per share for the periods
indicated  of  the  Common  Stock  in the  over-the-counter  market  based  upon
information  provided by the National  Association of Securities  Dealers,  Inc.
Effective November 10, 2000 the Company was notified by The NASDAQ Stock Market,
Inc. that its common stock would begin listing on the Over the Counter  Bulletin
Board.  This action was taken  because of the  inability  to maintain the $1 per
share bid price  requirement  for continued  listing on the NASDAQ Stock Market.
The  closing  quotations  represent  prices  between  dealers and do not include
retail  markups,   markdowns  or  commissions  and  may  not  represent   actual
transactions. There were 929 stockholders of record at December 31, 2001.


<TABLE>
<CAPTION>
Quarter Ended          March 31                 June 30                  September 30             December 31
                  High         Low          High          Low          High         Low         High        Low
---------------------------------------------------------------------------------------------------------------
<S>              <C>          <C>          <C>          <C>            <C>         <C>         <C>        <C>
2001             $ .33        $ .14        $ .35        $.21           $ .93       $.27        $.35       $.20
2000             $4.75        $1.56        $1.97        $.44           $1.19       $.53        $.84       $.13
</TABLE>



The  Company  has not  paid  dividends  on its  Common  Stock  and the  Board of
Directors  of the  Company  has  no  intention  of  declaring  dividends  in the
foreseeable  future and the Company's  loan  agreement  does not allow  dividend
payments.  The Company issued  mandatory  redeemable  preferred stock and common
stock  warrants  to its  lender in a private  transaction  in  exchange  for the
forgivenes of indeptedness in the Company's total debt restructuring.  (See Note
F to the consolidated financial statements for further information.)








                                       19
<PAGE>

ITEM 6 - SELECTED FINANCIAL DATA


SCAN-OPTICS, INC. AND SUBSIDIARIES
FIVE YEAR SUMMARY OF OPERATIONS

SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
(thousands, except share data)                   2001               2000               1999               1998              1997
   --------------------------------------------------------------------------------------------------------------------------------
<S>                                          <C>                <C>                <C>                <C>               <C>
  Total Revenues                             $    30,740        $    38,302        $    51,992        $    53,971       $    56,608
                                           ========================================================================================

  Income (loss) before income taxes               (6,280)           (17,709)            (8,415)             3,234             5,691

  Income taxes (benefit)                              33                 61               (240)             1,105               (99)
                                           ----------------------------------------------------------------------------------------

  Net Income (Loss)                          $    (6,313)       $   (17,770)       $    (8,175)       $     2,129       $     5,790
                                           ========================================================================================


  Basic earnings (loss) per share            $      (.90)       $     (2.53)       $     (1.17)       $      0.31       $      0.87


  Basic weighted-average shares                7,026,232          7,025,064          6,979,651          6,921,331         6,632,248


  Diluted earnings (loss) per share          $      (.90)       $     (2.53)       $     (1.17)       $      0.30       $      0.82


  Diluted weighted-average shares              7,026,232          7,025,064          6,979,651          7,102,658         7,070,013



  SELECTED BALANCE SHEET DATA

  Total assets                               $    25,279        $    34,436        $    55,186        $    52,992       $    38,707
  Working capital (deficit)                  $     3,886        $    (9,833)       $     4,727        $    15,107       $    24,643
  Long term obligation                       $    10,392
  Mandatory redeemable preferred stock       $     3,800
  Total stockholders' equity                 $       360        $     4,307        $    22,081        $    30,246       $    27,733
</TABLE>


The Company has not paid any dividends  for the five year period ended  December
31, 2001.

The  above  financial  data  should  be read in  conjunction  with  the  related
consolidated financial statements and notes thereto.


                                       20
<PAGE>


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

Outlook
The forward-looking  statements  contained in this Outlook and elsewhere in this
document are based on current  expectations.  Scan-Optics,  Inc. (the "Company")
and its future  operations  are  subject to a number of risks,  including  those
discussed  below. The following list is not intended to be an exhaustive list of
all the risks to which the Company's business is subject,  but only to highlight
certain  substantial  risks faced by the Company.  Although the Company recently
completed a total debt restructuring  (see Note F to the consolidated  financial
statements for further  information),  the Company remains highly  leveraged and
could be adversely  affected by a significant  increase in interest rates. A one
percent  increase in the prime rate would  increase the annual  interest cost on
the outstanding loan balance at December 31, 2001 of  approximately  $12 million
by $.1 million. The Company's  business could be adversely affected by downturns
in the domestic and international economy. The Company's international sales and
operations are subject to various  international  business risks.  The Company's
revenues depend in part on contracts with various state or federal  governmental
agencies,  and could be adversely  affected by patterns in government  spending.
The  Company  faces  competition  from many  sources,  and its  products  may be
replaced  with  products  relying on  alternative  technologies.  The  Company's
business could be adversely  affected by  technological  changes.  The foregoing
factors should not be construed as exhaustive.

The  Company  experienced  a net loss of $6.3  million  in 2001,  including  $.6
million of one time charges associated with the accrual of severance costs and a
stay bonus for senior executive management.  The operating loss, without the one
time  charges,  was $5.7  million.  The loss was mainly due to the  reduction in
revenue related to the concern over the expiration on July 1, 2001 and potential
non-renewal  of the bank agreement as well as the general  economic  environment
for goods and services.  Even with this negative impact,  the decline in revenue
was offset by a reduction of costs of revenue and  operating  expenses  over the
same  period  due to  the  efficiency  and  productivity  of  the  organization.
Furthermore,   the  professional  services  sector  of  the  solutions  division
experienced  four consecutive  quarters of profitability  during 2001. The gross
margin for professional services for 2001 was 38% compared to negative margin of
8% for the same period in 2000. This improvement shows continued progress on the
transition to a solutions company.

Because of the existence of significant non-cash expenses,  such as depreciation
of fixed assets and  amortization  of  intangible  assets and  customer  service
inventory,  the Company  believes that EBITDA (earning before  interest,  taxes,
depreciation  and  amortization)  contributes to a better  understanding  of the
Company's  ability  to satisfy  its  obligations  and to utilize  cash for other
purposes.  EBITDA should not be considered in isolation  from or as a substitute
for operating


                                       21
<PAGE>

income,  cash flow from operating  activities,  and other consolidated income or
cash flow  data  prepared  in  accordance  with  generally  accepted  accounting
principles.  EBITDA was $.4  million in 2001,  as  compared to an EBITDA loss of
$10.7 million in 2000.

The Company has three major  initiatives  currently  underway to improve revenue
growth and  profitability.  They are to emphasize  the  "Business of  Solutions"
focus in  targeted  markets,  to seek  opportunities  through  expansion  in the
international  marketplace,  and to capitalize on existing core  competencies of
the Company.  A fourth  initiative that is currently on hold is to add long term
value through the  acquisition  of key strategic  products or  enterprises.  The
inability  of the  Company  to carry out these  initiatives  may have a material
adverse effect on revenue growth and earnings.

The  first  initiative  is to  provide  cost  effective  solutions  through  the
Company's  development of target market data capture applications  combined with
its high speed  transports  and  archival  systems.  The Company has refined its
target market  approach and has chosen to focus  primarily on the government and
insurance markets,  while continuing to address the transportation,  assessment,
commercial balloting,  financial and order entry markets. The Company expects to
continue to  emphasize  its  "Business  of  Solutions"  focus on these  targeted
markets for the foreseeable  future. As other market  opportunities  emerge, the
Company  will  evaluate  the  potential  of using its  products  and services to
provide  solutions in these new markets.  The Company's revenue in the solutions
initiative  decreased $7.2 million from 2000 to 2001 due to the general economic
conditions and other matters as discussed earlier.

The second initiative is further  expansion into the international  marketplace.
The Company has  successfully  supplied  product to the Japanese  market and has
experienced strong sales activity in the past through  relationships with highly
qualified  and  productive  distributors.  The Company will continue to focus on
developing strong  relationships in Europe,  Latin America and other Pacific Rim
countries.  The Company  experienced a revenue increase of $2 million or 122% in
Europe from 2000 to 2001.  The Pacific  Rim  declined by $4.7  million or 79% in
2001 as compared to 2000. The economic  environment in Latin America has been an
impediment to growth, and revenue from Latin America was flat in comparison with
the prior year at $.2 million.

The third initiative relates to leveraging the Company's core competencies in an
effort to absorb fixed expenses and increase  revenues and profits.  The Company
has demonstrated that Access Services and Contract  Manufacturing  Services have
potential to sell their individual expertise,  experience and cost effectiveness
to other entities.  Access Services revenue  increased by $.5 million or 4% from
2000 to 2001.  Contract  manufacturing  revenue decreased by $1.5 million or 62%
from 2000 to 2001 due to the  completion of a contract with a major customer and
product release delays from new customers.

The Company has put on hold its initiative of long term growth through accretive
acquisitions  of key strategic  products or  enterprises.  No  acquisitions  are
currently being  considered due to  management's  focus on the operations of the
business and the liquidity position of the Company.

RESULTS OF OPERATIONS - 2001 VS. 2000

Total revenues decreased $7.6 million or 20% from 2000 to 2001.


                                       22
<PAGE>

Hardware and software revenue decreased $6.9 million or 38% from the prior year.
North  American  sales  decreased  $4.3 million or 41% due mainly to the concern
over the  expiration  on July 1,  2001  and  potential  non-renewal  of the bank
agreement as well as the general  economic  environment  for goods and services.
Total international sales decreased $2.6 million or 34% from 2000. International
sales in the Pacific Rim  decreased  79% or $4.6 million due to the  significant
reduction  of spare parts orders and scanner  systems  sold to Japan's  National
Ministry of Health.  Sales to Europe increased $2 million or 122% due to a large
integrated  solution  sale  to the  British  government,  Latin  American  sales
remained  consistent with the prior year mainly due to the continued  decline in
economic conditions in the Latin American countries.

Professional  services  revenue  decreased $1.2 million or 16% from 2000 to 2001
mainly due to the  completion  of various  contracts  during  2001 that were not
completed during 2000 and the slowdown in orders as noted above.

Access services revenue increased $.5 million or 4% from 2000 to 2001 due mainly
to an  increase  in new third  party  maintenance  contracts  and the  increased
retention of existing customers using Scan-Optics manufactured equipment.

Cost of hardware and software  revenue  decreased $5.4 million or 36% from 2000.
Cost of hardware  and  software  revenue as a  percentage  of revenue was 83% in
2001, as compared to 81% in 2000.  This decrease is mainly due to the decline in
hardware and software revenue.

Cost of  professional  services  revenue  decreased  $4.2 million or 51% in 2001
compared  to the prior  year  mainly due to a decrease  in  contractor  expense,
salaries and related benefits and travel expense.  Cost of professional services
revenue as a percentage of revenue was 62% in 2001, as compared to 108% in 2000.

Cost of Access services revenue  remained  consistent from 2000 to 2001. Cost of
Access services  revenue as a percentage of revenue was 85% in 2001, as compared
to 89% in 2000.

Sales and marketing expenses decreased $2 million or 34% from 2000 mainly due to
a decrease in salaries,  commissions and related benefits,  travel expense and a
provision for uncollectable accounts receivable.

Research and development  expenses decreased $.8 million or 21% from 2000 mainly
due to a decrease in consulting expense and salaries and related benefits.

General and administrative expenses decreased $6 million or 60% from 2000 mainly
due to the accounts  receivable  allowance recorded during the fourth quarter of
2000 for various accounts that were determined to be uncollectable which was not
required in 2001 and the recording of the  settlement  of the Southern  Computer
Systems  stock  purchase  agreement  which  forgave  $.5  million  due under the
consulting and non-compete retainer (See Note C).

Interest  expense  decreased $.6 million from 2000 due mainly to a change in the
interest  rate on the Company's  indebtedness.  Both the line of credit and term
loan  carried an  interest  rate of


                                       23
<PAGE>

prime  through  March 24, 2000 when the rate  increased  to prime plus 5%. As of
January 30, 2001 the  interest  rate was reduced to prime plus 2%. The  weighted
average interest rate was 9.8% in 2001 compared to 13.2% in 2000.


RESULTS OF OPERATIONS - 2000 VS. 1999

Total revenues decreased $13.7 million or 26% from 1999 to 2000.

Hardware and software revenue decreased $5.7 million or 24% from the prior year.
North  American  sales  decreased $8.6 million or 45% due mainly to the focus of
the sales  organization on improving  customer  satisfaction  and helping manage
deliverables related to the professional services  implementations underway from
the third and fourth  quarters of 1999.  Product sales were also impacted in the
last three  quarters of 2000 as orders were received but shipments  were delayed
due to the lack of cash  liquidity.  Total  international  sales  increased $2.9
million or 60% from 1999.  International sales in the Pacific Rim increased 114%
or $3.1 million due to a substantial  spare parts sale in support of the systems
installed at the  National  Ministry of Health as well as eight new system sales
for prefecture based claims processing. Sales to Europe decreased $.3 million or
16%, Latin American sales remained  consistent with the prior year mainly due to
the continued decline in economic conditions in the Latin American countries.

Professional  services  revenue  decreased $6.6 million or 47% from 1999 to 2000
due to the  Company's  focus on the  completion  of projects  from the third and
fourth quarters of 1999 as well as a cautious approach to accepting new business
until the past  issues  relating  to  professional  services  deliverables  were
addressed and mitigated.

Access  services  revenue  decreased  $1.4  million or 10% from 1999 to 2000 due
mainly to year 2000 non compliant  systems  removed from  maintenance and either
replaced with new systems that carried  warranty  periods and lower  maintenance
revenues or not replaced at all.

Cost of hardware and software revenue  decreased $1.4 million from 1999 to 2000.
Cost of hardware and software  revenue as a percentage  of hardware and software
revenue  increased from 67% in 1999 to 81% in 2000.  The percentage  increase is
due mainly to a $2.3 million  reduction in software product revenue from 1999 to
2000 which carries a significantly higher gross margin than hardware revenue.

Cost of professional services revenue decreased $4.6 million or 36% from 1999 to
2000 due mainly to the Company completing the majority of the projects that were
in process from the end of 1999 and a reduction in the number and total value of
new projects that were initiated during the year.

Cost of Access services  revenue  decreased $.4 million or 3% due to a reduction
in revenues and continued  management of the field  workforce in relation to the
installed base of customers.

Sales  and  marketing  expenses  decreased  by $2.1  million  in  2000  due to a
reduction in commissions  expense  related  directly to the reduction in revenue
and  reductions in other expenses as part of the increased  management  focus on
expenses.


                                       24
<PAGE>


Research and development  expenses  decreased $2 million from 1999 due mostly to
the  reduction  in  headcount,  outside  contractors  and third party  purchased
services.  The Company is continuing  to refine its focus on software  products,
solutions and specific development activities.  As a result, certain development
skills were no longer required, allowing for the reductions.

General and  administrative  expenses increased $4.9 million in 2000 compared to
the  prior  year.  The  increase  is due to the  accounts  receivable  allowance
recorded for various  accounts that were determined to be  uncollectable  during
the fourth quarter of 2000.

Interest  expense  increased  $1.1 million due to the change in interest rate at
the end of the first quarter of 2000 from prime to prime plus five percent.


LIQUIDITY AND CAPITAL RESOURCES

Cash and cash equivalents increased $1.6 million from 2000 to 2001.

At December 31, 2001, the Company had $11.9 million in  outstanding  borrowings,
with $1.5 million  classified as current,  against its $12.8  million  available
borrowings.   The  Company   anticipates   meeting  its  current  and  long-term
obligations  through the funds generated from operations.  The average borrowing
level  for 2001 was $18.3  million  compared  to $18.1  million  for  2000.  The
increase in borrowing level is directly related to the loss the Company reported
in 2000.

Effective  December 31, 2001, the Company  restructured its loan agreements with
Patriarch Partners,  LLC. ("Patriarch") that contains a forgiveness of a portion
of the term debt,  additional borrowing capability in the short term and reduced
interest expense due to reduced debt levels.  In exchange for the forgiveness of
debt,  the Company  issued  shares of  preferred  stock and warrants to purchase
common  stock.  The debt  agreement  expires on December 31,  2004.  The Company
believes that the restructuring  will allow execution of the Company's  business
plans for the foreseeable  future.  The loan agreement contains covenants which,
among other things,  require the maintenance of minimum earnings before interest
and taxes,  depreciation and amortization,  capital expenditure spending limits,
accounts  receivable  write-offs and backlog levels. (See Note F.) The Company's
ability to  achieve  the  required  financial  covenants  is  premised  upon the
attainment  of 2002  planned  revenue  objectives  and  continued  planned  cost
containment.  The  Company  began the year 2002 with a backlog  in excess of $22
million or 68% of its 2002  revenue  plan and  believes  that it will be able to
achieve its 2002 revenue and cost containment objectives.



                                       25
<PAGE>

The Company's  achievement of its 2002 revenue  forecast is dependent upon sales
of the  Company's  software and  solutions  products and  services.  The Company
continues to focus on achieving  strong software and solutions  revenues in 2002
by, among other  things,  adding six  experienced  software  and solution  sales
people  over the last  several  months.  The market the  Company  addresses  has
experienced  a slow down due to general  economic  conditions  and recent  world
events;  however, the Company continues to believe that there is sound financial
justification  within the user community for acquiring the products and services
it provides,  which should generate ongoing sales. There are also signs over the
last few months indicating  general  improvement in the domestic economy,  which
has  materialized  in  increased  customer and  prospect  activity.  The Company
believes that its strong backlog position as of the beginning of 2002,  combined
with the additions to the sales force and a continued improvement in the economy
within its market will lead to the achievement of its business plan and covenant
compliance. However, there can be no assurance that the Company will achieve its
revenue objectives and covenant compliance. (See Note A.)

The following summarizes the Company's significant  contractual  obligations and
commitments that impact its liquidity.

<TABLE>
<CAPTION>
Contractual Obligations                                    Payments Due by Period
----------------------------------------------------------------------------------------------------------------
(thousands)                                              Less than 1    1- 3 Years   4 - 5 Years  After 5 years
                                              Total         year
----------------------------------------------------------------------------------------------------------------
<S>                                               <C>          <C>            <C>          <C>           <C>
Long term debt                                 $ 10,392                    $ 10,392
Operating leases                                  3,099        $  822         1,492        $  488        $  297
                                          ----------------------------------------------------------------------
Total contractual cash obligations
                                               $ 13,491        $  822      $ 11,884        $  488        $  297
                                          ----------------------------------------------------------------------
</TABLE>

Operating  activities  provided $.9 million of cash in 2001 compared to a use of
cash of $.7 million in 2000.  The  non-cash  expenses in 2001 were $5.1  million
compared to $11.2 million in 2000. The non-cash items relate to  depreciation of
fixed assets which is discussed in net plant and equipment  below,  amortization
of customer service  inventory and software  license,  amortization of goodwill,
provisions  for  losses  on  accounts   receivable,   provisions  for  inventory
obsolescence and deferred taxes.  Other  components of operating  activities are
discussed below.

Net accounts  receivable  and unbilled  receivables  decreased $6.5 million from
December 31, 2000.  There are two main factors  associated with the net decrease
in accounts  receivables.  The first factor is the  collection of older solution
accounts  receivable  whose  collections  were  delayed due to the  professional
service issues encountered in prior years. The second factor is the reduction in
total revenue from 2000 levels.

Total  inventories  decreased  $.4  million  from  2000  levels.   Manufacturing
inventories  increased  $.2  million  during  the  year  due to an  increase  in
work-in-process  inventory  of $.7  million  and a  decrease  in  materials  and
component  parts  of  $.5  million,  mainly  due to the  Company's  increase  in
production  schedule for the first quarter of 2002. The manufacturing  inventory
increase was offset by a decrease in customer  service  inventory of $.6 million
which was mainly attributable to the reduced level of purchases of new inventory
and amortization of spare parts inventory.

Net plant and equipment  decreased $.6 million in 2001.  This decrease is mainly
due to depreciation.

Software license decreased by $.8 million due to amortization of the source code
license recorded during the year.

Goodwill  decreased by $1.7 million in 2001 due to  amortization of $1.3 million
and a $.4  million  adjustment  to goodwill  resulting  from the  settlement  of
disputes  with the former owners of Southern  Computer  Systems (SCS) that arose
under the June 1998  stock  purchase  agreement  pursuant  to which  Scan-Optics
acquired  100% of the equity in SCS.  The  transaction  was  accounted  for as a
purchase  and the excess cost over the fair value of the net assets  acquired of
$8.8 million is being  amortized over a twenty-year  period.  The acquisition of
the maintenance  division of Access Corporation,  which also occurred in June of
1998, was accounted for as a purchase and the excess cost over fair value of the
net assets acquired of $3.5 million is being amortized over a five-year  period.
The acquisition of the scanner and maintenance division of Photomatrix Corp. was
accounted  for as a purchase  and the excess cost over the fair value of the net
assets  acquired of $1.6 million is being  amortized  over an average  period of
twelve and one-half years.

Other  assets  decreased  by $.1  million  mainly due to the  expiration  of the
non-compete agreements with the former principals of SCS.


                                       26
<PAGE>


Accounts  payable  decreased  $2.6  million  from  December  31, 2000 due to the
control of expenses and the timing of payments.

Notes  payable  to  bank  decreased  $6.1  million  related  to the  total  debt
restructuring effective December 31, 2001. (See Note F.)

Salaries and wages  increased $.5 million from 2000 mainly due to the accrual of
a stay bonus for senior  management  and the  severance  accrual  for  headcount
reductions.

Other  current  liabilities  decreased  $.3  million  due  to the  reduction  in
professional service consulting and other accruals.

Other long term liabilities  increased $.2 million mainly due to the deferral of
lease  payments due to Patriarch as part of the total debt  restructuring.  (See
Note F.)

Mandatory  reedemable  preferred stock of $3.8 million was issued by the Company
as part of the total debt restructuring. (See Note F.)

Capital in excess of par increased by $2.7 million due the common stock warrants
issued by the Company as part of the total debt restructuring. (See Note F.)

Foreign currency translation adjustments increased $.3 million due to changes in
exchange  rates on assets and  liabilities  deployed in the Company's two active
subsidiaries in the United Kingdom and Canada.


OTHER MATTERS

New Accounting Standards

Refer to Note B of the Notes to Consolidated  Financial Statements in Item 8 for
a discussion of new accounting  pronouncements  and the potential  impact to the
Company's   consolidated  results  of  operations  and  consolidated   financial
position.

Critical Accounting Policies

The policies  discussed  below are considered by management to be critical to an
understanding of the financial  statements  because their application places the
most significant  demands on management's  judgement,  with financial  reporting
results  relying on estimation  about the effect of matters that are  inherently
uncertain.  Specific risks for these critical  accounting policies are described
in the following paragraphs.

Allowance for doubtful  accounts:  The Company  evaluates the  collectability of
accounts  receivable  based on a  combination  of  factors.  In cases  where the
Company has knowledge of a specific  customer's  inability to meet its financial
obligations (e.g.,  bankruptcy filings,  substantial slow-down in recent payment
history) or contract disputes, a specific reserve for uncollectable amounts will
be  recorded.  For all other  customers,  the Company  records a reserve for bad
debts based on the age of the receivable balance. If circumstances change (i.e.,



                                       27
<PAGE>

higher  than  expected  defaults,   unexpected  material  adverse  change  in  a
significant  customer's ability to meet its financial obligations to the Company
or contract  disputes),  estimates of the collectability of amounts due could be
reduced by a material amount.

Revenue  recognition - percentage of completion:  The Company recognizes revenue
and  profit  on  professional  services  engagements  using  the  percentage  of
completion  method of  accounting,  which relies on estimates of total  expected
contract  revenues and costs.  The Company follows this method since  reasonably
dependable  estimates of the revenue and costs applicable to various stages of a
contract can be made. Since the financial  reporting of these contracts  depends
on estimates,  which are assessed  continually  during the term of the contract,
recognized  revenues  and  profit  are  subject  to  revisions  as the  contract
progresses  to  completion.  Revisions in profit  estimates are reflected in the
period  in  which  the  facts  that  give  rise to the  revision  become  known.
Accordingly,   favorable  changes  in  estimates  result  in  additional  profit
recognition,  and  unfavorable  changes in  estimates  result in the reversal of
previously  recognized revenue and profits. When estimates indicate a loss under
a contract,  the  provision  for such loss is recorded in that  period.  As work
progresses  under a loss contract,  revenue  continues to be  recognized,  and a
portion of the contract costs incurred in each period is charged to the contract
loss reserve.  The estimated  loss is  calculated  and adjusted each period.  If
estimates change, the professional  services revenue,  cost of revenue and gross
margins will be impacted.


Inventories - slow moving and obsolete: The Company performs an annual review of
excess and obsolete  manufacturing  inventories  to  determine if the  inventory
reserve  recorded on the  balance  sheet is adequate to cover the value of parts
deemed excess or obsolete.  The review is based upon current  inventory  levels,
expected  product  sales over the next  twelve to twenty  four months and Access
Services  requirements for spare parts.  Should the Company not achieve expected
product sales or if Access  Services parts  requirements  should change,  future
losses may occur through the  requirement of additional  reserves for excess and
obsolete inventory.


Impairment  of  long-lived  assets:  The Company  records  impairment  losses on
goodwill  and  on  long-lived   assets  used  in  operations   when  events  and
circumstances  indicate  that the assets might be impaired and the  undiscounted
cash flows  estimated  to be  generated  by those  assets are less than net book
value. The Company also evaluates the amortization periods of assets,  including
goodwill  and  other  intangible   assets,   to  determine   whether  events  or
circumstances  warrant revised  estimates of useful lives. If the business plans
the Company utilized to calculate the undiscounted  cash flows are not achieved,
a  potential  impairment  could  exist and a  write-down  of the net book  value
of goodwill could be required.



                                       28
<PAGE>



ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The  Company  recently  completed  a total  debt  restructuring  (see Note F for
further information), however, the Company remains highly leveraged and could be
adversely  affected by a significant  increase in interest  rates. A one percent
increase  in the prime  rate would  increase  the  annual  interest  cost on the
outstanding  loan balance at December 31, 2001 of  approximately  $12 million by
$.1 million.

The Company has minimal foreign  currency  translation  risk. All  international
sales other than sales  originating  from the UK and Canadian  subsidiaries  are
denominated in United States dollars.

Refer  to the  Outlook  section  of  Management's  Discussion  and  Analysis  of
Consolidated Financial Condition and Results of Operations, and to Note A of the
Notes to Consolidated Financial Statements.









                                       29
<PAGE>







              ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





























                                       30
<PAGE>




                         REPORT OF INDEPENDENT AUDITORS


Stockholders and Board of Directors
Scan-Optics, Inc.

We have audited the  accompanying  consolidated  balance sheets of  Scan-Optics,
Inc.  and  subsidiaries  as of  December  31,  2001 and  2000,  and the  related
consolidated statements of operations,  stockholders' equity, and cash flows for
each of the three years in the period ended  December 31, 2001.  Our audits also
included the  financial  statement  schedule  listed in the Index at Item 14(a).
These financial  statements and schedule are the responsibility of the Company's
management.  Our  responsibility  is to express  an  opinion on these  financial
statements and schedule based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly,  in all  material  respects,  the  consolidated  financial  position  of
Scan-Optics,  Inc.  and  subsidiaries  at December  31,  2001 and 2000,  and the
consolidated  results of their  operations  and their cash flows for each of the
three years in the period ended December 31, 2001, in conformity with accounting
principles  generally accepted in the United States.  Also, in our opinion,  the
related financial statement  schedule,  when considered in relation to the basic
financial statements taken as a whole,  presents fairly in all material respects
the information set forth therein.

The  accompanying   financial   statements  have  been  prepared  assuming  that
Scan-Optics,  Inc. will continue as a going concern.  As more fully described in
Note A, the  Company has  incurred  operating  losses for the past three  years.
Effective  December 31, 2001, the Company  restructured its loan agreements with
its lender.  These agreements contain certain financial covenants with which the
Company must comply.  Failure to meet these conditions raises  substantial doubt
about the Company's ability to continue as a going concern.  Management's  plans
in  regard  to  these  matters  are  also  described  in Note A.  The  financial
statements do not include any adjustments to reflect the possible future effects
on  the   recoverability  and  classification  of  assets  or  the  amounts  and
classification  of  liabilities  that  may  result  from  the  outcome  of  this
uncertainty.

/s/ Ernst & Young LLP

Hartford, Connecticut
February 22, 2002






                                       31
<PAGE>



SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS


<TABLE>
<CAPTION>
                                                                                      December 31
(thousands, except share data)                                            2001                              2000
------------------------------------------------------------------------------------------------------------------------
<S>                                                                             <C>                               <C>
Assets
Current Assets:
  Cash and cash equivalents                                       $             1,662               $                36
  Accounts receivable less allowance of $1,936 in
    2001 and $2,926 in 2000                                                     2,252                             8,664
  Unbilled receivables - contracts in progress less
    allowance of $2,689 in 2000                                                   945                             1,064
  Refundable income taxes                                                                                           124
  Inventories                                                                   8,543                             8,898
  Deferred costs, net of revenues                                                 179                               171
  Prepaid expenses and other                                                      325                               798
                                                                --------------------------------------------------------
    Total current assets                                                       13,906                            19,755


Plant and Equipment:
  Equipment                                                                    13,340                            13,574
  Leasehold improvements                                                        5,232                             5,183
  Office furniture and fixtures                                                 1,338                             1,362
                                                                --------------------------------------------------------
                                                                               19,910                            20,119
  Less allowances for depreciation and amortization                            18,530                            18,126
                                                                --------------------------------------------------------
                                                                                1,380                             1,993

Software license, net of accumulated amortization
  of $1,773 in 2001 and  $937 in 2000                                             627                             1,463
Goodwill, net of accumulated amortization of $4,462 in 2001
  and $3,136 in 2000                                                            9,249                            10,975
Other assets                                                                      117                               250
                                                                --------------------------------------------------------

Total Assets                                                      $            25,279               $            34,436
                                                                ========================================================


</TABLE>




                                       32
<PAGE>






<TABLE>
<CAPTION>

                                                                                      December 31
(thousands, except share data)                                            2001                              2000
------------------------------------------------------------------------------------------------------------------------
<S>                                                               <C>                               <C>
Liabilities and Stockholders' Equity
Current liabilities:
  Accounts payable                                                $            3,462                $            6,066
  Notes payable to bank                                                        1,500                            18,000
  Salaries and wages                                                           1,380                               854
  Taxes other than income taxes                                                  524                               393
  Income taxes                                                                     5                               121
  Customer deposits                                                              507                             1,212
  Other                                                                        2,642                             2,942
                                                                --------------------------------------------------------
    Total current liabilities                                                 10,020                            29,588

Note payable to bank                                                          10,392
Other liabilities                                                                707                               541

Mandatory redeemable preferred stock, par value $.02
    per share, authorized 3,800,000 shares;
      3,800,000 issued and outstanding                                         3,800

Stockholders' Equity
  Preferred stock, par value $.02 per share, authorized
    1,200,000 shares; none issued or outstanding
  Common stock, par value $.02 per share,
    authorized 15,000,000 shares; issued 7,439,732
      shares in 2001 and 2000                                                    149                               149
  Common stock Class A Convertible, par
      value $.02 per share, authorized 3,000,000
        shares; available for issuance 2,145,536 shares;
        none issued or outstanding
  Capital in excess of par value                                              38,354                            35,654
  Retained-earnings deficit                                                  (34,498)                          (28,185)
  Accumulated other comprehensive loss                                          (999)                             (665)
                                                                --------------------------------------------------------
                                                                               3,006                             6,953
  Less cost of common stock in treasury,
    413,500 shares                                                             2,646                             2,646
                                                                --------------------------------------------------------
      Total stockholders' equity                                                 360                             4,307
                                                                --------------------------------------------------------
  Total Liabilities and Stockholders' Equity                      $           25,279                $           34,436
                                                                ========================================================
</TABLE>

See accompanying notes.

                                       33
<PAGE>


SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                                      Year Ended December 31
(thousands, except share data)                                               2001               2000                  1999
---------------------------------------------------------------------------------------------------------------------------
<S>                                                             <C>                 <C>                 <C>
Revenues
  Hardware and software                                         $          11,195   $         18,099    $           23,813
  Professional services                                                     6,352              7,534                14,096
  Access services                                                          13,193             12,669                14,083
                                                              -------------------------------------------------------------
    Total revenues                                                         30,740             38,302                51,992

Costs of Revenue
  Hardware and software                                                     9,331             14,685                16,056
  Professional services                                                     3,967              8,121                12,760
  Access services                                                          11,200             11,287                11,657
                                                              -------------------------------------------------------------
    Total costs of revenues                                                24,498             34,093                40,473

      Gross Margin                                                          6,242              4,209                11,519

Operating Expenses
  Sales and marketing expenses                                              3,914              5,909                 7,980
  Research and development expenses                                         2,936              3,720                 5,688
  General and administrative expenses                                       3,899              9,867                 4,950
  Interest expense                                                          1,788              2,393                 1,276
                                                              -------------------------------------------------------------
    Total costs and expenses                                               12,537             21,889                19,894
                                                              -------------------------------------------------------------

Operating loss                                                             (6,295)          (17,680)               (8,375)

Other income (loss), net                                                       15               (29)                  (40)
                                                              -------------------------------------------------------------

Loss before income taxes                                                   (6,280)         (17,709)                (8,415)

  Income tax expense (benefit)                                                 33                 61                 (240)
                                                              -------------------------------------------------------------

Net Loss                                                        $          (6,313)  $       (17,770)    $          (8,175)
                                                              =============================================================

Basic loss per share                                            $            (.90)  $         (2.53)    $           (1.17)
                                                              =============================================================

Basic weighted-average shares                                           7,026,232          7,025,064             6,979,651

Diluted loss per share                                          $            (.90)  $          (2.53)   $           (1.17)
                                                              =============================================================

Diluted weighted-average shares                                         7,026,232          7,025,064             6,979,651

</TABLE>
See accompanying notes.


                                       34
<PAGE>


<TABLE>
<CAPTION>

                                                 SCAN-OPTICS, INC. AND SUBSIDIARIES
                                                     CONSOLIDATED STATEMENTS OF
                                                        STOCKHOLDERS' EQUITY



                                                                                            Accumulated
                                        Common Stock          Capital in        Retained-      Other
                                     -------------------      Excess of         Earnings    Comprehensive  Treasury
 (thousands, except share data)       Shares     Amount       Par Value          Deficit        Loss         Stock         Total
 ----------------------------------------------------------------------------------------------------------------------------------
<S>                                  <C>         <C>          <C>               <C>           <C>          <C>           <C>
 Balance January 1, 1999             7,370,482   $  147       $  35,501         $ (2,240)     $ (516)      $ (2,646)     $ 30,246

   Issuance of common stock upon
     exercise of stock options          25,750        1              67                                                        68
   Net loss                                                                       (8,175)                                  (8,175)
   Currency translation adjustments                                                              (58)                         (58)
                                                                                                                          ---------
   Comprehensive loss                                                                                                      (8,233)
 ----------------------------------------------------------------------------------------------------------------------------------
 Balance December 31, 1999           7,396,232      148          35,568          (10,415)       (574)        (2,646)       22,081
   Issuance of common stock upon
     exercise of stock options          43,500        1              86                                                        87
   Net loss                                                                      (17,770)                                 (17,770)
   Currency translation adjustments                                                              (91)                         (91)
                                                                                                                          ---------
   Comprehensive loss                                                                                                     (17,861)
 ----------------------------------------------------------------------------------------------------------------------------------
 Balance December 31, 2000           7,439,732      149          35,654          (28,185)       (665)        (2,646)        4,307
   Issuance of common stock warrants                              2,700                                                     2,700
   Net loss                                                                       (6,313)                                  (6,313)
   Currency translation adjustments                                                             (334)                        (334)
                                                                                                                          ---------
   Comprehensive loss                                                                                                      (6,647)
 ----------------------------------------------------------------------------------------------------------------------------------
 Balance December 31, 2001           7,439,732   $  149       $  38,354         $(34,498)     $ (999)      $ (2,646)     $    360

 ==================================================================================================================================
</TABLE>

                                                       See accompanying notes.


                                                                 35
<PAGE>


SCAN-OPTICS, INC., AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                     Year Ended December 31
(thousands)                                                      2001          2000          1999
------------------------------------------------------------------------------------------------------
 Operating Activities
<S>                                                           <C>           <C>           <C>
   Net loss                                                   $ (6,313)     $(17,770)     $ (8,175)
   Adjustments to reconcile net loss
     to net cash provided (used) by operating activities:
     Depreciation                                                  677           887         1,115
     Amortization of customer service inventory and
        software license                                         2,886         2,400         1,912
     Amortization of goodwill                                    1,326         1,308         1,251
     Provision for losses on accounts receivable                               5,505            94
     Provision for inventory obsolescence                          178         1,064           229
     Deferred taxes                                                                            697
     Changes in operating assets and liabilities:
       Accounts receivable                                       6,531         8,503          (586)
       Refundable income taxes                                     124         1,158        (1,282)
       Recoverable income taxes                                                  740          (740)
       Inventories                                              (1,873)       (1,578)          450
       Prepaid expenses and other                                  473           178           112
       Software license                                                         (174)       (2,225)
       Accounts payable                                         (2,604)       (2,013)        1,790
       Accrued salaries and wages                                  526          (946)         (424)
       Taxes other than income taxes                               131          (717)          419
       Income taxes                                               (116)          121           (35)
       Deferred costs, net of revenues                              (8)          359           (28)
       Customer deposits                                          (705)         (141)        1,254
       Other                                                      (330)          371           699
                                                           ----------------------------------------
     Net cash provided (used) by operating activities              903          (745)       (3,473)

 Investing Activities
   Business acquisitions, net of cash acquired                                              (2,111)
   Acquisition related settlement                                  400
   Proceeds from the sale of plant and equipment                                 215
   Purchases of plant and equipment, net                           (64)         (122)         (575)
                                                           ----------------------------------------
     Net cash provided (used) by investing activities              336            93        (2,686)

 Financing Activities
   Proceeds from issuance of common stock                                         87            68
   Proceeds from borrowings                                      3,485        25,686        51,941
   Principal payments on borrowings                             (3,098)      (25,123)      (46,028)
                                                           ----------------------------------------
     Net cash provided by financing activities                     387           650         5,981

 Increase (decrease) in cash and cash equivalents                1,626            (2)         (178)
 Cash and Cash Equivalents at Beginning of Year                     36            38           216
                                                           ----------------------------------------
 Cash and Cash Equivalents at End of Year                     $  1,662      $     36      $     38
                                                           ========================================

 Supplemental Cash Flow Information
 Interest paid                                                $  1,579      $  2,301      $  1,229
                                                           ========================================
 Income taxes paid                                            $     61      $      8      $  1,183
                                                           ========================================

</TABLE>

 See accompanying notes


                                       36
<PAGE>

SCAN-OPTICS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE A - DESCRIPTION OF BUSINESS

The  Company   combines   technology,   experience   and  expertise  to  develop
cost-effective  solutions for applications that include  government,  insurance,
assessment,  transportation,  financial and order entry. The Company's  systems,
software  and  services are marketed  worldwide  to  commercial  and  government
organizations  either  directly by the Company's  sales  organization or through
distributors.  The Company also markets with system  integrators and specialized
niche  suppliers.  The  Company's  business is vulnerable to a number of factors
beyond its control.  These include (1) the effect of a weakening in the domestic
and  international  economies which potentially  impacts capital  investments by
customers,  (2)  the  cyclical  nature  of  funding  within  federal  and  state
government   agencies,   (3)  competition   from  similar   products,   (4)  the
implementation of other  technologies which may provide  alternative  solutions,
and (5) the stability of sole source suppliers.

Management's Plan: The accompanying  consolidated financial statements have been
prepared assuming that the Company will continue as a going concern. The Company
experienced  a net loss of $6.3 million in 2001 and has incurred  losses for the
prior two years.  Effective December 31, 2001, the Company restructured its loan
agreements with its lender, which is expected to improve the Company's liquidity
as no  principal  payments  are  required  until  maturity on December 31, 2004,
except  for  excess  cash  flow  recapture.  As  discussed  in  Note  F  to  the
consolidated  financial  statements,  the agreements  contain certain  financial
covenants which,  among other things,  require the Company to achieve  quarterly
planned   earnings  before  interest,   taxes,   depreciation  and  amortization
("EBITDA")  levels during 2002.  The  Company's  ability to achieve the required
EBITDA levels is dependent  upon the  attainment of 2002 planned  revenue levels
and continued planned cost containment each quarter.  If the financial covenants
are not met  during  2002 and a waiver  from the  lender  is not  obtained,  all
outstanding debt could become due and payable.  These matters raise  substantial
doubt about the Company's ability to continue as a going concern.

With respect to attainment  of its revenue plan for 2002,  the Company began the
year with a backlog  of $22.5  million  towards  its 2002  revenue  plan and has
increased its sales force with experienced  software/solutions sales people over
the last several months to assist in increasing  solution  revenues during 2002.
Management is also committed to continuing  its cost  containment  efforts.  The
Company believes that its cost  containment  efforts,  strong backlog  position,
combined  with the additions to the sales force and a continued  improvement  in
the economy  within its targeted  markets,  will lead to the  achievement of its
business plan and covenant compliance.

The consolidated  financial statements do not include any adjustments to reflect
the possible future effects on the  recoverability  and classification of assets
or the amounts and  classification  of  liabilities  that might  result from the
outcome of this uncertainty.

NOTE B - ACCOUNTING POLICIES

Basis  of  Presentation:  The  consolidated  financial  statements  include  the
accounts of  Scan-Optics,  Inc.  and its  subsidiaries,  all  wholly-owned.  All
intercompany  accounts  and  transactions  are  eliminated  in the  consolidated
financial statements. The preparation of financial statements in conformity with
generally accepted  accounting  principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying  notes.  While  management  believes that the estimates and related
assumptions   used  in  the  preparation  of  these  financial   statements  are
appropriate, actual results could differ from those estimates.

Cash Equivalents:  Highly liquid investments  purchased with maturities of three
months or less are considered cash equivalents.

Inventories:  Inventories are valued at the lower of cost  (first-in,  first-out
method) or market. The Company periodically reviews for obsolete and slow-moving
inventory based on historical usage,  future  requirements and anticipated spare
parts demand.

Plant  and  Equipment:  Plant  and  equipment  is  stated  on the basis of cost.
Depreciation is computed principally using the straight-line method over periods
of 3 to 10 years.  Leasehold  improvements are amortized over the useful life of
the improvements or the life of the lease, whichever is shorter.

Intangibles:  Goodwill  relating to the acquisitions  completed in 1998 and 1999
represents  the  excess  cost  over  fair  value of  tangible  and  identifiable
intangible net assets acquired.  It is amortized on a straight-line basis over 5
to 20 years.  Software  license acquired in 1999 is amortized on a straight-line
basis over 3 years.



                                       37
<PAGE>

Impairment  of  Long-Lived  Assets:  The Company  records  impairment  losses on
goodwill  and  on  long-lived   assets  used  in  operations   when  events  and
circumstances  indicate  that the assets might be impaired and the  undiscounted
cash flows  estimated  to be  generated  by those  assets are less than net book
value. The Company also evaluates the amortization periods of assets,  including
goodwill  and  other  intangible   assets,   to  determine   whether  events  or
circumstances warrant revised estimates of useful lives.

Revenue   Recognition:   Revenues   relating  to  sales  of  certain   equipment
(principally  optical  character  recognition  equipment)  are  recognized  upon
acceptance,  shipment, or installation depending on the contract specifications.
When customers,  under the terms of specific  orders or contracts,  request that
the Company  manufacture and invoice the equipment on a bill and hold basis, the
Company  recognizes  revenue  based  upon an  in-house  acceptance  test that is
certified by the customer.

Revenues  under systems  integration  and  professional  services  contracts are
recognized on the basis of the ratio of earned revenue to total contract  price,
after  considering  accumulated  costs  and  estimated  costs to  complete  each
contract or when  services have been  performed  and accepted,  depending on the
nature of the project.  Under fixed price contracts,  the Company may encounter,
and on certain contracts from time to time has encountered, cost overruns caused
by project management  problems and the expense of hiring outside contractors to
assist in project  completions,  as well as changes to  previously  agreed  upon
project designs.  Adjustments to contract cost estimates are made in the periods
in which the facts  requiring  such revisions  become known.  When the estimates
indicate a loss, such loss is provided for when identified.

Revenues from maintenance services are recognized as earned.

Income Taxes:  Deferred  income taxes are provided for  differences  between the
income tax and the financial  reporting  bases of assets and  liabilities at the
statutory tax rates that will be in effect when the  differences are expected to
reverse. A valuation allowance for deferred tax assets is recorded to the extent
the Company cannot  determine that the ultimate  realization of net deferred tax
assets is more  likely  than not.  In making  such  determination,  the  Company
considers   estimated  future  reversals  of  existing  temporary   differences,
estimated future earnings and available tax planning  strategies.  To the extent
that the estimates of these items are reduced or not realized, the amount of the
deferred tax assets considered realizable could be adversely affected.

Stock Based  Compensation:  The Company  generally  grants stock  options to key
employees and members of the Board of Directors  with an exercise price equal to
the fair  value of the shares on the date of grant.  The  Company  accounts  for
stock option grants in accordance with APB Opinion No. 25,  Accounting for Stock
Issued to Employees,  and,  accordingly,  recognizes no compensation expense for
the stock  option  grants.  Therefore,  the Company  has elected the  disclosure
provisions only of FASB Statement No. 123.

Earnings  (Loss)  Per  Share:  Basic and  diluted  earnings  (loss) per share is
calculated in accordance  with FASB Statement No. 128,  Earnings Per Share.  For
2001,  2000 and 1999, the  computation of diluted  earnings (loss) per share was
antidilutive,  therefore,  the amounts  reported for basic and diluted  earnings
(loss) per share were the same.


                                       38
<PAGE>

Foreign Currency  Translation:  The financial statements of foreign subsidiaries
have been translated into U.S. dollars in accordance with FASB Statement No. 52,
Foreign  Currency  Translation.  All balance sheet accounts have been translated
using the  exchange  rates in effect at the  balance  sheet date.  Statement  of
operations  amounts have been translated using the average exchange rate for the
year.  The gains and losses  resulting  from the changes in exchange  rates from
year to year have been  reported in other  comprehensive  loss,  a component  of
Stockholders' Equity.

Reclassifications:  Certain  2000 and 1999  amounts  have been  reclassified  to
conform to the current year presentation.

New Accounting Pronouncements

In  July  2001,  the  Financial   Accounting  Standards  Board  ("FASB")  issued
Statements of Financial  Accounting  Standards No. 141, "Business  Combinations"
and  142,"Goodwill  and Other  Intangibles".  Statement  No.  141  requires  all
business  combinations  initiated  after June 30, 2001 to be accounted for using
the purchase method of accounting.  Statement No. 142 eliminates amortization of
goodwill and requires at least an annual  assessment for  impairment  applying a
fair value  based test.  Furthermore,  an acquired  intangible  asset  should be
separately recognized if the benefit of the intangible asset is obtained through
contractual  or other  legal  rights,  or if the  intangible  asset can be sold,
transferred, licensed, rented, or exchanged, regardless of the acquirer's intent
to do so. The  Company is required  to adopt  Statement  No. 142 for fiscal year
2002  and  management  does  not  believe  there  will be any  financial  impact
associated with the adoption.  The Company incurred $1.3 million of amortization
expense related to goodwill during 2001.


NOTE C- Acquisition Activities

During June 1999,  the Company  completed the  acquisition of the product rights
and  certain  assets of the  Photomatrix  Imaging  Corporation's  subsidiary  of
Photomatrix,  Inc.  for $2.1  million in cash.  The  Company  acquired  accounts
receivable  net of reserves of $1 million,  manufacturing  and customer  service
inventory  net of reserves of $1.2 million and other assets of $.1 million.  The
Company also assumed  liabilities for accounts payable of $.8 million,  deferred
revenue  of $.5  million,  salary  and  benefits  accruals  of $.2  million  and
acquisition  related expenses of $.3 million.  The acquisition was accounted for
as a purchase and the operations are included in the  consolidated  statement of
operations from the date of acquisition.  The Company reported  goodwill related
to the transaction of $1.6 million, which is amortized over an average period of
twelve and one-half years. Subsequent to the acquisition date adjustments of $.6
million have been made to decrease goodwill to $1 million.

On June 19,  2001 the Company  reached a  settlement  with the former  owners of
Southern  Computer  Systems (SCS)  regarding  certain  disputes that arose under
their original stock purchase  agreement executed in June 1998 pursuant to which
Scan-Optics  acquired  100% of the equity in SCS. As part of the stock  purchase
agreement,  Scan-Optics  was  required  to make  certain  payments to the former
owners of SCS in connection  with a consulting and  non-compete  agreement.  The
stock purchase  agreement also required the deposit of funds in a representation
and  warranty  general  escrow,  which  funds were to be  released to the former
owners of SCS on the second anniversary following the


                                       39
<PAGE>

date of purchase.  The settlement provided for the release of all claims made by
Scan-Optics  relating to the former owners'  representations  and warranties and
the  release of all claims made by the former  owners  against  Scan-Optics.  In
exchange for this release,  the former owners  forgave $.5 million due under the
consulting and  non-compete  agreements and made a cash payment from the general
escrow account of $.4 million to Scan-Optics. The forgiveness of the $.5 million
for the  consulting  and  non-compete  retainer  was  recorded as a reduction in
Scan-Optics'  general and administrative  expense in the second quarter of 2001.
The $.4 million  payment from the general escrow account was accounted for as an
adjustment of the original purchase price through a decrease in goodwill.

The  Company  prepared a  detailed  analysis  in  accordance  with FASB 121,  at
December 31, 2001. Based upon the  undiscounted  cash flow analysis of the three
individual business segments,  no impairment of goodwill in any of the Company's
business segments exists at December 31, 2001.

The Company determines the amount of goodwill and the amortization  period based
upon a review of the acquired business and its earnings potential.


NOTE D - UNBILLED RECEIVABLES - CONTRACTS IN PROGRESS

Amounts billed under  contracts in progress and included in accounts  receivable
were $.1 million and $1.3 million at December  31, 2001 and 2000,  respectively.
Unbilled  amounts in  accounts  receivable  were $.9  million  and $1 million at
December 31, 2001 and 2000,  respectively  and are recoverable from the customer
upon  completion  of  the  phase  or  milestone.


NOTE E- INVENTORIES

The components of inventories were as follows:
                                               December 31
(thousands)                                 2001             2000
-----------------------------------------------------------------
Finished goods                        $      199       $      196
Work-in-process                            1,604              846
Service parts                              3,941            4,552
Materials and component parts              2,799            3,304
                                       --------------------------
                                        $  8,543          $ 8,898
                                        =========================


NOTE F - CREDIT ARRANGEMENTS

On May 10, 1999, the Company amended its credit agreement (the "Agreement") with
a bank to extend the  maturity  date to May 10, 2002 and to reduce the line from
$13  million  to $10  million.  The  unused  portion of the line is subject to a
commitment  fee of 3/8% per annum.


                                       40
<PAGE>

Additionally,  on May 10,  1999,  a  five-year  term  loan in the  amount of $10
million was established to better match the cash  expenditures  for acquisitions
with the cash flow that results from the acquired  businesses.  The  outstanding
balance on the term loan at December 31, 2000 was $8.5 million,  all of which is
classified as a current  liability on the consolidated  balance sheet.  Both the
line of credit and the term loan bore  interest at prime through March 24, 2000,
at which point the rate increased to prime plus 5%.

Fleet National Bank sold the Agreement to Patriarch Partners,  LLC on January 4,
2001. The Agreement contains  covenants which,  among other things,  require the
maintenance of specified  working  capital,  debt to equity  ratios,  net income
levels,  tangible net worth levels and backlog levels.  The Company entered into
an amendment and waiver  agreement with Patriarch  Partners,  LLC on January 31,
2001 that waived  defaults on the revolver and term loans  through July 1, 2001.
The amendment also reduced the interest rate to prime plus 2% effective  January
30, 2001.

Effective  December 31, 2001, the Company  restructured its loan agreements with
Patriarch Partners, LLC. ("Patriarch"). The restructuring includes the following
terms:

     o    The maturity date of the Company's  Loan  Agreement  with Patriarch is
          extended through December 31, 2004.

     o    Patriarch's  commitment under the Company's existing revolving line of
          credit was increased from $10 million to $10.75 million until June 30,
          2002, at which point the commitment amount will return to $10 million.
          All  revolving  loans  continue to accrue  interest at a rate of prime
          plus 2%.

     o    The  Company's  existing term loan was reduced from $8.5 million to $2
          million and  continues to accrue  interest at a rate of prime plus 2%.
          No principal  payments are required on the term loan until maturity on
          December 31, 2004. The agreement  contains a provision that allows for
          the quarterly recapture of fifty percent of the excess cash flow to be
          applied to the term loan,  based upon the  calculation of consolidated
          cash  flow  minus  the  aggregate  amount  of  consolidated  financial
          obligations.

     o    The  Company  issued  to  Patriarch,  shares  of  preferred  stock and
          warrants to purchase  common stock in exchange for  forgiveness of the
          remaining $6.5 million balance of the term loan.

     o    The warrants represent the right to purchase up to 4,975,000 shares of
          common stock of the Company,  or  approximately  33% of the  currently
          outstanding  shares,  plus  shares  reserved  for stock  options.  The
          Company may  repurchase  the warrants once the term loan and revolving
          loan are paid off, if the Company  also redeems the  preferred  stock.
          The  repurchase  price of the  warrants is $2.7  million  plus accrued
          interest calculated at prime plus 2%. In addition, if the warrants are
          repurchased in 2002,  10% of the Company's  common stock will transfer
          to  Patriarch.  This amount  increases to 15% in 2003 and 30% in 2004.
          The warrants are not exercisable until after December 31, 2004, except
          upon certain events of default.  The exercise price of the warrants is
          $.02 per share. The warrants are accounted for as an equity instrument
          through an increase to additional paid in capital.

     o    The  mandatory  redeemable  preferred  stock  ("preferred  stock")  is
          subject to redemption  for $3.8 million plus interest at prime plus 2%
          on December 31, 2004.  The preferred  stock is non-voting  except upon
          exercise of the warrants.  The preferred stock is accounted as a quasi
          equity instrument found on the balance sheet between other liabilities
          and stockholders' equity.





                                       41
<PAGE>

     o    All monthly lease  payments  owed to Patriarch  have been deferred and
          become due on December 31, 2004. The lease  obligation that accrues on
          a monthly basis will be added to the term loan.

     o    The Agreement contains  covenants which,  among other things,  require
          the   maintenance  of  minimum   earnings  before   interest,   taxes,
          depreciation and amortization,  capital  expenditure  spending limits,
          accounts receivable write-offs and backlog levels.

As a result of the debt  restructuring the term loan as of December 31, 2001 was
reduced by $6.5  million and  warrants to purchase  common stock of $2.7 million
were  recorded  as paid in  capital  and  preferred  stock of $3.8  million  was
recorded, accordingly, no gain resulted from the transaction.



At December 31, 2001, the Company had $11.9 million in  outstanding  borrowings.
The  revolving  line of  credit  has  been  classified  as long  term,  with the
exception  of $1.5  million  classified  as current,  since  management  has the
ability to maintain the December 31, 2001  outstanding  balance  through  fiscal
year 2002. The available  balance on the outstanding  borrowings was $.9 million
and $.5 million at December 31, 2001 and December  31, 2000,  respectively.  The
weighted average  interest rate on borrowings  during 2001 and 2000 was 9.8% and
13.2%, respectively.

The carrying value of the notes payable to bank  approximates its fair value and
is secured by all of the Company's assets.


NOTE G- CAPITAL STOCK

The Board of Directors is authorized to issue shares of the Company's  preferred
stock in  series,  to  establish  from  time to time the  number of shares to be
included  in each series and to fix the  designation,  powers,  preferences  and
other terms and conditions  with respect to such stock. As of December 31, 2001,
the Company issued  3,800,000  shares of mandatory  redeemable  preferred stock.
These shares do not contain voting rights until the warrants issued to Patriarch
are exercised.

At December 31, 2001, the Company had reserved  2,357,955 shares of common stock
for the  issuance or exercise of stock  options.  The Company has also  reserved
4,975,000 shares of common stock, as part of the total debt  restructuring,  for
the exercise of warrants.(See Note F)

Class A Convertible  stock has the same rights as common stock,  except that its
holders may not vote for the election of directors,  and it is convertible  into
common stock on a share for share basis.  On September 2, 1994, all  outstanding
shares of Class A Convertible  stock were  converted to common stock.  No shares
were outstanding at December 31, 2001 and 2000.


NOTE H - STOCK OPTION PLANS

The Company has elected to follow  Accounting  Principles  Board Opinion No. 25,
Accounting   for  Stock   Issued  to   Employees   (APB  No.  25)  and   related
interpretations  in accounting for its stock options.  Under APB No. 25, because


                                       42

<PAGE>

the exercise  price of the Company's  stock  options  equals market price of the
underlying stock on the date of grant, no compensation expense is recognized.

The Company has six stock  option  plans for key  employees  and board  members.
Options  granted under the plans are for a period of ten years and at prices not
less than 85% of the fair market  value of the shares at date of grant.  Options
for employees are not  exercisable  for one year following the date of grant and
then are exercisable in such installments during the period prior to expiration,
as the Stock  Option  and  Executive  Compensation  Committee  shall  determine.
Options for senior  management that were granted on December 31, 2001 as part of
the total debt  restructuring  are not  exercisable  until six months  after the
grant thereof.  Options for Directors are also not exercisable  until six months
after the grant thereof.  Options may be exercised from time to time, in part or
as a whole,  on a  cumulative  basis  as  determined  by the  Stock  Option  and
Executive Compensation Committee under all stock option plans.


The following  schedule  summarizes the changes in stock options for each of the
three years in the period ended December 31, 2001:

<TABLE>
<CAPTION>
                                                        Number of          Option Price
                                                         Shares              Per Share
------------------------------------------------------------------------------------------
<S>                                                       <C>             <C>        <C>
Outstanding January 1, 1999 (531,420 exercisable)         688,433        $1.50  to  $9.19
  Granted                                                 140,000         3.25  to   3.50
  Exercised                                               (25,750)        2.00  to   3.25
  Canceled                                                (47,700)        2.00  to   9.19
                                                        ---------------------------------
Outstanding December 31, 1999 (560,457 exercisable)       754,983         1.50  to   9.19

2000 Activity
  Granted                                                 561,700          .31  to   1.06
  Surrendered                                             (42,500)        6.38  to   9.19
  Exercised                                               (43,500)        2.00  to   2.00
  Canceled                                               (108,550)        1.06  to   5.75
                                                       ----------------------------------
Outstanding December 31, 2000 (545,245 exercisable)     1,122,133          .31  to   9.19

2001 Activity
  Granted                                               1,145,000          .24  to    .25
  Canceled                                                (69,050)         .31  to   3.69
                                                        ---------------------------------
Outstanding December 31, 2001 (782,261 exercisable)     2,198,033         $.24  to  $9.19
                                                        ==================================
</TABLE>


At December 31, 2001 there were  159,872  options  available  for grant of which
90,000 were reserved for the Directors.

The  weighted-average  fair value of options  granted  was $.24,  $.46 and $3.45
during  2001,  2000,  and 1999,  respectively.  The  weighted-average  remaining
contractual life of the options outstanding at December 31, 2001 was 8 years.


                                       44
<PAGE>

Pro forma information regarding net income and earnings per share is required by
FASB Statement No. 123, and has been  determined as if the Company had accounted
for its stock  options under the fair value method of that  Statement.  The fair
value of these options was estimated at the date of grant using a  Black-Scholes
option pricing model.

Option  valuation  models  require  the input of highly  subjective  assumptions
including  the expected  stock price  volatility.  The  assumptions  used in the
valuation model were: risk free interest rate - 7%, expected life - 10 years and
expected volatility of 1.24 to 1.50.

Because the Company's stock options have characteristics significantly different
from  those of traded  options,  and  because  changes in the  subjective  input
assumptions  can  materially  affect the fair value  estimate,  in  management's
opinion,  the  existing  models do not  necessarily  provide a  reliable  single
measure of the fair value of its stock options.


For the purpose of pro forma disclosures,  the estimated fair value of the stock
options is expensed ratably over the vesting period,  which is 36 months for key
employees and 6 months for the Board of Directors. Options for senior management
that were granted on December  31, 2001 as part of the total debt  restructuring
are  exercisable  six months after the date of grant.  The  Company's  pro forma
information follows:

<TABLE>
<CAPTION>
                                                                  December 31
(thousands, except per share amounts)                  2001            2000          1999
------------------------------------------------------------------------------------------
<S>                                                 <C>            <C>             <C>
  Net loss, as reported                             $  (6,313)     $  (17,770)     $(8,175)
  Stock option expense                                   (134)            (51)        (693)
                                                ------------------------------------------
  Pro forma net loss                                $  (6,447)     $  (17,821)     $(8,868)
                                                ==========================================

  Basic and diluted loss per share, as reported     $    (.90)     $    (2.53)     $ (1.17)
  Stock option expense                                   (.02)           (.01)        (.10)
                                                -------------------------------------------
  Pro forma basic and diluted loss per share        $    (.92)     $    (2.54)     $ (1.27)
                                                ==========================================
</TABLE>


NOTE I - RESEARCH AND DEVELOPMENT AGREEMENTS

During 1999,  the Company  entered into four custom  development  agreements for
specific   customers.   A  $125,000   agreement   involved  the  development  of
localization  software for screen displays in Japanese. A $115,000 agreement was
for recognition  enhancements to a current product. A $75,000 agreement involved
enhancements for the reading of Japanese stock certificates. A $58,000 agreement
involved  software  developments  for the  processing  of mortgage  payments and
taxes. The Company recorded all revenue related to these development  agreements
in 1999. These revenues offset the related costs incurred for this  development.
The ownership of these  technologies  remains with the Company.  No royalties or
other considerations are required as part of these agreements.

During 2000 and 2001, the Company completed a number of small custom development
contracts for specific customers resulting in revenue of approximately  $200,000
and $110,000, respectively. These revenues offset the related costs incurred for



                                       44
<PAGE>

this development.  The ownership of these technologies remains with the Company.
No royalties or other considerations are required as part of these agreements.


NOTE J - EMPLOYEE BENEFITS

The Company  maintains a Retirement  Savings Plan for United  States  employees.
Under this plan,  all  employees  may  contribute up to 15% of their salary to a
retirement  account up to the maximum amount  allowed by law.  Starting in 1997,
the Company  contributed  an amount equal to 50% of the first 6%  contributed by
the  participant  and in 2001,  the employer  match was  increased to 67% of the
first 6%. The Company's  contributions to this plan were $254,000,  $306,000 and
$374,000, in 2001, 2000 and 1999, respectively.

The Company  sponsors an Employee  Stock  Ownership  Plan (the "Plan")  covering
substantially  all  full-time  employees.  The  Plan,  which is a tax  qualified
employee  benefit plan,  was adopted by the Board of Directors of the Company in
1988 to provide retirement benefits for employees.  The Plan borrowed $1,325,000
to  purchase   260,000  shares  of  the  Company's  stock  to  be  allocated  to
participants ratably over a ten year period. The ESOP loan was guaranteed by the
Company and the outstanding  balance of the loan was repaid in 1991. The Company
did not allocate any  additional  shares to the Plan in 2001,  2000 or 1999.  At
December  31,  1998,  all  shares  had  been  allocated.  The  Company,  at  its
discretion, may make annual allocations to the Plan in the future. There were no
expenses related to the Plan in 2001, 2000 and 1999.


NOTE K - INCOME TAXES

At December  31, 2001,  the Company has U.S.  federal and state  operating  loss
carryforwards of approximately  $25,140,000 and $27,630,000,  respectively.  The
U.S. federal and state net operating loss carryforwards  expire through 2021. At
December  31,  2001,  the Company has  approximately  $400,000,  $3,500,000  and
$800,000 of net operating loss  carryforwards for Canada, the United Kingdom and
Germany,  respectively,  which begin to expire in 2007. For financial  reporting
purposes,  a valuation  allowance  has been  recorded for 2001 and 2000 to fully
offset  deferred tax assets  relating to U.S.  federal,  state,  and foreign net
operating loss carryforwards and other temporary differences.

Loss before income taxes is set forth in the following tabulation:

                                         Year Ended December 31
(thousands)                         2001             2000            1999
---------------------------------------------------------------------------
Domestic                     $  (6,270)         $(17,436)          $(7,806)
Foreign                            (10)             (273)             (609)
                             ----------------------------------------------
Loss before income taxes     $  (6,280)         $(17,709)          $(8,415)
                             ==============================================




                                       45
<PAGE>



Income taxes (benefit) are summarized as follows:
                                              Year Ended December 31
(thousands)                              2001             2000            1999
------------------------------------------------------------------------------
Current (benefit):
  Federal                                                              $  (956)
  State                             $       28        $      49             26
  Foreign                                    5               12             (7)
                                    ------------------------------------------
Total current (benefit)             $       33        $      61        $  (937)
                                    ------------------------------------------
Deferred (benefit):
  Federal                                                                  620
  State                                                                     77
                                    ------------------------------------------
Total deferred (benefit)                                               $   697
                                    ------------------------------------------

                                    $       33        $      61        $ (240)
                                    ==========================================

Significant components of the Company's deferred tax liabilities and assets were
as follows:

                                                          December 31
(thousands)                                          2001           2000
---------------------------------------------------------------------------
 Deferred tax assets:
   Net operating loss carryforward                 $8,557           $ 8,556
   Alternative minimum tax credit carryforward        168               168
   Depreciation                                        92                92
   Charitable contribution carryforward                37                53
   Inventory valuation                                586               553
   Inventory                                          328               180
   Accounts receivable reserves                       669             2,057
   Goodwill                                           604               206
   Vacation accrual                                   209               216
   Other                                              157               156
                                                 --------------------------
      Total gross deferred tax assets              11,407            12,237

Deferred tax liabilities:
Depreciation and other                               (359)             (449)
                                                 ---------------------------
      Total gross deferred tax liabilities           (359)             (449)

Valuation allowance                               (11,048)          (11,788)
                                                  --------------------------
      Net deferred tax asset                     $     --           $    --
                                                 ===========================



                                       47

<PAGE>



A reconciliation of the statutory tax rate to the effective rate is as follows:

                                                   Year Ended December 31
                                                2001      2000        1999
---------------------------------------------------------------------------
Statutory federal income tax rate               (34)%      (34)%      (34)%
  State income taxes, net of federal benefit   .44          .3          1
  Adjustments to prior year taxes                                      (3)
  Foreign income taxes                                      .1          2
  Net operating loss carryforward               34          34         33
  Other                                        .09                     (2)
                                               -----------------------------
Effective tax rate                             .53%         .4%        (3)%
                                               =============================


NOTE L - LEASE COMMITMENTS

The  Company's  principal  lease  commitment  is for its  corporate  office  and
manufacturing facility in Manchester,  Connecticut. The Manchester lease expires
on December 31, 2006.  Minimum  rental  payments for all  noncancelable  leases,
which are  operating  leases  with terms equal to or in excess of one year as of
December 31, 2001, are as follows:
                                                Minimum Rental
(thousands)                                         Payments
--------------------------------------------------------------

           2002                                     $   822
           2003                                         657
           2004                                         412
           2005                                         423
           2006                                         438
           Thereafter                                   347
                                                    -------

           Total minimum lease payments             $ 3,099
                                                    =======

Rental  expense  for the years  ended  December  31,  2001,  2000,  and 1999 was
$718,000, $1,114,000, and $1,062,000, respectively.


NOTE M - CONTINGENCIES

There are two lawsuits currently pending against the Company.  Both lawsuits are
in reaction to lawsuits filed by the Company  against the  plaintiffs.  Although
the ultimate  outcome is uncertain,  based on currently known facts, the Company
believes that it has strong  defenses  against these lawsuits and the resolution
of these  matters  will not have a  material  adverse  effect  on the  Company's
financial position or annual operating results.



                                       47
<PAGE>



NOTE N - SEGMENT INFORMATION

Business  segment data and geographic  area data for the years ended 2001,  2000
and 1999 as  included  in Item 1 of this  report are an  integral  part of these
financial statements.


NOTE O - BILL AND HOLD TRANSACTIONS

Revenues relating to sales of certain equipment  (principally  optical character
recognition equipment) are recognized upon acceptance, shipment, or installation
depending on the contract  specifications.  When  customers,  under the terms of
specific orders or contracts,  request that the Company  manufacture and invoice
the  equipment on a bill and hold basis,  the Company  recognizes  revenue based
upon an in-house  acceptance  test that is certified by the  customer.  Revenues
recorded during 2001, 2000, and 1999 included bill and hold  transactions of $.1
million,  $1.7  million  and $5.6  million,  respectively.  Accounts  receivable
included  bill and hold  receivables  of $.1 million and $.4 million at December
31, 2001 and 2000, respectively.


NOTE P - EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per
share:

<TABLE>
<CAPTION>
                                                                 December 31
(thousands, except share data)                       2001           2000           1999
----------------------------------------------------------------------------------------------
<S>                                                 <C>             <C>           <C>
Numerator:
      Net Loss                                      $ (6,313)       $(17,770)     $  (8,175)
                                                ==============================================


Denominator:
      Denominator for basic and diluted
      loss per share (weighted-average              7,026,232      7,025,064       6,979,651
      shares)
                                                ==============================================

Basic loss per share                                  $  (.90)      $  (2.53)      $  (1.17)
                                                ==============================================

Diluted loss per share                                $  (.90)      $  (2.53)      $  (1.17)
                                                ==============================================
</TABLE>



                                       49
<PAGE>



NOTE Q - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

The following is a summary of the quarterly  results of operations for the years
ended December 31, 2001 and 2000.

<TABLE>
<CAPTION>
(thousands, except per share amounts)            March          June       September         December
-----------------------------------------------------------------------------------------------------

2001
<S>                                            <C>           <C>           <C>               <C>
Revenues                                       $ 10,908      $  6,991      $  5,586          $  7,255
Cost of product sales and service expenses        8,336         5,338         4,547             6,277
Net loss                                           (664)         (940)       (1,809)           (2,900)
Basic loss per share                               (.09)         (.13)         (.26)             (.41)
Diluted loss per share                         $   (.09)     $   (.13)     $   (.26)         $   (.41)

2000
Revenues                                       $ 11,102      $  9,924      $ 10,015          $  7,261
Cost of product sales and service expenses        9,186         8,847         7,719             8,341
Net loss                                         (2,275)       (3,256)       (1,781)          (10,458)
Basic loss per share                               (.32)         (.46)         (.25)            (1.49)
Diluted loss per share                         $   (.32)     $   (.46)     $   (.25)         $  (1.49)
</TABLE>


Fourth quarter 2001 net loss of $2.9 million includes charges to expense of $1.5
million or $.21 per share.  The major  components of these  charges  include $.4
million  of  inventory  reserves  related  to  obsolete  parts,  $.2  million of
additional  amortization  of Access  Services  parts  inventory,  $.2 million of
accrued severance costs, $.3 million of accrued lease expense and $.4 million of
a management stay bonus.

Fourth  quarter 2000 net loss of $10.5  million  includes  charges to expense of
$6.3 million or $.90 per share.  The major  components of these charges  include
$5.3 million of accounts receivable allowances for various accounts, $.7 million
for inventories and an investment in a contract manufacturing  customer, and $.3
million of inventory reserves.



                                       49
<PAGE>


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


None.





                                    PART III

ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information  pertaining to Directors and  additional  information  pertaining to
Executive  Officers is included  under the captions  "Governance of the Company"
and  "Compliance  with Section 16(a) of the Securities  Exchange Act of 1934" in
the Company's  definitive proxy statement for the Annual Meeting of Stockholders
to be held on June 6, 2002 and is  incorporated  herein by reference  and made a
part hereof.

ITEM 11 - EXECUTIVE COMPENSATION

This information is included in the Company's definitive proxy statement for the
Annual Meeting of  Stockholders  to be held on June 6, 2002 and is  incorporated
herein by reference.

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

This information is included under the captions  "Security  Ownership of Certain
Beneficial  Owners"  and  "Share  Ownership  of  Management"  in  the  Company's
definitive  proxy statement for the Annual Meeting of Stockholders to be held on
June 6, 2002 and is incorporated herein by reference.

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

This  information is included under the caption  "Certain  Transactions"  in the
Company's  definitive  proxy statement for the Annual Meeting of Stockholders to
be held on June 6, 2002 and is incorporated herein by reference.


                                       50
<PAGE>



                                     PART IV

ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K

(a) The following  consolidated  financial  statements and report of independent
auditors of the Company and its subsidiaries are included in Item 8:

         (1)     Report of Independent Auditors

                 Consolidated Balance Sheets at December 31, 2001 and 2000

                 Consolidated Statements of Operations for the years ended
                 December 31, 2001, 2000 and 1999

                 Consolidated Statements of Stockholders' Equity for the
                 years ended December 31, 2001, 2000 and 1999

                 Consolidated Statements of Cash Flows for the years ended
                 December 31, 2001, 2000 and 1999

                 Notes to Consolidated Financial Statements - December 31, 2001

         (2)     The following consolidated financial statement schedule is
                 included in Item 14(a):

                   Schedule II -- Valuation and Qualifying Accounts


All other  schedules for which  provision is made in the  applicable  accounting
regulation of the Securities and Exchange  Commission are not required under the
related instructions or are inapplicable, and therefore have been omitted.

         (3)               Listing of Exhibits

         *3.1(a)  Certificate of  Incorporation,  including  amendments  thereto
                  (filed as Exhibit 3.1 to the Company's  Registration Statement
                  on Form S-1, File No. 2-70277).

         *3.1(b)  Amendments to  Certificate  of  Incorporation  adopted May 17,
                  1984,  included  in  Exhibits  A, B, C and D in the  Company's
                  Proxy Statement dated April 17, 1984 for the Annual Meeting of
                  Stockholders held May 17, 1984.

         *3.1(c)  Amendment to Article Tenth of the Certificate of Incorporation
                  included as Exhibit A in the Company's  Proxy  Statement dated
                  April 16, 1987 for the Annual Meeting of Stockholders held May
                  19, 1987.



                                       51
<PAGE>

         *3.2(a)  By-laws of the Company  (filed as Exhibit 3.2 to the Company's
                  Registration Statement on Form S-1, File No. 2-70277).

         *3.2(b)  Amendments  to By-laws of the Company  adopted  May 17,  1984,
                  included in Exhibits A and B in the Company's  Proxy Statement
                  dated  April 17, 1984 for the Annual  Meeting of  Stockholders
                  held May 17, 1984.

         *3.2(c)  Amendment to By-laws of the Company  adopted at the meeting of
                  the Board of  Directors  on  January  28,  1991,  included  as
                  Exhibit  3.2(c)  in the  Company's  Annual  Report on Form 10K
                  filed for the year ended December 31, 1991.

         *+10.2   The Scan-Optics,  Inc. 1984 Incentive and Non-Qualified  Stock
                  Option  Plan  included  in  Exhibit E in the  Company's  Proxy
                  Statement  dated  April 19,  1984 for the  Annual  Meeting  of
                  Stockholders held on May 17, 1984.

         *+10.3   The Scan-Optics,  Inc. 1987 Incentive and Non-Qualified  Stock
                  Option  Plan  included  in  Exhibit B in the  Company's  Proxy
                  Statement  dated  April 16,  1987 for the  Annual  Meeting  of
                  Stockholders held on May 19, 1987.

         *+10.4   The Scan-Optics,  Inc. 1990 Incentive and Non-Qualified  Stock
                  Option  Plan  included  in  Exhibit A in the  Company's  Proxy
                  Statement  dated  April 30,  1990 for the  Annual  Meeting  of
                  Stockholders held on June 12, 1990.

         *+10.5   The  Scan-Optics,  Inc.  1990 Stock  Option  Plan for  Outside
                  Directors  included  in  Exhibit  B  in  the  Company's  Proxy
                  Statement  dated  April 30,  1990 for the  Annual  Meeting  of
                  Stockholders held on June 12, 1990.

         *+10.6   The Scan-Optics,  Inc. 1990 Incentive and Non-Qualified  Stock
                  Option  Plan  amendment  included  as Item 2 in the  Company's
                  Proxy Statement dated April 14, 1994 for the Annual Meeting of
                  Stockholders held on May 18, 1994.

         *+10.7   The  Scan-Optics,  Inc.  1990 Stock  Option  Plan for  Outside
                  Directors  amendment included as Item 2 in the Company's Proxy
                  Statement  dated  April 15,  1996 for the  Annual  Meeting  of
                  Stockholders held on May 15, 1996.

         *+10.8   The Scan-Optics,  Inc. 1999 Incentive and Non-Qualified  Stock
                  Option  Plan  included  in  Exhibit A in the  Company's  Proxy
                  Statement  dated  April 8,  1999  for the  Annual  Meeting  of
                  Stockholders held on May 20, 1999.

         *+10.9   Employment  agreement,  effective  as of  December  31,  1996,
                  between  Scan-Optics,  Inc.  and James C.  Mavel,  included as
                  Exhibit  10.10 in the  Company's  Annual  Report  on Form 10-K
                  filed for the year ended December 31, 1996.

         *+10.10  Executive  severance  agreement  between  Joseph P. Crouch and
                  Scan-Optics, Inc. dated November 15, 1999, is filed as Exhibit
                  10.10 in the  Company's  Annual  Report on Form 10-K filed for
                  the year ended December 31, 1999.


                                       52
<PAGE>

         *+10.11  Executive  severance  agreement between Marianna C. Emanuelson
                  and  Scan-Optics,  Inc.  dated  November 17, 1997, is filed as
                  Exhibit  10.11 in the  Company's  Annual  Report  on Form 10-K
                  filed for the year ended December 31, 1999.

         *+10.12  Executive  severance  agreement between Richard C. Goyette and
                  Scan-Optics, Inc. dated November 17, 1997, is filed as Exhibit
                  10.12 in the  Company's  Annual  Report on Form 10-K filed for
                  the year ended December 31, 1999.

         *+10.13  Executive  severance  agreement  between  Joel K.  Howser  and
                  Scan-Optics, Inc. dated November 17, 1997, is filed as Exhibit
                  10.13 in the  Company's  Annual  Report on Form 10-K filed for
                  the year ended December 31, 1999.

         *+10.14  Executive  severance  agreement  between  Clarence W. Rife and
                  Scan-Optics, Inc. dated November 17, 1997, is filed as Exhibit
                  10.14 in the  Company's  Annual  Report on Form 10-K filed for
                  the year ended December 31, 1999.

         *+10.15  Executive  severance  agreement between Michael J. Villano and
                  Scan-Optics, Inc. dated November 17, 1997, is filed as Exhibit
                  10.15 in the  Company's  Annual  Report on Form 10-K filed for
                  the year ended December 31, 1999.

         *+10.16  Executive   severance  agreement  between  Alan  W.  Ware  and
                  Scan-Optics,  Inc.  dated May 22,  2001,  is filed as  Exhibit
                  10.16 in the Company's Quarterly Report on Form 10-Q filed for
                  the quarter ended June 30, 2001.

         *10.17   Certificate   of   Designations,   Preferences,   Rights   and
                  Restrictions  for Series A  Redeemable  Preferred  Stock dated
                  December  31, 2001,  is filed as Exhibit 3.3 in the  Company's
                  Registration  statement on Form S-8 (no. 333-83598),  filed on
                  March 1, 2002.

         10.18    Warrant to  Purchase  Shares of Common  Stock of  Scan-Optics,
                  Inc. dated December 31, 2001, is filed as Exhibit 10.18 in the
                  Company's  Annual Report on Form 10-K filed for the year ended
                  December 31, 2001.

         10.19    Fourth  Amendment  Agreement  dated as of  December  31,  2001
                  between ARK CLO  2000-1,  Limited and  Scan-Optics,  Inc.  and
                  prior  loan  agreements,  is  filed  as  Exhibit  10.19 in the
                  Company's  Annual Report on Form 10-K filed for the year ended
                  December 31, 2001.

         *22.     List of subsidiaries of the Company,  included as Exhibit 10.8
                  in the Company's Annual Report on Form 10-K filed for the year
                  ended December 31, 1999.

         23.      Consent of Independent Auditors.

        * Exhibits so marked have  heretofore been filed by the Company with the
Securities and Exchange Commission and are incorporated herein by reference.


                                       53
<PAGE>

        + Management  contract for compensatory plan or arrangement  required to
be filed as an exhibit to this form pursuant to Item 14(c) of this report.


                 (b)       Reports on Form 8-K

                           No report on Form 8-K was filed for the quarter ended
                           December 31, 2001.

                 (c)       Exhibits

                           The  exhibits  required  by this  item  are  included
                           herein.

                 (d)       Financial Statement Schedule

                           The  response to this portion of Item 14 is submitted
                           as a separate section of this report.





                                       54
<PAGE>


                                   SIGNATURES

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

                                SCAN-OPTICS, INC.
                                Registrant
                                By:          /ss/
                                    ----------------------------------------
                                James C. Mavel
                                Chairman, Chief Executive Officer and
                                President
                                Date:        March 27, 2002

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the  following  persons on behalf of the  Registrant in
the capacities and on the dates indicated.

     /ss/
---------------------
James C. Mavel            Chairman, Chief Executive Officer and President
                          (Principal Executive Officer)
                          Date:         March 27, 2002
     /ss/
---------------------
Michael J. Villano        Chief Financial Officer, Vice President and
                          Treasurer
                          (Principal Financial and Accounting Officer)
                          Date:         March 27, 2002

     /ss/
---------------------
Logan Clarke, Jr.         Director      March 27, 2002

     /ss/
---------------------
Richard J. Coburn         Director      March 27, 2002

     /ss/
---------------------
E. Bulkeley Griswold      Director      March 27, 2002

     /ss/
---------------------
Lyman C. Hamilton, Jr.    Director      March 27, 2002

     /ss/
---------------------
John J. Holton            Director      March 27, 2002

     /ss/
---------------------
Robert H. Steele          Director      March 27, 2002

A majority of the Directors


                                       55
<PAGE>


<TABLE>
<CAPTION>

                                                                                                       SCHEDULE II



                                                     SCAN-OPTICS, INC. AND SUBSIDIARIES
                                                     VALUATION AND QUALIFYING ACCOUNTS
                                             THREE YEARS ENDED DECEMBER 31, 2001, 2000 AND 1999
                                                                (thousands)

                  COLUMN A                       COLUMN B                 COLUMN C                     COLUMN D     COLUMN E
                                                                         Additions
                                                              ---------------------------------
                                                Balance at      Charged to       Charged to                        Balance at
                                                Beginning        Costs and         Other                             End of
              Description                       Of Period        Expenses         Accounts            Deductions     Period
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                          <C>              <C>                <C>                <C>             <C>
Year ended December 31, 2001                   $   5,615        $      93                             $3,772(1)       $ 1,936
      Reserve for doubtful accounts
          (billed and unbilled)

Year ended December 31, 2000:                  $     308        $   5,505       $    13  (2)          $  211(1)       $ 5,615
      Reserve for doubtful accounts
          (billed and unbilled)

Year ended December 31, 1999:                  $     206         $     94       $    56  (2)          $  48 (1)       $   308
      Reserve for doubtful accounts

<FN>
(1) Uncollectible accounts written off, net of recoveries.
(2) Represents reclassifications from other accounts.
</FN>
</TABLE>

The required  information  regarding  the  valuation  allowance for deferred tax
assets is included in Note K.



                                       56