SECURITIES AND EXCHANGE COMMISSION
                              Washington D.C. 20549

                                    FORM 20-F

      |_|   REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE
            SECURITIES EXCHANGE ACT OF 1934

                                       OR

      |X|   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
            EXCHANGE ACT OF 1934
                  For the fiscal year ended December 31, 2004

                                       OR

      |_|   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
            EXCHANGE ACT OF 1934
              For the transition period from _________ to _________

                         Commission file number: 0-28950

                        MER TELEMANAGEMENT SOLUTIONS LTD.
              (Exact name of Registrant as specified in its charter
               and translation of Registrant's name into English)

                                     Israel
                 (Jurisdiction of incorporation or organization)

                    22 Zarhin Street, Ra'anana 43662, Israel
                    (Address of principal executive offices)

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

Securities registered or to be registered pursuant to Section 12(g) of the Act:

                       Ordinary Shares, NIS 0.01 Par Value
                                (Title of Class)

Securities for which there is a reporting obligation pursuant to Section 15(d)
of the Act: None

Indicate the number of outstanding shares of each of the issuer's classes of
capital or common stock as of the close of the period covered by the annual
report:

      Ordinary Shares, par value NIS 0.01 per share ............ 4,638,004
                            (as of December 31, 2004)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

                               Yes  X      No
                                   ----       ----

Indicate by check mark which financial statement item the registrant has elected
to follow:

                             Item 17      Item 18  X
                                                 ----

This Report on Form 20-F is incorporated by reference into our Form F-3
Registration Statement File No. 333-11644 and into our Form S-8 Registration
Statements File No. 333-12014 and 333-123321.
<PAGE>

                                  INTRODUCTION

      Mer Telemanagement Solutions Ltd. is a total solutions provider in the
telecom expense and billing arenas. We design, develop, market and support a
comprehensive line of telecommunication management, expense management and
customer care and billing, or CC&B, solutions that enable business organizations
and other enterprises to improve the efficiency and performance of their
Internet Protocol, or IP, operations and to significantly reduce associated
costs. Our products include call accounting and management products, fault
management systems and Web-based management solutions for converged voice, voice
over IP, IP data and video and CC&B solutions. These products are designed to
provide telecommunication and information technology managers with tools to
reduce communication costs, recover charges payable by third parties, detect and
report the abuse and misuse of telephone networks, monitor and detect hardware
and software faults in telecommunications networks and generate
telecommunications usage information for use in the management of an enterprise.
We were among the first to offer PC-based call accounting systems when we
introduced our TABS product in 1985. To date, over 60,000 TABS call accounting
systems have been sold to end-users in more than 60 countries.

      Since our public offering in May 1997, our ordinary shares have been
listed on the NASDAQ Stock Market (symbol: MTSL). As used in this annual report,
the terms "we," "us" and "our" mean Mer Telemanagement Solutions Ltd. and its
subsidiaries, unless otherwise indicated.

      Except for the historical information contained in this annual report, the
statements contained in this annual report are "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, and the Private
Securities Litigation Reform Act of 1995, as amended, with respect to our
business, financial condition and results of operations. Such forward-looking
statements reflect our current view with respect to future events and financial
results. We urge you to consider that statements which use the terms
"anticipate," "believe," "do not believe," "expect," "plan," "intend,"
"estimate," "anticipate" and similar expressions are intended to identify
forward-looking statements. We remind readers that forward-looking statements
are merely predictions and therefore inherently subject to uncertainties and
other factors and involve known and unknown risks that could cause the actual
results, performance, levels of activity, or our achievements, or industry
results, to be materially different from any future results, performance, levels
of activity, or our achievements expressed or implied by such forward-looking
statements. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof. Except as
required by applicable law, including the securities laws of the United States,
we undertake no obligation to publicly release any update or revision to any
forward-looking statements to reflect new information, future events or
circumstances, or otherwise after the date hereof. We have attempted to identify
significant uncertainties and other factors affecting forward-looking statements
in the Risk Factors section that appears in Item 3D. "Key Information - Risk
Factors"

      We have obtained trademark registrations for TABS by MER(R), TABS.IT(TM),
eTABS(TM), VoIPTABS(TM), wTABS(TM), FaciliTRAK(TM), TABSbill(TM), TOPS(TM) and
PMSi(TM). We have been using "Application Suite" as a trade name for our suite
of modules for a comprehensive telecommunications management solution. All other
trademarks and trade names appearing in this annual report are owned by their
respective holders.


                                       i
<PAGE>

      Our consolidated financial statements appearing in this annual report are
prepared in U.S. dollars and in accordance with generally accepted accounting
principles in the United States, or U.S. GAAP. All references in this annual
report to "dollars" or "$" are to U.S. dollars and all references in this annual
report to "NIS" are to New Israeli Shekels.

      Statements made in this annual report concerning the contents of any
contract, agreement or other document are summaries of such contracts,
agreements or documents and are not complete descriptions of all of their terms.
If we filed any of these documents as an exhibit to this annual report or to any
registration statement or annual report that we previously filed, you may read
the document itself for a complete description of its terms.


                                       ii
<PAGE>

                                TABLE OF CONTENTS

                                                                            Page
                                                                            ----

PART I........................................................................5

ITEM 1.    IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS..............5
ITEM 2.    OFFER STATISTICS AND EXPECTED TIMETABLE............................5
ITEM 3.    KEY INFORMATION....................................................5
             A. Selected Financial Data.......................................5
             B. Capitalization and Indebtedness...............................6
             C. Reasons for the Offer and Use of Proceeds.....................6
             D. Risk Factors..................................................6
ITEM 4.    INFORMATION ON THE COMPANY........................................18
             A. History and Development of the Company.......................18
             B. Business Overview............................................20
             C. Organizational Structure.....................................29
             D. Property, Plants and Equipment...............................30
ITEM 5.    OPERATING AND FINANCIAL REVIEW AND PROSPECTS......................30
             A. Operating Results............................................36
             B. Liquidity and Capital Resources..............................42
             C. Research and Development.....................................43
             D. Trend Information............................................44
             E. Off-Balance Sheet Arrangements...............................44
             F. Tabular Disclosure of Contractual Obligations................44
ITEM 6.    DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES........................45
             A. Directors and Senior Management..............................45
             B. Compensation.................................................47
             C. Board Practices..............................................48
             D. Employees....................................................54
             E. Share Ownership..............................................55
ITEM 7.    MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS.................59
             A. Major Shareholders...........................................59
             B. Related Party Transactions...................................60
             C. Interests of Experts and Counsel.............................60
ITEM 8.    FINANCIAL INFORMATION.............................................60
             A. Consolidated Statements and Other Financial Information......60
             B. Significant Changes..........................................61
ITEM 9.    THE OFFER AND LISTING.............................................61
             A. Offer and Listing Details....................................61
             B. Plan of Distribution.........................................62
             C. Markets......................................................62
             D. Selling Shareholders.........................................62
             E. Dilution.....................................................62
             F. Expense of the Issue.........................................62
ITEM 10.   ADDITIONAL INFORMATION............................................63
             A. Share Capital................................................63


                                      iii
<PAGE>

             B. Memorandum and Articles of Association.......................63
             C. Material Contracts...........................................66
             D. Exchange Controls............................................66
             E. Taxation.....................................................66
             F. Dividend and Paying Agents...................................80
             G. Statement by Experts.........................................81
             H. Documents on Display.........................................81
             I. Subsidiary Information.......................................81
ITEM 11.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.......81
ITEM 12.   DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES............82

PART II......................................................................82

ITEM 13.   DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES...................82
ITEM 14.   MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND
           USE OF PROCEEDS...................................................82
ITEM 15.   CONTROLS AND PROCEDURES...........................................82
ITEM 16.   [RESERVED]........................................................83
ITEM 16A.  AUDIT COMMITTEE FINANCIAL EXPERT..................................83
ITEM 16B.  CODE OF ETHICS....................................................83
ITEM 16C.  PRINCIPAL ACCOUNTING FEES AND SERVICES............................83
ITEM 16D.  EXEMPTIONS FROM THE LISTING REQUIREMENTS AND STANDARDS FOR
           AUDIT COMMITTEE...................................................84
ITEM 16E.  PURCHASE OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATES
           AND PURCHASERS....................................................84

PART III.....................................................................85

ITEM 17.   FINANCIAL STATEMENTS..............................................85
ITEM 18.   FINANCIAL STATEMENTS..............................................85
ITEM 19.   EXHIBITS..........................................................86

SIGNATURES...................................................................88


                                       iv
<PAGE>

                                     PART I

ITEM 1.  IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

      Not applicable.

ITEM 2.  OFFER STATISTICS AND EXPECTED TIMETABLE

      Not applicable.

ITEM 3.  KEY INFORMATION

A.    SELECTED FINANCIAL DATA

      The following selected consolidated financial data for and as of the five
years ended December 31, 2004 are derived from our audited consolidated
financial statements, which have been prepared in accordance with U.S. GAAP. Our
audited consolidated financial statements with respect to the three years ended
December 31, 2004 and as of December 31, 2003 and 2004 appear elsewhere in this
Annual Report. Our selected consolidated financial data as of December 31, 2002,
2001 and 2000 and for the years ended December 31, 2001 and 2000 have been
derived from audited consolidated financial statements not included in this
Annual Report. The selected consolidated financial data set forth below should
be read in conjunction with Item 5. "Operating and Financial Review and
Prospects," and our consolidated financial statements and notes thereto included
elsewhere in this annual report.

Statement of Operations Data:

<TABLE>
<CAPTION>
                                                                        Year Ended December 31,
                                                    ----------------------------------------------------------------
                                                      2000          2001          2002          2003          2004
                                                    --------      --------      --------      --------      --------
                                                                   (in thousands, except per share data)
<S>                                                 <C>           <C>           <C>           <C>           <C>
Revenues .........................................  $ 11,067      $ 10,725      $  9,787      $  9,230      $  9,413
Cost of revenues .................................     2,842         2,552         1,896         1,849         2,814
                                                    --------      --------      --------      --------      --------
Gross profit .....................................     8,225         8,173         7,891         7,381         6,599
Selling and marketing ............................     4,853         4,911         3,954         3,916         6,300
Research and development, net ....................     4,039         3,562         2,127         1,825         2,362
General and administrative .......................     1,845         1,943         1,858         1,830         2,101
In process research and development write-
    off ..........................................       945            --            --            --            --
                                                    --------      --------      --------      --------      --------
Operating loss ...................................    (3,457)       (2,243)          (48)         (190)       (4,164)
Financial income, net ............................       374           138           134           124            78
Other income (expenses) ..........................     1,591          (654)         (140)            6            --
                                                    --------      --------      --------      --------      --------
Loss before taxes ................................    (1,492)       (2,759)          (54)          (60)       (4,086)
Taxes on income (tax benefit) ....................      (155)           16            52           198           266
                                                    --------      --------      --------      --------      --------

Net Loss before equity in earnings of affiliate ..    (1,337)       (2,775)         (106)         (258)       (4,352)
Equity in earnings of affiliate ..................        66           221           236           345           225
                                                    --------      --------      --------      --------      --------
Net income (loss) ................................  $ (1,271)     $ (2,554)     $    130      $     87      $ (4,127)
                                                    ========      ========      ========      ========      ========
Basic net earnings (loss) per share ..............  $  (0.26)     $  (0.53)     $   0.03      $   0.02      $  (0.89)
                                                    ========      ========      ========      ========      ========
Diluted net earnings (loss) per share ............  $  (0.26)     $  (0.53)     $   0.03      $   0.02      $  (0.89)
                                                    ========      ========      ========      ========      ========
</TABLE>


                                        5
<PAGE>

Balance Sheet Data:

<TABLE>
<CAPTION>
                                                                           As of December 31,
                                                    ----------------------------------------------------------------
                                                      2000          2001          2002          2003          2004
                                                    --------      --------      --------      --------      --------
<S>                                                 <C>           <C>           <C>           <C>           <C>
Working capital ..................................  $ 10,342      $  9,060      $  9,244      $  9,437      $  2,773
Total assets .....................................    21,812        18,095        17,707        18,182        15,323
Long-term loans ..................................        84            13             8            --            --
Shareholders' equity .............................    16,497        13,856        14,013        14,464        10,657
</TABLE>

B.    CAPITALIZATION AND INDEBTEDNESS

      Not applicable.

C.    REASONS FOR THE OFFER AND USE OF PROCEEDS

      Not applicable.

D.    RISK FACTORS

      Investing in our ordinary shares involves a high degree of risk and
uncertainty. You should carefully consider the risks and uncertainties described
below before investing in our ordinary shares. If any of the following risks
actually occurs, our business, prospects, financial condition and results of
operations could be harmed. In that case, the value of our ordinary shares could
decline, and you could lose all or part of your investment.

Risks Relating to Our Business and Market

We have had a recent history of operating losses and may not achieve or sustain
profitability in the future.

      We have incurred operating losses in each of the five last fiscal years
and we cannot assure you that we will be able to achieve or sustain profitable
operations in the future. To the extent that we continue to incur operating
losses, we may not have sufficient working capital to fund our operations in the
future. If we do not generate sufficient cash from operations, we will be
required to obtain additional financing or reduce level of expenditure. There
can be no assurance that such financing will be available in the future, or, if
available, will be on terms satisfactory to us.

Our operating results fluctuate significantly.

      Our quarterly results have fluctuated significantly in the past and are
likely to fluctuate significantly in the future. Our future operating results
will depend on many factors, including, but not limited to the following:

      o     demand for our products;

      o     changes in our pricing policies or those of our competitors;

      o     the number, timing and significance of product enhancements;


                                       6
<PAGE>

      o     new product announcements by us and our competitors;

      o     our ability to develop, introduce and market new and enhanced
            products on a timely basis;

      o     changes in the level of our operating expenses;

      o     budgeting cycles of our customers;

      o     customer order deferrals in anticipation of enhancements or new
            products that we or our competitors offer;

      o     product life cycles;

      o     changes in our strategy;

      o     seasonal trends and general domestic and international economic and
            political conditions, among others; and

      o     currency exchange rate fluctuations and economic conditions in the
            geographic areas where we operate.

      Due to the foregoing factors, quarterly revenues and operating results are
difficult to forecast, and it is likely that our future operating results will
be adversely affected by these or other factors.

      Revenues are also difficult to forecast because the market for
telecommunication management solutions is rapidly evolving and our sales cycle,
from initial evaluation to purchase, is lengthy and varies substantially from
customer to customer. We typically ship product orders shortly after receipt of
a purchase order and, consequently, order backlog at the beginning of any
quarter has in the past represented only a small portion of that quarter's
revenues. As a result, license revenues in any quarter depend substantially on
orders booked and shipped in that quarter.

      Due to all of the foregoing, we cannot predict revenues for any future
quarter with any significant degree of accuracy. Accordingly, we believe that
period-to-period comparisons of our operating results are not necessarily
meaningful and you should not rely upon them as indications of future
performance. We have experienced revenue decline in the past and we cannot
assure you that we will be able to achieve revenue growth in the future.

Our operating results vary quarterly and seasonally.

      We have often recognized a substantial portion of our revenues in the last
quarter of the year and in the last month, or even weeks or days, of a quarter.
Our expense levels are substantially based on our expectations for future
revenues and are therefore relatively fixed in the short term. If revenue levels
fall below expectations, our quarterly results are likely to be
disproportionately adversely affected because a proportionately smaller amount
of our expenses varies with our revenues.


                                       7
<PAGE>

      Our operating results reflect seasonal trends and we expect to continue to
be affected by such trends in the future. Due to the foregoing factors, in some
future quarter, our operating results may be below the expectations of public
market analysts and investors. In such event, it is likely that the price of our
ordinary shares would be materially and adversely affected.

We depend on the market for telemanagement products, which market has declined
in recent years.

      In recent years we have derived substantially all of our revenues from our
TABS.IT call accounting and billing products. We have implemented a new strategy
that has led to the development and introduction of our Application Suite. The
Application Suite is built on the Microsoft.Net platform and establishes a
framework for us to provide customized solutions that include customer care and
billing, in addition to the traditional telemanagement solutions. The main
functions of our TABS.IT and the WinTrak family of products were incorporated
into the Application Suite. Our future financial performance will depend, in
significant part, on the successful development, introduction, marketing and
customer acceptance of the Application Suite and related telemanagement
products. Except for a slight increase in revenues in the 2004 fiscal year, our
revenues have declined each year since 1999 and there can be no assurance that
the market for these products will grow in the future. If the market for the
Application Suite and related telemanagement products fails to return to
previous levels, or grows more slowly than we currently anticipate, our
business, operating results and financial condition would be materially and
adversely affected.

We depend on business telephone system manufacturers, vendors and distributors
for our sales.

      One of the primary distribution channels for our call accounting
management products are private branch exchange, or PBX, original equipment
manufacturers, or OEMs, and vendors who market our products to end-users in
conjunction with their own products. We have entered into partnership agreements
with each of NEC and Avaya for the integration of our products with their own
products and the marketing of the integrated product. Sales by PBX manufacturers
and vendors have declined markedly in the recent past, and no assurance can be
given that sales through this channel will recover. Our success will be
dependent to a substantial degree on the marketing and sales efforts of such
third parties in marketing products integrating our products. There can be no
assurance that these customers will give priority to the sale of our products as
an enhancement to their products. Although most of the major business telephone
switching systems manufacturers and vendors currently rely on third-party
suppliers to provide call accounting and other telemanagement products, no
assurance can be given that these manufacturers and vendors, including our
current customers, will not develop their own competing products or purchase
competing products from others.

      We are highly dependent upon the active marketing and distribution efforts
of our PBX OEM's. In 2002, 2003 and 2004, our three major OEMs, Siemens Gmbh,
Philips Communications Systems B.V. and Ericsson, generated 46.0%, 51.0% and
47.0% of our consolidated revenues respectively. The percentage of sales
attributable to each of these OEMs in each of the three years ended December 31,
2004 follows:


                                       8
<PAGE>

                                         2002         2003         2004
                                       -------      -------      -------
Siemens..........................        36.0%        40.0%        38.0%
Philips..........................         6.0%         7.0%         5.0%
Ericsson.........................         4.0%         4.0%         4.0%

      Because we sell our products through local master distributors in
countries where we do not have a marketing subsidiary, we are highly dependent
upon the active marketing and distribution efforts of our distributors. We also
depend in large part upon our distributors for product maintenance and support.
There can be no assurance that our distributors will continue to provide
adequate maintenance and support to end-users or will provide maintenance and
support for new products, which might cause us to seek new or additional
distributors or incur additional service and support costs. The distributors to
whom we sell our products are generally not contractually required to make
future purchases of our products and could, therefore, discontinue carrying our
products at any time. None of our distributors or resellers are subject to any
minimum purchase requirements under their agreements with us. There can be no
assurance that we will continue our relationships with our OEM customers or, if
such relationships are not maintained, that we would be able to attract and
retain comparable PBX original equipment manufacturers. The loss of any of our
major reseller or OEM relationships, either to competitive products offered by
other companies or products developed by such resellers, would have a material
adverse effect on our business, financial condition and results of operations.
Our future performance will depend, in part, on our ability to attract
additional PBX manufacturers and vendors that will be able to market and support
our products effectively, especially in markets in which we have not previously
distributed our products.

We have recently acquired certain assets of Teleknowledge Group Ltd., and there
can be no assurance that we will successfully integrate their products.

      In December 2004, we completed the acquisition of certain assets and
liabilities of Teleknowledge Group Ltd., or Teleknowledge, a provider of carrier
class billing and related solutions. The acquisition of the Teleknowledge
billing solution enables us to offer an end-to-end customer care and billing
solution, including pre/post paid billing, Web self-care, assets management,
partner management, help desk and order management modules. These products offer
a complimentary solution to our own products. There can be no assurance that we
will successfully integrate the Teleknowledge products into our products.

We face risks associated with expanding and maintaining our distribution
network.

      We sell our products through distributors, business telephone switching
systems manufacturers and vendors, post, telephone and telegraph authorities, or
PTTs and our direct sales force. Our ability to achieve revenue growth in the
future will depend in large part on our success in establishing and maintaining
relationships with business telephone switching systems manufacturers and
vendors and PTTs, establishing and maintaining relationships with distributors,
and recruiting and training additional direct sales personnel. We plan to invest
significant resources to expand our direct sales force and to develop new
distribution relationships. Historically, we have at times experienced
difficulty in recruiting qualified sales personnel and in establishing effective
distribution relationships. There can be no assurance that we will be able to
successfully expand our direct sales force or other distribution channels or
that any such expansion will result in an increase in revenues. The failure to
expand or maintain our direct sales force or other distribution channels could
have a material adverse effect on our business, operating results and financial
condition.


                                       9
<PAGE>

We are subject to risks associated with international operations.

      We are based in Israel and generate a large percentage of our sales
outside the United States. Our sales in the United States accounted for 66.0%,
53.0% and 53.0% of our total revenues for the years ended December 31, 2002,
2003 and 2004, respectively. Although we continue to expand our international
operations and commit significant management time and financial resources to
developing direct and indirect international sales and support channels , we
cannot be certain that we will be able to maintain or increase international
market demand for our products. To the extent that we cannot do so in a timely
manner, our business, operating results and financial condition will be
materially and adversely affected.

      International operations are subject to inherent risks, including the
following:

      o     the impact of possible recessionary environments in multiple foreign
            markets;

      o     costs of localizing products for foreign markets;

      o     longer receivables collection periods and greater difficulty in
            accounts receivable collection;

      o     unexpected changes in regulatory requirements;

      o     difficulties and costs of staffing and managing foreign operations;

      o     reduced protection for intellectual property rights in some
            countries;

      o     potentially adverse tax consequences; and

      o     political and economic instability.

      We cannot be certain that we, our distributors or resellers will be able
to sustain or increase revenues from international operations or that the
foregoing factors will not have a material adverse effect on our future revenues
and, as a result, on our business, operating results and financial condition.

      We may be adversely affected by fluctuations in currency exchange rates.
While our revenues are generally denominated in U.S. dollars and Euros, a
significant portion of our expenses are incurred in NIS. We do not currently
engage in any currency hedging transactions intended to reduce the effect of
fluctuations in foreign currency exchange rates on our results of operations. If
we were to determine that it was in our best interests to enter into any hedging
transactions in the future, there can be no assurance that we will be able to do
so or that such transactions, if entered into, will materially reduce the effect
of fluctuations in foreign currency exchange rates on our results of operations.
In addition, if, for any reason, exchange or price controls or other
restrictions on the conversion of foreign currencies into NIS were imposed, our
business could be adversely affected. Although exposure to currency fluctuations
to date has not had a material adverse effect on our business, there can be no
assurance such fluctuations in the future will not have a material adverse
effect on revenues from international sales and, consequently, on our business,
operating results and financial condition.


                                       10
<PAGE>

We are subject to risks relating to proprietary rights and risks of
infringement.

      We are dependent upon our proprietary software technology and we rely
primarily on a combination of copyright and trademark laws, trade secrets,
confidentiality procedures and contractual provisions to protect our proprietary
rights. We try to protect our software, documentation and other written
materials under trade secret and copyright laws, which afford only limited
protection. It is possible that others will develop technologies that are
similar or superior to our technology. Despite our efforts to protect our
proprietary rights, unauthorized parties may attempt to copy aspects of our
products or to obtain and use information that we regard as proprietary. It is
difficult to police the unauthorized use of our products, and we expect software
piracy to be a persistent problem, although we are unable to determine the
extent to which piracy of our software products exists. In addition, the laws of
some foreign countries do not protect our proprietary rights as fully as do the
laws of the United States. We cannot be certain that our means of protecting our
proprietary rights in the United States or abroad will be adequate or that our
competition will not independently develop similar technology.

      We are not aware that we are infringing upon any proprietary rights of
third parties. It is possible, however, that third parties will claim
infringement by us of their intellectual property rights. We believe that
software product developers will increasingly be subject to infringement claims
as the number of products and competitors in our industry segment grows and the
functionality of products in different industry segments overlaps. It would be
time consuming for us to defend any such claims, with or without merit, and any
such claims could:

      o     result in costly litigation;

      o     divert management's attention and resources;

      o     cause product shipment delays; or

      o     require us to enter into royalty or licensing agreements. Such
            royalty or licensing agreements, if required, may not be available
            on terms acceptable to us, if at all.

      If there is a successful claim of product infringement against us and we
are not able to license the infringed or similar technology, our business,
operating results and financial condition would be materially and adversely
affected.

      We rely upon certain software that we license from third parties,
including software that we integrate with our internally developed software. We
cannot be certain that these third-party software licenses will continue to be
available to us on commercially reasonable terms. If we lose or are unable to
maintain any such software licenses, we could suffer shipment delays or
reductions until equivalent software could be developed, identified, licensed
and integrated, which would materially and adversely affect our business,
operating results and financial condition.

Our results may be adversely affected by competition.

      The market for telemanagement products is fragmented and is intensely
competitive. Competition in the industry is generally based on product
performance, depth of product line, technical support and price. We compete both
with international and local competitors (including providers of
telecommunications services), many of whom have significantly greater financial,
technical and marketing resources than us. We anticipate continuing competition
in the telemanagement products market and the entrance of new competitors into
the market. Our existing and potential customers, including business telephone
switching system manufacturers and vendors, may be able to develop
telemanagement products and services that are as effective as, or more effective
or easier to use than, those offered by us. Such existing and potential
competitors may also enjoy substantial advantages over us in terms of research
and development expertise, manufacturing efficiency, name recognition, sales and
marketing expertise and distribution channels. There can be no assurance that we
will be able to compete successfully against current or future competitors or
that competition will not have a material adverse effect on our future revenues
and, consequently, on our business, operating results and financial condition.


                                       11
<PAGE>

We are subject to risks associated with rapid technological change and risks
associated with new versions and new products.

      The telecommunications management market in which we compete is
characterized by rapid technological change, introductions of new products,
changes in customer demands and evolving industry standards. Our future success
will depend upon our ability to keep pace with the technological developments
and to timely address the increasingly sophisticated needs of our customers by
supporting existing and new telecommunication technologies and services and by
developing and introducing enhancements to our current and new products. There
can be no assurance that we will be successful in developing and marketing
enhancements to our products that will respond to technological change, evolving
industry standards or customer requirements, that we will not experience
difficulties that could delay or prevent the successful development,
introduction and sale of such enhancements or that such enhancements will
adequately meet the requirements of the marketplace and achieve any significant
degrees of market acceptance. If release dates of any new products or
enhancements are delayed or, if when released, they fail to achieve market
acceptance, our business, operating results and financial condition would be
materially and adversely affected. In addition, the introduction or announcement
of new product offerings or enhancements by us or our competitors may cause
customers to defer or forgo purchases of current versions of our product, which
could have a material adverse effect on our business, operating results and
financial condition.

We may not be able to retain or attract key managerial, technical and research
and development personnel we need to succeed.

      Our success has largely depended and will depend in the future on our
skilled professional and technical employees, substantially all of whom have
written employment agreements. The competition for these employees is intense.
We may not be able to retain our present employees, or recruit additional
qualified employees as we require them.

Three of our shareholders are in a position to control matters requiring a
shareholder vote.

      Mr. Chaim Mer, our Chairman, and his wife, Dora Mer, currently control the
vote of approximately 41.81% of our outstanding ordinary shares, and Isaac
Ben-Bassat, one of our directors, is the owner of 14.40% of our outstanding
ordinary shares.


                                       12
<PAGE>

      As a result, such persons control and will continue to control the
election of our entire Board of Directors other than our two outside directors
and generally have the ability to direct our business and affairs.

We are subject to risks arising from product defects and potential product
liability.

      We provide free warranty and support for up to one year for end-users and
up to 15 months for our OEM distributors. Our sales agreements typically contain
provisions designed to limit our exposure to potential product liability or
related claims. The limitation of liability provisions contained in our
agreements may not be effective. Our products are used by businesses to reduce
communication costs, recover charges payable by third parties and prevent abuse
and misuse of telephone networks and, as a result, the sale of products by us
may entail the risk of product liability and related claims. A product liability
claim brought against us could have a material adverse effect upon our business,
operating results and financial condition. Products such as those offered by us
may contain undetected errors or failures when first introduced or when new
versions are released. Despite our testing and testing by current and potential
customers, there can be no assurance that errors will not be found in new
products or releases after commencement of commercial shipments. The occurrence
of these errors could result in adverse publicity, loss of or delay in market
acceptance or claims by customers against us, any of which could have a material
adverse effect upon our business, operating results and financial condition.

Risk Factors Related to Our Ordinary Shares

We are classified as a passive foreign investment company, or PFIC, which will
subject our U.S. investors to adverse tax rules.

      Holders of our ordinary shares who are United States residents face income
tax risks. There is a substantial risk that we are a passive foreign investment
company, commonly referred to as PFIC. Our treatment as a PFIC could result in a
reduction in the after-tax return to the holders of our ordinary shares and
would likely cause a reduction in the value of such shares. For U.S. Federal
income tax purposes, we will be classified as a PFIC for any taxable year in
which either (i) 75% or more of our gross income is passive income, or (ii) at
least 50% of the average value of all of our assets for the taxable year produce
or are held for the production of passive income. For this purpose, cash is
considered to be an asset, which produces passive income. As a result of our
substantial cash position and the decline in the value of our stock, we believe
that we became a PFIC in 2004 under a literal application of the asset test
described above, which looks solely to the market value. If we are classified as
a PFIC for U.S. federal income tax purposes, highly complex rules would apply to
U.S. Holders owning ordinary shares. Accordingly, you are urged to consult your
tax advisors regarding the application of such rules. United States residents
should carefully read "Item 10E. Additional Information - Taxation, United
States Federal Income Tax Consequences" for a more complete discussion of the
U.S. federal income tax risks related to owning and disposing of our ordinary
shares.

Our share price has been volatile in the past and may decline in the future.

      Our ordinary shares have experienced significant market price and volume
fluctuations in the past and may experience significant market price and volume
fluctuations in the future in response to factors such as the following, some of
which are beyond our control:


                                       13
<PAGE>

      o     quarterly variations in our operating results;

      o     operating results that vary from the expectations of securities
            analysts and investors;

      o     changes in expectations as to our future financial performance,
            including financial estimates by securities analysts and investors;

      o     announcements of technological innovations or new products by us or
            our competitors;

      o     announcements by us or our competitors of significant contracts,
            acquisitions, strategic partnerships, joint ventures or capital
            commitments;

      o     changes in the status of our intellectual property rights;

      o     announcements by third parties of significant claims or proceedings
            against us;

      o     additions or departures of key personnel;

      o     future sales of our ordinary shares; and

      o     stock market price and volume fluctuations.

      Domestic and international stock markets often experience extreme price
and volume fluctuations. Market fluctuations, as well as general political and
economic conditions, such as a recession or interest rate or currency rate
fluctuations or political events or hostilities in or surrounding Israel, could
adversely affect the market price of our ordinary shares.

      In the past, securities class action litigation has often been brought
against a company following periods of volatility in the market price of its
securities. We may in the future be the target of similar litigation. Securities
litigation could result in substantial costs and divert management's attention
and resources.

We do not expect to distribute cash dividends.

      We do not anticipate paying cash dividends in the foreseeable future. Our
Board of Directors will decide whether to declare any cash dividends in the
future based on the conditions then existing, including our earnings and
financial condition. According to the Israeli Companies Law, a company may
distribute dividends out of its profits (within the meaning of the Israeli
Companies Law), so long as the company reasonably believes that such dividend
distribution will not prevent the company from paying all its current and future
debts.

Compliance with changing regulation of corporate governance and public
disclosure may result in additional expenses.

      Changing laws, regulations and standards relating to corporate governance
and public disclosure, including the Sarbanes-Oxley Act of 2002, new Securities
and Exchange Commission regulations and NASDAQ Stock Market rules, are creating
uncertainty for companies such as ours. We are committed to maintaining high
standards of corporate governance and public disclosure. As a result, we intend
to invest reasonably necessary resources to comply with evolving standards, and
this investment may result in increased general and administrative expenses and
a diversion of management time and attention from revenue-generating activities
to compliance activities, which could harm our operating results and business
prospects.


                                       14
<PAGE>

The implementation of SFAS No. 123(R), which will require us to record
compensation expense in connection with equity share based compensation as of
the first quarter of 2006, may reduce our profitability.

      On December 16, 2004, the Financial Accounting Standards Board, or FASB,
issued Statement No. 123 (revised 2004), Share-Based Payment, or SFAS No.
123(R), which is a revision of SFAS No. 123. Generally, the approach in SFAS No.
123(R) is similar to the approach described in SFAS No. 123. However, SFAS No.
123 permitted, but did not require, share-based payments to employees to be
recognized on the basis of their fair values while SFAS No. 123(R) requires, as
of the first quarter of 2006, all share-based payments to employees to be
recognized on the basis of their fair values. SFAS No. 123(R) also revises,
clarifies and expands guidance in several areas, including measuring fair value,
classifying an award as equity or as a liability and attributing compensation
cost to reporting periods. The adoption of SFAS No. 123(R) may have a
significant effect on our results of operations in the future; however, the
impact of its adoption cannot be predicted at this time. In addition, such
adoption could limit our ability to use stock options as an incentive and
retention tool, which could, in turn, negatively impact our ability to recruit
employees and retain existing employees.

Risks Relating to Operations in Israel

Conducting business in Israel entails special risks.

      We are incorporated under the laws of, and our executive offices and
research and development facilities are located in, the State of Israel.
Although most of our sales are made to customers outside Israel, we are directly
influenced by the political, economic and military conditions affecting Israel.
Specifically, we could be adversely affected by any major hostilities involving
Israel, a full or partial mobilization of the reserve forces of the Israeli
army, the interruption or curtailment of trade between Israel and its present
trading partners, or a significant downturn in the economic or financial
condition of Israel.

      Since the establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors, and a state of
hostility, varying from time to time in intensity and degree, has led to
security and economic problems for Israel. Since September 2000, there has been
a marked increase in violence, civil unrest and hostility, including armed
clashes, between the State of Israel and the Palestinians, and acts of terror
have been committed inside Israel and against Israeli targets in the West Bank
and Gaza. There is no indication as to how long the current hostilities will
last or whether there will be any further escalation. Any further escalation in
these hostilities or any future armed conflict, political instability or
violence in the region may have a negative effect on our business condition,
harm our results of operations and adversely affect our share price.
Furthermore, there are a number of countries that restrict business with Israel
or Israeli companies. Restrictive laws or policies of those countries directed
towards Israel or Israeli businesses had, and may in the future continue to
have, an adverse impact on our operations, our financial results or the
expansion of our business. No predictions can be made as to whether or when a
final resolution of the area's problems will be achieved or the nature thereof
and to what extent the situation will impact Israel's economic development or
our operations.


                                       15
<PAGE>

Political trade relations could limit our ability to sell or buy
internationally.

      We could be adversely affected by the interruption or reduction of trade
between Israel and its trading partners. Some countries, companies and
organizations continue to participate in a boycott of Israeli firms and others
doing business with Israel or with Israeli companies. To date, these measures
have not had a material adverse affect on our business. However, there can be no
assurance that restrictive laws, policies or practices towards Israel or Israeli
businesses will not have an adverse impact on our business.

Our results of operations may be negatively affected by the obligation of our
personnel to perform military service.

      Many of our directors, officers and employees in Israel are obligated to
perform annual reserve duty in the Israeli Defense Forces and may be called for
active duty under emergency circumstances at any time. If a military conflict or
war arises, these individuals could be required to serve in the military for
extended periods of time. Our operations could be disrupted by the absence for a
significant period of one or more of our executive officers or key employees or
a significant number of other employees due to military service. Any disruption
in our operations could adversely affect our business.

The economic conditions in Israel have not been stable in recent years.

      In recent years Israel has been going through a period of recession in
economic activity, resulting in low growth rates and growing unemployment.
Although economic activity in Israel has improved recently, our operations could
be adversely affected if the economic conditions in Israel begin to deteriorate
once again. In addition, due to significant economic measures proposed by the
Israeli Government, there have been several general strikes and work stoppages
in 2003 and 2004, affecting all banks, airports and ports. These strikes have
had an adverse effect on the Israeli economy and on business, including our
ability to deliver products to our customers.

Our financial results may be adversely affected by inflation and currency
fluctuations.

      Since we report our financial results in dollars, fluctuations in rates of
exchange between the dollar and non-dollar currencies may affect our results of
operations. The majority of our expenses are paid in NIS (primarily salaries)
and are influenced by the timing of, and the extent to which, any increase in
the rate of inflation in Israel over the rate of inflation in the United States
is not offset by the devaluation of the NIS in relation to the dollar. We
believe that the rate of inflation in Israel has not had a material adverse
effect on our business to date. However, our dollar costs in Israel will
increase if inflation in Israel exceeds the devaluation of the NIS against the
dollar or if the timing of such devaluation lags behind inflation in Israel.
Over time, the NIS has been devalued against the dollar, generally reflecting
inflation rate differentials. We cannot predict any future trends in the rate of
inflation in Israel or the rate of devaluation of the NIS against the dollar. If
the dollar cost of our operations in Israel increases, our dollar measured
results of operations will be adversely affected. Likewise, our operations could
be adversely affected if we are unable to guard against currency fluctuations in
the future.


                                       16
<PAGE>

The government programs and tax benefits we currently participate in or receive
require us to meet several conditions and may be terminated or reduced in the
future.

      We have benefited from certain Israeli Government grants, programs and tax
benefits. To remain eligible for these grants, programs and tax benefits, we
must comply with certain conditions, including making specified investments in
fixed assets from our own equity and paying royalties with respect to grants
received. In addition, some of these programs restrict our ability to
manufacture particular products and to transfer particular technology outside of
Israel. If we do not meet these conditions in the future, the benefits we
received could be canceled and we may have to refund payments previously
received under these programs or pay increased taxes. The Government of Israel
has reduced the benefits available under these programs in recent years and
these programs and tax benefits may be discontinued or curtailed in the future.
While we do not expect to receive any grants during 2005, we may apply for
grants in 2006.

Service and enforcement of legal process on us and our directors and officers
may be difficult to obtain.

      Service of process upon our directors and officers and the Israeli experts
named herein, most of whom reside outside the United States, may be difficult to
obtain within the United States. Furthermore, since substantially all of our
assets, most of our directors and officers and the Israeli experts named in this
annual report are located outside the United States, any judgment obtained in
the United States against us or these individuals or entities may not be
collectible within the United States.

      There is doubt as to the enforceability of civil liabilities under the
Securities Act and the Securities Exchange Act in original actions instituted in
Israel. However, subject to certain time limitations and other conditions,
Israeli courts may enforce final judgments of United States courts for
liquidated amounts in civil matters, including judgments based upon the civil
liability provisions of those Acts.

Provisions of Israeli law may delay, prevent or make difficult an acquisition of
us, which could prevent a change of control and therefore depress the price of
our shares.

      Provisions of Israeli corporate and tax law may have the effect of
delaying, preventing or making more difficult a merger with, or other
acquisition of, us. This could cause our ordinary shares to trade at prices
below the price for which third parties might be willing to pay to gain control
of us. Third parties who are otherwise willing to pay a premium over prevailing
market prices to gain control of us may be unable or unwilling to do so because
of these provisions of Israeli law.

The rights and responsibilities of our shareholders are governed by Israeli law
and differ in some respects from the rights and responsibilities of shareholders
under U.S. law.

      We are incorporated under Israeli law. The rights and responsibilities of
holders of our ordinary shares are governed by our memorandum of association,
articles of association and by Israeli law. These rights and responsibilities
differ in some respects from the rights and responsibilities of shareholders in
typical U.S. corporations. In particular, each shareholder of an Israeli company
has a duty to act in good faith in exercising his or her rights and fulfilling
his or her obligations toward the company and other shareholders and to refrain
from abusing his power in the company, including, among other things, in voting
at the general meeting of shareholders on certain matters. Israeli law provides
that these duties are applicable in shareholder votes on, among other things,
amendments to a company's articles of association, increases in a company's
authorized share capital, mergers and interested party transactions requiring
shareholder approval. In addition, a controlling shareholder of an Israeli
company or a shareholder who knows that it possesses the power to determine the
outcome of a shareholder vote or who has the power to appoint or prevent the
appointment of a director or officer in the company has a duty of fairness
toward the company. However, Israeli law does not define the substance of this
duty of fairness. Because Israeli corporate law has undergone extensive revision
in recent years, there is little case law available to assist in understanding
the implications of these provisions that govern shareholder behavior.


                                       17
<PAGE>

ITEM 4.  INFORMATION ON THE COMPANY

A.    HISTORY AND DEVELOPMENT OF THE COMPANY

      MER Telemanagement Solutions Ltd. was incorporated under the laws of the
State of Israel in December 1995. We are a public limited liability company
under the Israeli Companies Law 5739-1999 and operate under such law and
associated legislation. Our registered offices and principal place of business
are located at 22 Zarhin Street, Ra'anana 43662, Israel, and our telephone
number is 972-9-762-1777. Our address on the Internet is www.mtsint.com. The
information on our website is not incorporated by reference into this annual
report.

      We are a total solutions provider in the telecom expense and billing
arenas. We design, develop, market and support a comprehensive line of
telecommunication management, expense management and customer care and billing,
or CC&B, solutions that enable business organizations and other enterprises to
more effectively manage and optimize the use of their communication resources.
Our products include call accounting and management products, fault management
systems and Web-based management solutions for converged voice, voice over IP,
or VoIP, IP data and video and CC&B solutions. These products are designed to
provide telecommunication and information technology managers with tools to
reduce communication costs, recover charges payable by third parties, detect and
report the abuse and misuse of telephone networks, monitor and detect hardware
and software faults in telecommunications networks and generate
telecommunications usage information for use in the management of an enterprise.
We were among the first to offer PC-based call accounting systems when we
introduced our TABS product in 1985. To date, over 60,000 TABS call accounting
systems have been sold to end-users in more than 60 countries. In addition,
approximately 1,000 WinTrak systems (which we acquired from IntegraTRAK, Inc. in
April 2000) have been sold in the United States market since 1985. Although we
are no longer marketing WinTRAK, we continue to support this product.


                                       18
<PAGE>

      Call accounting systems afford businesses easy access to complete
information on telephone usage, including the dialed number, calling extension,
call duration, time of day, destination, trunk line usage, cost of each call and
multi-carrier analysis. We started developing the TABS line of call accounting
products for the DOS operating system and have upgraded and re-written our call
accounting and management systems as the industry and technology advanced
providing full compatibility to support the Windows operating systems and most
versions of Windows NT. As our sales of TABS were worldwide, we needed to have a
flexible and easily updated set of pricing tables to accommodate the different
pricing schemes and modes used worldwide and with different carriers. As
enterprises expanded and required information from their remote sites, so TABS
has expanded to accommodate their needs by providing multi-site solutions and
supporting most business telephone switching systems currently available for
sale. The solutions are capable of monitoring up to 100,000 extensions. The
Application Suite provides for an unlimited number of extensions, subject to the
capabilities of the customer's hardware, as well as an unlimited number of
remote sites. The sites can be monitored from a browser at any point as the
application is web based. Various modules were developed to service the needs of
different vertical markets such as our PMSi module for the hotel industry and a
solution for performing tie-line reconciliation for organizations and utilities
having multiple PBXs. TRAK-View, our fault management system, provides an
enterprise with early warning problem detection and prevention for multi-site
and multi-vendor networks including PBXs. In 1998, we introduced IP.TRAK, a
Web-based call accounting and management system that was built on the original
model and principles of TABSweb(TM). IP.TRAK was designed to harness the power
of the Internet for the needs of Information Technology managers through its
ability to access reports using a standard Internet browser. We then added
additional modules that could collect the information from routers, firewalls
and gateways. These additional modules provided tools for a comprehensive
communications management system. We were able to collect additional data from
files, FTP servers, VoIP, and external buffers. We then merged the functionality
of PBX systems and IP networks to provide a unified management solution for
multiple communication platforms from different vendors supporting voice, VoIP,
video and data communications.

      We operate in five geographical areas. Our operations in Israel include
research and development, sales, marketing and support. Our operations in the
United States, Brazil, Europe and Asia include sales, marketing and customer
service.

      On April 24, 2000, we acquired all of the assets and assumed certain
liabilities of IntegraTRAK Inc., a privately held Seattle-based company, engaged
in the development and sale of packaged computer software for tracking telephone
calls and costs.

      In line with our strategic planning, we determined in late 2001 not to
promote TRAK-View and IP.TRAK as stand-alone products, but to offer them as part
of larger solutions.

      In 2001, we developed our Web Access module that provides access and
control to the communications usage database, under strict control and privacy,
from anywhere on the web. During the second quarter of 2002, we added
FaciliTRAK, which is a comprehensive software system that greatly simplifies the
day-to-day task of maintaining and managing the physical layer details for any
network. FaciliTRAK allows the user to record the equipment, cables, and
pathways for the cable plant and define the connectivity and circuit routes. A
user can utilize FaciliTRAK to plan and manage the moves and changes within his
or her organization with the aid of the self-documenting service desk functions.
The FaciliTRAK system is an essential tool for any enterprise that is thinking
of implementing a disaster recovery program.


                                       19
<PAGE>

      In July 2000, we sold a 31% interest in Silverbyte, a 50% owned privately
held affiliate. We received $150,000 in consideration from the sale payable in
24 equal monthly payments. In December 2000, we reached an agreement to
reschedule the remaining balance of the payments due. According to this
agreement, the balance of $110,000 will be repaid in 19 monthly payments
starting April 2002. In April 2002, we reached a new agreement rescheduling the
remaining $85,000 balance to be repaid in 48 monthly payments starting April
2002. We recorded a $73,000 gain from the sale. Although we continue to hold a
19% interest in Silverbyte, we do not have any representation on its board of
directors. Accordingly, our investment in Silverbyte is accounted for according
to the cost method.

      In December 2004 we completed the acquisition of certain assets and
liabilities of TeleKnowledge Group Ltd., or TeleKnowledge, a provider of carrier
class billing and related solutions. In connection with the acquisition, we paid
an initial consideration of $2.374 million in cash and agreed to pay additional
contingent consideration of up to $3.65 million over a period of three years
based on post acquisition revenue performance. The acquisition of the
Teleknowledge billing solution enables us to offer an end-to-end customer care
and billing solution, including pre/post paid billing, Web self-care, assets
management, partner management, help desk and order management modules.

B.    BUSINESS OVERVIEW

Industry Background

      Technological advances and worldwide deregulation and privatization in the
telecommunications industry have resulted in the growth of alternative
telecommunication services providers, such as cellular companies, competitive
access providers, cable companies and data transmission companies. This growth,
in conjunction with dramatic improvements in computing and communications
technology, including the convergence of telephony systems and computers, or
computer telephony integration, has fostered the rapid expansion of
communication services and an increase in the volume of voice and data traffic
by business organizations. The diversification of services and providers using
varied pricing algorithms and the proliferation of domestic and international
networks using varied equipment and technologies for different services and
modes of transmission has placed new demands on telecommunication and
information technology managers and has created the need for sophisticated and
flexible telecommunication management solutions. This has created a demand for
telemanagement solutions that are capable of supporting multiple sites,
switching platforms, languages and currencies, as well as the generation of
telecommunications usage information vital to an enterprise's operations.

      Telemanagement solutions have evolved from the stand-alone PC-based
telephone call accounting and billing systems of the mid-1980's to local area
network or LAN-based systems operating in Windows 98/2000/XP and Windows NT
environments offering call accounting, fraud detection and fault management
solutions for users with complex voice and data networks. Today, the trend is
moving more and more to Web-based solutions.

      Call accounting products, a fundamental management tool, record, retrieve
and process data received from a PBX or other telephone switching system,
providing a telecommunications manager with information on telephone usage. This
information enables managers to optimize an enterprise's telecommunications
resources and reduce communication expenses, typically the second or third
highest administrative expense of a business, through cost-tracking and
management awareness.


                                       20
<PAGE>

      As the trend continues toward enterprises utilizing one infrastructure for
both voice and data services, more and more emphasis will be placed on finding
efficient solutions to cope with the increasing demand on network resources and
for reducing congestion. Enterprises have been required to buy additional
communications resources to meet this demand immediately rather than optimizing
their existing networks due to the time consuming nature of such projects. IT
managers are constantly trying to justify the ever increasing expenses created
by managing the enormous amount of data that is being transmitted through the
Internet.

      The abuse and misuse of telephone and data networks, either by employees
making unauthorized telephone calls or by outside "hackers" who tap into an
organization's long distance service has become a major problem for
organizations resulting in great losses. Likewise, employees surfing the web for
private use during working hours overloads the network, preventing critical
tasks from getting through as well as reducing the overall productivity of the
enterprise. These losses have led to the development of intelligent toll fraud
detection systems that immediately alert or initiate preventive measures upon
detecting a suspicious occurrence in network usage traffic.

      Organizations with multiple PBXs and providers of maintenance services
require systems that are capable of alerting telecommunications managers of
impending or actual problems in a communications network. Financial and
operational benefits of a fault management system can be immediate and
significant, as down time of the system is reduced due to early problem
detection and real information on remote site events. Maintenance costs are
significantly lowered through better use of human resources and more efficient
inventory management.

      In addition, other executives and operational managers are now seeking
telemanagement solutions which permit them to assess how efficiently employees
are using their time, monitor customer service calls, analyze the effectiveness
of marketing expenditures, utilize toll-free responses to determine demographics
of callers through the use of Caller ID information, know who is using the
network and when they are using it, and obtain additional data that aid them in
management of the business.

      IP telephony and video conferencing are reaching technological maturity
and are being adopted by an increasing number of organizations. Enterprises have
begun to use the IP platform as a single common telecommunication infrastructure
for all services. The convergence of voice, data and video has become
commonplace, and there is a trend of data equipment manufacturers and PBX system
manufacturers offering platforms that support all services. These developments
as well as customer demands will require future management systems to be
upgraded to support the convergence of voice, data and video and provide a
unified management system that will provide information technology managers with
knowledge about the usage of their resources, the ability to ensure the optimal
use of these resources and centralized control over their networks.

      With today's greater mobility, the need to keep track of moves and changes
in an organization requires the use of tools to control, manage and document
these changes more effectively. The useful life of a standard cabling structure
should be fifteen years. This means that existing cables should be able to
support an average of three upgrades of communication equipment during its
lifetime, plus an average of five changes to all outlets. It is virtually
impossible to achieve this performance level without maintaining accurate
records reflecting all details of cabling installations.


                                       21
<PAGE>

      The continuing increase in use of cellular phones for business, during and
outside working hours, has created the need to develop products that will enable
an enterprise to generate a true and full record of all the calls made by its
employees, including cellular calls and calls made by calling cards and other
charge plans.

      A new trend that is becoming popular is telephony over the Internet, which
provides voice communications using the Internet. Although the cost of these
calls is insignificant, as most companies or enterprises already have the
infrastructure in place, it is important to keep track of the calls for
marketing purposes, security, or even just to increase worker productivity.
Skypes is an example of one of these services using computer to computer
communications. Others such as Cisco, Mera, ArelNet, Radvision use gateways,
while other PBX manufacturers use special line cards in the PBX to connect to
the Internet and provide this service, which is known as Voice over the Internet
protocol (VoIP). We provide telemanagement and billing solutions for these new
services. Another area used in conjunction with these new services is
"pre-paid," which allows a customer to buy a certain amount of time (expressed
as a function of money) either from the web or through the purchase of a
"scratch" card (which contains an account or Personal Identification Number
(PIN) and units of time) and debits the account with each usage.

      Another new area for which we have already prepared billing solutions is
WiFi or "hot-spots", which are being installed in public places, such as
airports, hotels, universities and coffee houses. This enables the user's
account to be charged for any usage of the service by the user while connected
to these devices.

Products and Services

      We offer a range of call accounting and converged voice/data management
solutions, based on our standard platform which can be adjusted to specific
customers' needs and requests, as well as fault management systems for networks
and PBXs, and facilities management for cabling and equipment. Additionally,
some of our products are geared for communications resellers and as such enable
them to issue regular bills for the communications services rendered. Today
these products and services, starting with the original TABS line, constitute
the basic building blocks for adding modules to cater to the new advanced
communications infrastructures and services.

Background History

      We were the first to offer a PC-based non-dedicated call accounting system
when we introduced the first version of TABS in 1985. To date, over 60,000 TABS
accounting systems have been sold to end-users located in over 60 countries.
TABS supports worldwide charging methods (pulse and duration), call pricing
tables and currencies and is available in different languages. Our PBX interface
database includes default formats for the major PBX manufacturers and business
phone systems, including those manufactured by Ericsson, Philips, Siemens,
Lucent, Nortel, Alcatel, ECI/Tadiran, Harris, NEC, Avaya, Mitel, Damovo, LG and
Panasonic, making TABS compatible with substantially all currently available PBX
and business phone systems. Our flexible format allows some of the newer
equipment such as VoIP PBXs and routers/gateways to be inputted to and reported
on TABS. This includes the RADVision and Cisco gateways and gatekeepers.


                                       22
<PAGE>

Call Accounting and Management Solutions for Enterprises

TABS.IT

      TABS.IT is a solution for small offices, medium sized businesses, and
Fortune 500 enterprises that want to take full control over their communications
network. Specific applications enable hotels, shared tenant environments,
hospitals, universities and service bureaus to resell communications services to
users employing simple, yet efficient mark-up formulas.

      TABS.IT tracks the details of all voice communications usage (dialed
numbers, call duration, destination, cost of each call, trunk line usage, etc.)
and produces accurately priced individual customer bills. In addition, TABS.IT
tracks the details of all data communications (IP address, name, number of
bytes, bandwidth usage, nodes, etc.) and can produce a relative cost figure.
TABS.IT products are able to:

      o     Register and track incoming and outgoing, trunk-to-trunk and
            internal calls, including response time, ring time and Caller ID.

      o     Add billing details and cost of calls according to applicable
            pricing tables, including mark-up calculations by extension and
            other user-defined categories and rate updates.

      o     Perform multi-carrier analysis, providing carrier comparison "what
            if" reports.

      o     Support authorization and account codes.

      o     Identify inactive and defective trunks and extensions.

      o     Operate in a LAN environment, permitting multi-user and
            multi-tasking functionality.

      o     Generate and electronically distribute billing documents, management
            and verification reports and 3-D color graphs for easy data
            analysis.

      With additional modules, the following optional features are available:

      o     Reporting on e-mails (eTABS).

      o     Reporting on VoIP (VoIPTABS).

      o     Reporting on web browsing (wTABS).

      o     Accessing the information over the Internet (Web Access).

      These additional modules were developed especially for Internet usage and
provide enterprises with the scalability necessary to permit growing enterprise
organizations to further extend their ability to monitor and optimize their
local networks. With the introduction of Web Access, multiple users now have the
ability to access the TABS database and easily generate reports and graphs from
any PC that has access to the Internet. With this new module, each authorized
user anywhere in the world can browse and review reports containing restricted
data, according to his authorization. These reports are created from the TABS
database by using a web browser at a remote station. In addition, powerful
graphs give the manager an immediate overview of the situation. Both the graphs
and reports can be exported to other applications, such as PowerPoint for the
graphs or Excel for the reports.


                                       23
<PAGE>

      The powerful TABS.IT report generator provides a wide variety of usage
reports that are easy to read and understand, yet provide all the information
necessary to identify how communications network resources are being utilized.
These reports can be generated either as a summary of the call data or complete
with all the details necessary to make informed management decisions. Their
structural flexibility allows the user to quickly zero in on the specific data
of greatest interest. Historical reports may be maintained for an unlimited
period of time and can become useful tools for assessing budget needs for the
coming months or years. Specific report categories include ring time reports,
call breakdown reports, hit parade reports, directory reports, exception reports
and trunk reports. In addition, a robust custom reporting feature offers the
user an effective means of generating reports that can go far beyond the
standard categories. With this feature, the user is able to create reports that
can be tailored to meet even the most specific of reporting requirements, and
they can be scheduled to run automatically at a prescribed time.

      Version 7 of TABS.IT is fully web-based allowing users to see their own
call usage on-line from anywhere, and incorporates most of the features that
were offered as separate modules in previous versions. This version is easily
adapted to companies that have multiple sites, and would want to view the
activity from a central site. The administrative functions can also be performed
remotely using Internet Explorer. Full security and privacy is assured by use of
various levels of password protection.

      The WinTRAK family of products is MTS IntegraTrak's telemanagement
solution that has been sold in the United States market since 1985. After
incorporating all the functionality of WinTRAK, we migrated TABS.IT for use in
the United States in 2002. Although we are no longer marketing WinTRAK, we
continue to support this product.

Application Suite

      The Application Suite is an integrated, customized solution to manage and
control the entire communications network, from internal IT operations to
complete IT service management and CC&B solutions. The Application Suite
implements and monitors real time performance and usage defined by the
organization to maintain budget control, usage performance and system health,
and utilized by service providers for converged pre and post paid billing. The
system's flexible architecture enables organizations, service providers,
Internet service providers and operators to effectively manage their entire
billing process, adding on capabilities as their business grows, in accordance
with customer's requests, special projects or market trends. Utilizing its
web-based user centric capabilities, the platform provides its users, including
administrators, employees, and customers, with a single easy-to-use interface
self provisioning customer care, while guaranteeing corporate security via the
different authentication levels.

      The main functions of the TABS.IT and WinTRAK family of products were
incorporated into the Application Suite solution, which supersedes these
solutions. In addition, budget control monitoring modules were added to the
Application Suite solution to verify that the extensions, departments, cost
centers operate within budget, and a credit limit may be assigned.


                                       24
<PAGE>

Facilities Management System

      With today's greater mobility, the need to keep track of moves and changes
in an organization requires the use of tools to control, manage and document
these changes more effectively. In March 2002, we acquired a software product
from Total Wire Software Company, Inc., a privately held Florida-based company.
That product was superseded by new software during 2002, and is marketed as
FaciliTRAK, enables us to offer a product that provides tracking of inventory
such as telephones, computers and ancillary equipment associated with a user and
develop a complete composite report of an enterprise's resources. Additionally,
it gives us the ability to provide a full "total information" system to
enterprises for controlling and managing the entire physical layer of an
organization's voice and data system. The "top of the line" FaciliTRAK product
is a full featured, graphic-oriented cable and asset management system, that
comes complete with Visio Technical, a CAD interface, and is available in both a
single workstation and a multi-user network version. Its unique flexibility
allows users to "mirror" complex networks commonly found in large companies,
while its enhanced ability allows it to document and design cable plant projects
of all sizes.

      FaciliTRAK documents and controls the management of the physical layer,
device configuration and circuit connectivity for a wide range of network
topologies including ethernet, token ring, voice, fiber distributed data
interface, etc. that range in size, from just a few hundred nodes to many
thousand, and with its universal functionality can be extended to interface with
logical network management systems, cable testing and labeling systems, help
desk, call accounting, and other facility management tools. Using a flexible and
multipurpose database, FaciliTRAK documents the physical characteristics for any
network, recording the network, asset, user, device configuration, and exact
connections between equipment and cabling. The results are then presented in
either a database view, dynamic schematic, or Visio Technical drawing. The
schematics generated by those modules are used to show the physical connectivity
and logical path of the equipment and cabling connections in the database.

      As a multi site system, FaciliTRAK can store information for multiple
buildings or campuses and show views by floor, closet and zones. Specific
information such as port or pair assignment, network addresses, and circuit
connections are easily entered to match the level of detail required.

      The FaciliTRAK help desk feature provides both an administrative process
and audit trail for recording, scheduling and maintenance changes that need to
be made to items and connections in a site. There are three options within
service desk: (i) service requests, (ii) trouble tickets, and (iii) work orders.
Each provides its own choices and reference numbering for easy tracking and
assignment. Both service requests and trouble tickets provide the option of
being used globally for the entire organization, regardless of whether the item
in service has been recorded in the site database, or used for items within the
current site. The main features of the FaciliTRAK, which are inventory control,
help desk, and cable management, have been incorporated into the new Application
Suite solution.


                                       25
<PAGE>

Billing Solutions

      In 2002, we introduced the TABSBill module for vertical enterprises, such
as hospitals, universities, medical clinics and tenant sharing facilities,
enabling the enterprises to rapidly generate bills based on usage. TABSBill,
which is geared to resellers of billing services, provides for the scheduled
reporting and automatic distribution of customer communications bills based on
tracking phone calls, e-mail and network usage, as well as for one time or
recurring charges. The bills can be generated directly from the data collected
by TABS, from CDs from the service provider, or from downloaded files of call
data. All kinds of communications usage data may be billed. The user can view
his bills on-line as TABSBill is web based. The bills can be displayed, printed
out or sent by e-mail. There is even provision for the secure payment of the
bill on-line. Our billing solutions have been enhanced as a result of the
acquisition of the Teleknowledge billing solution, which enables us to offer a
comprehensive end-to-end customer care and billing solution, including data
collection, verification and validation, mediation, guiding, rating, processing,
reporting and issuing of invoices. The solutions also track usage of some of the
new value-added services (such as Video on Demand and information) as well as
for content (such as games, music, downloads and ring tones). The billing
solutions provide a converged user centric solution, enabling the user to view
all telecommunications expenditures on one bill, including mobile phones,
calling cards, pre-paid billing and landlines. The billing solutions cover a
full range of billing applications, from simple customer bills, VoIP billing and
WiFi billing, to full Interconnect (or wholesale) billing. In addition to the
main billing solution, our billing solution provides customer Web self-care,
Help Desk, and Order Management modules.

Other Modules

      An add-on module, Tie Line Reconciliation, or TLR, provides for the
accurate costing of calls in a private PBX network by calculating the actual
cost of calls routed over private tie lines and assigning charges to the
originating extension. The call is resolved into an accurate
origination-destination configuration even though the call may pass many "nodes"
along the way, with each potentially discharging an independent call record.

      Another add-on module, Property Management System interface, or PMSi,
provides an interface protocol and format for telecommunication management
systems with hotel billing solutions (Front Office or PMS systems). Through the
use of this interface, which can also connect to PBXs, the hotel system is able
to control the opening and closing of guest extensions on check in or out.

      Another add-on module is our Budget Manager, which allows an administrator
to assign credit limits to extensions, departments, cost centers, or any other
organizational hierarchy, and monitor whether these limits have been exceeded or
the calls remain within their allocated budgets.

Customer Service and Installation

      We provide customer support to end-user customers in the United States,
Israel, Hong Kong, the Netherlands and Brazil on both a service contract and a
per-incident basis. Our technical support engineers answer support calls
directly and generally seek to provide same-day responses. We provide updated
telephone rate tables to customers on a periodic basis under annual service
contracts. The rate tables are obtained from third-party vendors who provide
this data for all major long-distance service providers. Our distributors
provide a full range of service and technical support functions for our
products, including rate tables, to their respective end-user customers.


                                       26
<PAGE>

      Our support staff installs products at end-user locations from offices in
Israel, the United States, Hong Kong, the Netherlands and Brazil. Customers who
maintain their own technical staffs are often able to install our products
themselves with minimal telephone support from us. We charge our customers a fee
for each installation performed by our employees. Our distributors are
responsible for the installation and support of our products with respect to
their end-user customers.

Sales and Marketing

      We market our products in over 60 countries worldwide through OEM
distribution channels and our own direct sales force in the United States,
Europe, Israel, Hong Kong and Brazil, and through a network of local
distributors in these and various other countries in Europe, Asia and Latin
America. We employed 35 persons in our sales and marketing force and 45 persons
in support as of December 31, 2004. With the acquisition of IntegraTRAK in April
2000, our marketing efforts in North America were significantly increased. This
also enabled us to acquire additional Fortune 500 companies as our customers. We
also sell our products to business telephone switching systems manufacturers and
vendors, distributors and PTTs. Since 1985, over 60,000 TABS call accounting
products have been sold, many of which have been sold to large organizations. In
addition, as customers move to consolidate the management of their multi-site
telecommunications activities, we intend to capitalize on our initial successes
with our customers and expand the use of our products by offering these
organizations the added capabilities of expanding and monitoring on the Web. By
acquiring the FaciliTRAK software in March 2002, we gained access to a whole new
realm of opportunities and we now are able to offer a complete solution to the
high-end market sector.

Managed Services

      Our managed services solution is an outsourcing solution geared to
multi-national companies that centrally manage their telecommunications usage
and is being offered as an added value service. This solution has been offered
in the United States where our Seattle office acts as a service bureau.

      Switching Systems Manufacturers and Vendors. We believe that the most
efficient means of selling our telemanagement products is to enter into
relationships with major business telephone system manufacturers and vendors who
market our products on either an original equipment manufacturer, or OEM, basis,
or supplemental sales basis at the time they sell their switching systems. We
also utilize our distributors to market our products to local business telephone
switching systems manufacturers and distributors. We intend to establish
additional strategic relationships with business telephone switching systems
manufacturers and vendors and PTTs. These manufacturers have begun to consider
telemanagement capability as a competitive tool when selling their products and
have begun to offer end-users a complete, integrated solution. Among the
companies that have been selling our products are Siemens, Philips, Ericsson,
Nortel, Alcatel, ECI/Tadiran, NEC, Cisco, Damovo and Panasonic. In addition, we
intend to work with such gateway providers as Cisco, Mera, ArelNet and
Radvision. The percentages of sales attributable to our three largest OEM
customers, Siemens, Philips and Ericsson, in each of the three years ended
December 31, 2004 are as follows:


                                       27
<PAGE>

                                             2002           2003         2004
                                             ----           ----         ----
Siemens..........................            36.0%          40.0%        38.0%
Philips..........................             6.0%           7.0%         5.0%
Ericsson.........................             4.0%           4.0%         4.0%

      Distributors. In general, in those countries where we do not have a
marketing subsidiary, we distribute our products through a local distributor.
Marketing, sales, training, product and client support are provided by our local
distributors. A local distributor is typically a telecommunication products
marketing organization with the capability to add value with installation,
training, and support. Distributors are generally responsible for the
localization of our products into their native language. The distributor also
translates our standardized product marketing literature and technical
documentation. Prior to becoming an authorized distributor, the distributor's
employees must undergo sales and technical training. We are available for
second-tier support for the distributor and for end-users. In coordination with
the distributors, we also provide technical support for large and multinational
accounts. We have distributors worldwide and intend to expand our network of
distributors and resellers and to expand our direct sales force and field
organization in selected markets.

      PTTs. We also market our products to PTTs who integrate our solutions with
the telephone systems they sell or lease to their customers. Among the PTTs who
sell our products are Telecom Italy, Cable and Wireless, Trinidad PTT and Hong
Kong Telecom.

      Strategic Relationships. As part of our marketing strategy, we attempt to
develop and establish new strategic relationships with manufacturers of voice
and data communication systems and IP based equipment as means of entering new
markets and channels. We are also continuing our relationship with RADVision, a
recognized IP technology leader. Together with RADVision, we offer solutions
consisting of RADVision's Gatekeeper and our advanced Web-based call management
solution. We also signed an agreement with Cisco, pursuant to which Cisco will
include our VoIP solution in their CallManager call processing software, a key
component of Cisco's AVVID (Architecture for Voice, Video and Integrated Data).
Our software provides validated reports on call records, start time, duration,
and origin and final destination. Additional features include the ability to
allocate usage-sensitive call costing and, using an integrated fraud module,
detect unauthorized or inappropriate system access.

      Other Marketing Activities. We are conducting a wide range of marketing
activities aimed at generating awareness and leads, including public relations,
attendance at trade shows and exhibitions, user conferences, direct mail,
response mail and seminars. We have joined alliances with strategic partners
such as Alcatel and Cisco. We regularly advertise our products in prominent
trade publications, and we also participate in major regional and international
technology and communications trade shows, forums, and fairs worldwide. These
activities are intended both to generate leads and maintain the general public
awareness of our products. We maintain our web site on-line, allowing for
correspondence and queries from new potential customers as well as promoting
support for our existing customer base.


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<PAGE>

Competition

      The market for telemanagement products and billing solutions is fragmented
and is intensely competitive. Competition in the industry is generally based on
product performance, depth of product line, technical support and price. We
compete both with international and local competitors (including providers of
telecommunications and billing services), many of whom have significantly
greater financial, technical and marketing resources than we do. Our existing
and potential customers, including business telephone switching system
manufacturers and vendors, may be able to develop telemanagement and billing
products and services that are as effective as, or more effective or easier to
use than, those offered by us. Such existing and potential competitors may also
enjoy substantial advantages over us in terms of research and development
expertise, manufacturing efficiency, name recognition, sales and marketing
expertise and distribution channels. Although we believe that the quality of our
products is equal to or better than the product quality of our competitors with
regard to performance and reliability, we have no quantitative data other than
the evaluations of our present customers from which to assess our current
ability to compete. There can be no assurance that we will be able to compete
successfully against current or future competitors or that competition will not
have a material adverse effect on our future revenues and, consequently, on our
business, operating results and financial condition.

Intellectual Property Rights

      We do not hold any patents and rely upon a combination of security
devices, copyrights, trademarks, trade secret laws, confidentiality procedures
and contractual restrictions to protect our rights in our products. Our policy
has been to pursue copyright protection for our software and related
documentation and trademark registration of our product names. Some of our
products have the added protection afforded by a hardware component which has
embedded software that it is difficult to misappropriate. In addition, our key
employees and independent contractors are required to sign non-disclosure and
secrecy agreements. All of the intellectual property rights with respect to our
current products are held by Mer Telemanagement Solutions Ltd.

      Our trademark rights include rights associated with the use of our
trademarks, and rights obtained by registration of our trademarks. We have
obtained trademark registrations in Israel and the United States. The use and
registration rights of our trademarks does not ensure that we have superior
rights over other third parties that may have registered or used identical
related marks on related goods or services.

      We believe that, because of the rapid pace of technological change in the
communication industry, the legal protections for our products are less
significant factors in our success than the knowledge, ability and experience of
our employees, the frequency of product enhancements and the timeliness and
quality of support services provided by us.

C.    ORGANIZATIONAL STRUCTURE

      Our wholly owned subsidiaries in the United States, Hong Kong, the
Netherlands and Brazil, MTS IntegraTRAK Inc., MTS Asia Ltd., JARAGA B.V. and
TABS Brazil Ltd., respectively, act as marketing and customer service
organizations in those countries. Our 50% owned affiliate in Spain, Jusan S.A.,
is engaged in the development, manufacture, assembly, sales, distribution and
maintenance of vocal server and call billing applications.


                                       29
<PAGE>

D.    PROPERTY, PLANTS AND EQUIPMENT

      Our executive offices and research and development facilities are located
at 22 Zarhin Street, Ra'anana, Israel, where we occupy approximately 14,600
feet. The lease, which expires on December 31, 2005, has an annual rental charge
of approximately $235,000.

      Our U.S. subsidiary occupies approximately 6,368 square foot space in
Bellevue, Washington at annual rental charge of approximately $127,359. The
lease will expire in September 2006. We have subleased 1,900 square feet of this
space until September 2006 and are receiving annual rental income of
approximately $26,940.

      In addition, we have an office in New Jersey, where we occupy
approximately 1,852 square feet of space. The lease, which expires in September
2006, has an annual rental charge of approximately $33,000.

      The annual rental cost for our Hong Kong and Sao Paulo offices is
approximately $28,000.

ITEM 5.  OPERATING AND FINANCIAL REVIEW AND PROSPECTS

      The following discussion of our results of operations should be read
together with our consolidated financial statements and the related notes, which
appear elsewhere in this annual report. The following discussion contains
forward-looking statements that reflect our current plans, estimates and beliefs
and involve risks and uncertainties. Our actual results may differ materially
from those discussed in the forward-looking statements. Factors that could cause
or contribute to such differences include those discussed below and elsewhere in
this annual report.

Overview

      We are a total solutions provider in the telecom expense and billing
arenas. We design, develop, market and support a comprehensive line of
telecommunication management and customer care and billing, or CC&B, solutions,
that enable business organizations and other enterprises to improve the
efficiency and performance of all IP operations, and to significantly reduce
associated costs. Our products include call accounting and management products,
fault management systems and Web-based management solutions for converged voice,
voice over IP, IP data and video and CC&B solutions. These products are designed
to provide telecommunication and information technology managers with tools to
reduce communication costs, recover charges payable by third parties, detect and
report the abuse and misuse of telephone networks, monitor and detect hardware
and software faults in telecommunications networks and generate
telecommunications usage information for use in the management of an enterprise.
We were among the first to offer PC-based call accounting systems when we
introduced our TABS product in 1985. To date, over 60,000 TABS call accounting
systems have been sold to end-users in more than 60 countries.


                                       30
<PAGE>

General

      Our consolidated financial statements are stated in dollars and prepared
in accordance with generally accepted accounting principles in the United
States. Transactions and balances originally denominated in dollars are
presented at their original amounts. Transactions and balances in other
currencies are remeasured into dollars in accordance with the principles set
forth in Financial Accounting Standards Board Statement No. 52. The majority of
our sales are made outside Israel in dollars. In addition, substantial portions
of our costs are incurred in dollars. Since the dollar is the primary currency
of the economic environment in which we and certain of our subsidiaries operate,
the dollar is our functional and reporting currency and, accordingly, monetary
accounts maintained in currencies other than the dollar are remeasured using the
foreign exchange rate at the balance sheet date. Operational accounts and
non-monetary balance sheet accounts are measured and recorded at the exchange
rate in effect at the date of the transaction. The financial statements of
certain subsidiaries and an affiliate whose functional currency is not the
dollar, have been translated into dollars. 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 period. The resulting translation adjustments are reported as a
component of shareholders' equity in accumulated other comprehensive income
(loss).

Discussion of Critical Accounting Policies and Estimations

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

      Critical accounting policies are those that are both most important to the
portrayal of a company's financial position and results of operations, and
require management's most difficult, subjective or complex judgments. Although
not all of our significant accounting policies require management to make
difficult, subjective or complex judgments or estimates, the following policies
and estimates are those that we deem most critical:

      Revenue Recognition

      We recognize software license revenues when both parties sign an agreement
or other persuasive evidence of an arrangement exists, when the software has
been shipped or electronically delivered, when the fees are fixed or
determinable, and when collection of the resulting receivable is probable, and
no other significant obligations remain. For multiple element arrangements,
where vendor-specific objective evidence of fair value exists for all
undelivered elements, we account for the delivered elements in accordance with
the "residual method". Vendor specific objective evidence of fair value is based
on the price a customer is required to pay when the element is sold separately.
We assess whether the fee is fixed or determinable and collection is probable at
the time of the transaction. In assessing whether the fee is fixed or
determinable, we analyze the payment terms of the transaction and other factors,
including the nature and class of customer, our historical experience of
collecting under our payment terms without granting a concession. If we
determine the fee is not fixed or determinable, we defer the revenue until the
payments under the arrangement become due. We assess whether collection is
probable based on a number of factors, including the customer's past transaction
history and credit worthiness. If we determine that collection of a fee is not
probable, we defer the fee and recognize revenue only at the time that
collection becomes probable, which is generally upon the receipt of cash.


                                       31
<PAGE>

      Revenue from maintenance contracts is recognized ratably over the term of
the maintenance contract.

      Income Taxes

      We use the liability method to account for income taxes whereby deferred
tax assets and liability account balances are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse. Valuation allowances were provided to
reduce deferred tax assets are provided to reduce their estimated realizable
value.

      Contingencies

      We periodically estimate the impact of various conditions, situations
and/or circumstances involving uncertain outcomes to our financial condition and
operating results. These events are called "contingencies." Contingency is
defined as "an existing condition, situation, or set of circumstances involving
uncertainty as will ultimately be resolved when one or more future events occur
or fail to occur." Legal proceedings are a form of such contingencies.

      In April 2000, the tax authorities in Israel issued a demand for a tax
payment for the period of 1997-1999, in the amount of approximately NIS 6.0
million ($1,350). We have appealed to the Israeli District Court in respect of
such tax demand. Based on the opinion of our legal counsel, we believe that
certain defenses can be raised against the demand of the tax authorities. We
made a provision in the amount of $464,000 in our financial statements, based on
the current evidence and on the basis of the said opinion of our legal counsel.

      On April 18, 2005, Amdocs (Israel) Ltd. and Amdocs Ltd. filed a complaint
in the Tel Aviv District Court naming our company, our chief executive officer
and others as defendants (Civil File No. 32419-05/05). The complaint alleges,
among other things, that professional and commercial information belonging to
the plaintiffs was transferred to the defendants for use in our company's
activity. The plaintiffs are seeking an injunction prohibiting the defendants
from making any use of the information and trade secrets that were allegedly
transferred, and mandatory injunctions requiring the return of any such
information and the payment of estimated damages of NIS 14,775,000
(approximately $3,360,000). Due to the preliminary stage of the litigation, we
cannot currently advise as to the outcome of the lawsuit. We intend to
vigorously defend this action.

      Impairment of long-lived assets

      Our long-lived assets and certain identifiable assets are reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of an asset
to the future undiscounted cash flows expected to be generated by the assets. If
such assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceeds the
fair value of the assets. As of December 31, 2004, no impairment losses have
been identified. The use of different assumptions with respect to the expected
cash flows from our assets and other economic variables, primarily the discount
rate, may lead to different conclusions regarding the recoverability of our
assets' carrying values and to the potential need to record an impairment loss
for our long-lived assets.


                                       32
<PAGE>

      Goodwill

      Goodwill represents excess of the costs over the net assets of business
acquired. Goodwill from acquisitions made prior to July 1, 2001 was amortized
until December 31, 2001 by the straight-line method over 10 years. Goodwill
acquired in a business contraction on or after July 1, 2001 will not be
amortized.

      Effective January 1, 2002, we adopted SFAS No. 142. SFAS No. 142 requires
goodwill to be tested for impairment on adoption and at least annually
thereafter, and written down when impaired, rather than being amortized as
previous accounting standards required. Goodwill attributable to each of our
reporting units is tested for impairment by comparing the fair value of each
reporting unit with its carrying value. Fair value is determined using
discounted cash flows. Significant estimates used in the methodologies include
estimates of future cash flows, future short-term and long-term growth rates,
and weighted average cost of capital for each of the reportable units. We have
selected September 30 as the date we will perform our annual goodwill impairment
tests. The annual goodwill impairment test for 2004 was prepared for us by an
independent consulting firm. As of December 31, 2004, no impairment was
required. Any changes in our key assumptions could result in an impairment
charge and such a change could have a material adverse affect on our financial
position and results of operations.

      Investments in affiliate and other companies

      Our investments in a privately held company, in which we hold 50%
ownership of voting rights and can exercise significant influence over operating
and financial policy of the affiliate, are presented using the equity method of
accounting. Goodwill related to investments in the affiliate is no longer
amortized. The goodwill is reviewed annually (or more frequently if
circumstances indicate impairment has occurred) for impairment. Before January
1, 2002, goodwill was amortized on a straight-line basis over 10 years.

      Investments in privately held companies in which the we hold less than 20%
and do not have the ability to exercise significant influence over their
operating and financial policy, are presented at cost. We periodically review
the carrying value. If this review indicates that the carrying value is not
recoverable, the carrying value is reduced to its estimated fair value. As of
December 31, 2004, no impairment losses have been identified. Any changes in our
key assumptions concerning their carrying value could have a material adverse
affect on our financial position and results of operations.

      Research and development costs

      Research and development costs, net of grants received, are charged to
expenses as incurred. Certain software development costs must be capitalized
subsequent to the establishment of technological feasibility. Based on our
product development process, technological feasibility is established upon
completion of a working model. Costs incurred by us between completion of the
working model and the point at which the product is ready for general release
should be capitalized. During 2004, we capitalized $0.4 million of research and
development costs.


                                       33
<PAGE>

      Capitalized software costs are amortized by the greater of: (i) ratio of
current gross revenues from sales of the software to the total of current and
anticipated future gross revenues from sales of that software or (ii) the
straight-line method over the remaining estimated useful life of the product
(not greater than three years). We assess the recoverability of this intangible
asset on a regular basis on every balance sheet date by determining whether the
amortization of the asset over our remaining life can be recovered through
undiscounted future operating cash flows from the specific software product
sold. Based on the most recent analyses, our management believes that our
existing capitalized software as at December 31, 2004 should be amortized by the
straight-line method over the remaining estimated useful life of the product
(three years). Under different assumptions with respect to the recoverability of
this intangible asset, our determination may be different, which may negatively
affect our financial position and results of operations.

      Concentrations of credit risk

      Financial instruments that potentially subject us and our subsidiaries to
concentrations of credit risk consist principally of cash and cash equivalents,
marketable securities, trade receivables and long-term loans. Our cash and cash
equivalents are deposited in major Israeli and U.S. banks. Such deposits in U.S.
banks may be in excess of insured limits and are not insured in other
jurisdictions. We believe that the financial institutions that hold our
investments are financially sound and, accordingly, minimal credit risk exists
with respect to these investments. Our marketable securities mainly include
investments in corporate debt and mutual funds. We believe that the portfolio is
well diversified, and accordingly, minimum credit risk with respect to these
marketable securities exists.

      We perform ongoing credit evaluations of our customers and have not
experienced any material losses in recent years. An allowance for a doubtful
account is determined with respect to those amounts that we have determined to
be doubtful of collection. Any changes in our assumptions relating to the
collectability of our accounts receivable may affect our financial position and
results of operations.

      We have no off-balance-sheet concentration of credit risk, such as foreign
exchange contracts, option contracts or other foreign hedging arrangements.

Acquisition of TeleKnowledge

      In December 2004 we completed the acquisition of certain assets and
liabilities of TeleKnowledge Group Ltd., or TeleKnowledge, a provider of carrier
class billing and related solutions. In connection with the acquisition, we paid
an initial consideration of $2.374 million and agreed to pay additional
contingent consideration of up to $3.65 million over a period of three years
based on post acquisition revenue performance. The acquisition of the
Teleknowledge billing solution enables us to offer an end-to-end customer care
and billing solution, including pre/post paid billing, Web self-care, assets
management, partner management, help desk and order management modules.

      Based upon a valuation of tangible and intangible assets acquired and
liabilities assumed, we have allocated the total cost of the acquisition to
assets and liabilities, as follows:


                                       34
<PAGE>

                                                                 U.S. dollars in
                                                                    thousands
                                                                 --------------

      Trade receivables                                          $          100
      Property and equipment, net                                            40
      Intangible assets:
         Developed technology (four-year useful life)                       690
         Customer relationship (six-year useful life)                       300
         Goodwill                                                         1,391
                                                                 --------------
      Total assets acquired                                               2,521
      Liabilities assumed:
         Deferred revenues                                                  (76)
                                                                 --------------
      Total liabilities assumed                                             (76)
                                                                 --------------

      Net assets acquired                                        $        2,445
                                                                 ==============

Recently Issued Accounting Standards

      On December 16, 2004, the Financial Accounting Standards Board, or FASB,
issued Statement of Financial Accounting Standards No. 123 (revised 2004),
"Share-Based Payment", or SFAS 123(R), which is a revision of Statement of
Financial Accounting Standards No. 123, "Accounting for Stock Based
Compensation", or SFAS 123. Generally, the approach in SFAS 123(R) is similar to
the approach described in SFAS 123. However, SFAS 123 permitted, but did not
require, share-based payments to employees to be recognized based on their fair
values while SFAS 123(R) requires all share-based payments to employees to be
recognized based on their fair values. SFAS 123(R) also revises, clarifies and
expands guidance in several areas, including measuring fair value, classifying
an award as equity or as a liability and attributing compensation cost to
reporting periods. The new standard will be effective for us commencing January
1, 2006.

      SFAS 123(R) permits companies to adopt its requirements using one of the
following two methods:

      1.    The "modified prospective" method, in which compensation cost is
            recognized commencing with the effective date (i) based on the
            requirements of SFAS 123(R) for all share-based payments granted
            after the effective date and (ii) based on the requirements of SFAS
            123 for all awards granted to employees prior to the effective date
            of SFAS 123(R) that remain unvested at the effective date.

      2.    The "modified retrospective" method, which includes the requirements
            of the modified prospective method described above, but also permits
            entities to restate based on the amounts previously recognized under
            SFAS 123, for purposes of pro forma disclosures either (i) all prior
            periods presented or (ii) the prior interim period of the year of
            adoption.

      As permitted by SFAS 123, we currently account for share-based payments to
employees using APB 25, the intrinsic value method, and, as such, recognize no
compensation cost for employee stock options. Accordingly, the adoption of the
SFAS 123(R) fair value method will have significant impact on our results of
operations, although it will have no impact on our overall financial position.
The impact of the adoption of SFAS 123(R) cannot be predicted at this time, as
it depends on levels of share-based payments for future grant. However, had we
adopted SFAS 123(R) in prior periods, the impact of that Standard would have
approximated the impact of SFAS 123, as described in the disclosure of the pro
forma net loss and net loss per share in the footnote to our financial
statements.


                                       35
<PAGE>

A.    OPERATING RESULTS

      The following table presents certain financial data expressed as a
percentage of total revenues for the periods indicated:

<TABLE>
<CAPTION>
                                                                              Year Ended December 31,
                                                                           2002         2003         2004
                                                                        ---------    ---------    ----------
<S>                                                                         <C>          <C>          <C>
      Revenues
      Product sales...................................................      75.6%        75.2%        75.1%
      Services                                                              24.4         24.8         24.9
                                                                        ---------    ---------    ----------
      Total revenues..................................................     100.0%       100.0%       100.0%
      Cost of revenues
      Product sales...................................................      16.9         16.5         25.6
      Services........................................................       2.5          3.5          4.3
      Total cost of revenues..........................................      19.4         20.0         29.9
      Gross profit....................................................      80.6         80.0         70.1
      Selling and marketing...........................................      40.4         42.5         66.9
      Research and development........................................      21.7         19.8         25.1
      General and administrative......................................      19.0         19.8         22.3
                                                                        ---------    ---------    ----------
      Operating loss..................................................      (0.5)        (2.1)       (44.2)
      Financial income, net...........................................       1.4          1.3          0.8
      Other income (expenses).........................................      (1.5)         0.1          0.0
                                                                        ---------    ---------    ----------
      Loss before taxes...............................................      (0.6)        (0.7)       (43.4)
      Taxes on income.................................................       0.5          2.1          2.8
                                                                        ---------    ---------    ----------
      Net loss before equity in earnings of affiliate.................      (1.1)        (2.8)       (46.2)
      Equity in earnings of affiliate.................................       2.4          3.7          2.4
                                                                        ---------    ---------    ----------
      Net income (loss)...............................................       1.3%         0.9%       (43.8)%
                                                                        =========    =========    ==========
</TABLE>

Years Ended December 31, 2004 and 2003

      Revenues. Revenues consist primarily of software license fees sales and
revenues from services, including service bureau, maintenance and support.
Revenues increased 2.0% to $9.41 million in 2004 from $9.23 million in 2003. In
2004, the revenues from our wholly owned U.S. subsidiary, MTS IntegraTRAK,
increased 0.7% from 2003 and accounted for 52.6% of our total revenues. We
expect that our revenues will slightly increase in 2005.

      Cost of Revenues. Cost of revenues consists primarily of (i) production
costs (including hardware, media, packaging, freight and documentation); (ii)
certain royalties and licenses payable to third parties (including the Office of
the Chief Scientist of the Ministry of Industry and Trade of the State of
Israel), (iii) professional services; and (iv) warranty and support costs for up
to one year for end-users. Cost of revenues increased by 52.2% to $2.81 million
in 2004 from $1.85 million in 2003, principally as a result of the significant
number of new employees recruitments in professional services and Tech support
departments and their travel expenditure.


                                       36
<PAGE>

      Selling and Marketing. Selling and marketing expenses consist primarily of
costs relating to sales representatives and their travel expenses, trade shows
and marketing exhibitions, advertising and presales support. Selling and
marketing expenses were $6.30 million in 2004, an increase of approximately
60.9% from $3.92 million in 2003. This increase selling and marketing expenses
in 2004 is primarily attributable to the increase in our personnel globally
across our sales division. We believe that we now have the necessary
infrastructure in place to drive marked penetration and revenue expansions. We
expect that our selling and marketing expenses will increase in 2005 as a result
of our decision to recruit new employees in the United States and Europe.

      Research and Development. Research and development expenses consist
primarily of salaries of employees engaged in on-going research and development
activities, outsourcing subcontractor development and other related costs.
Research and development costs increased by 29% to $2.36 million (after the
capitalization of $0.4 million of software development costs) from $1.83 million
in 2003. Total research and development expenses increased in 2004 due to the
increase of our research and development activity including the recruitment of
new employees in that department and outsourcing additional subcontractors for
development. We did not receive any royalty-bearing grants from the Office of
the Chief Scientist in the last three years and we do not expect to receive any
grants during 2005. We expect that our research and development expenses will
significantly increase in 2005 as a result of our efforts to expand our product
line and its functionalities.

      General and Administrative. General and administrative expenses consist
primarily of compensation costs for administration, finance and general
management personnel, professional fees and office maintenance and
administrative costs. General and administrative expenses increased by 14.8% to
$2.10 million in 2004 from $1.83 million in 2003 as we increased our overall
activity.

      Financial Income, Net. Financial income consists primarily of interest
income on bank deposits and foreign currency translation adjustments. Financial
income decreased by 37% to $78,000 in 2004 from $124,000 in 2003. During the
last four years our interest income was negatively affected by the prevailing
low interest rates in both the United States and in Israel and the decrease in
the total cash and cash equivalents held by us.

      Taxes on Income. In 2004, our taxes on income were $266,000 as compared to
$198,000 in 2003. Most of the taxes in 2004 were the result of our provision for
the Israeli tax authorities demand for tax payment for the period of 1997-1999.
Based on the opinion of our tax consultants, we believe that we have made an
adequate provision for this demand.

      Equity in Results of Affiliate. We recognize income and loss from the
operations of our 50%-owned affiliate, Jusan S.A. In 2004 and 2003, we
recognized income of $225,000 and $345,000, respectively.

Years Ended December 31, 2003 and 2002

      Revenues. Revenues decreased 5.8% to $9.23 million in 2003 from $9.8
million in 2002 as a result of the continued global decline in the demand for
telecommunication products, such as PBX systems, which effected our revenue
stream. In 2003, the revenues from our wholly-owned U.S. subsidiary, MTS
IntegraTRAK, declined 23% from 2002 and accounted for 53.0% of our total
revenues.


                                       37
<PAGE>

      Cost of Revenues. Cost of revenues decreased 2.6% to $1.85 million in 2003
from $1.9 million in 2002, principally as a result of the overall decrease in
revenues.

      Selling and Marketing. Selling and marketing expenses were $3.92 million
in 2003, a decrease of 1% from $3.95 million in 2002. In 2003, we succeeded in
increasing our sales to existing OEM customers, which increased by 45% to $2.3
million compared to $1.59 million in 2002.

      Research and Development. Research and development costs decreased 14% to
$1.83 million in 2003 from $2.13 million in 2002. The total research and
development expenses decreased due to the downsizing process that we continued
to implement through the end of the third quarter of 2003. Beginning in the
fourth quarter of 2003, we began to increase our research and development
expenses. We did not receive any royalty-bearing grants from the Office of the
Chief Scientist in 2002 or 2003. We did not capitalize any software development
costs in either year.

      General and Administrative. General and administrative expenses decreased
by 1.6% to $1.83 million in 2003 from $1.86 million in 2002 as we attempted to
contain such expenses in light of our decreased sales.

      Financial Income, Net. We recorded financial income of $124,000 in 2003 as
compared to financial income of $134,000 in 2002. During the last three years
our interest income was negatively affected by the prevailing low interest rates
in both the United States and in Israel and the decrease in the total cash and
cash equivalents held by us.

      Other Income. During 2003, we recorded income of $6,000 from the exercise
of marketable securities compared to a loss of $140,000 in 2002. During 2002,
the loss was the result of the decline in the value of our marketable securities
whose value had decreased as a result of the global recession.

      Taxes on Income. In 2003, our taxes on income were $198,000 as compared to
$52,000 in 2002. Most of the taxes in 2003 were the result of our realization of
the deferred tax assets according to our conservative accounting policy. During
2003, we realized a tax benefit of $80,000 from a tax return received from the
Spanish tax authorities.

      Equity in Results of Affiliate. We recognize income and loss from the
operations of our 50%-owned affiliate, Jusan S.A. In 2003 and in 2002, we
recognized income of $345,000 and $236,000, respectively.

Quarterly Results of Operations

      The following tables set forth certain unaudited quarterly financial
information for the two years ended December 31, 2004. The data has been
prepared on a basis consistent with our audited consolidated financial
statements included elsewhere in this annual report and include all necessary
adjustments, consisting only of normal recurring adjustments, that we consider
necessary for a fair presentation. The operating results for any quarter are not
necessarily indicative of results for any future periods.


                                       38
<PAGE>

<TABLE>
<CAPTION>
                                                                              Three months ended
                                                              2003                                          2004
                                          ----------------------------------------------------------------------------------------
                                          Mar. 31,    Jun. 30,  Sept. 30,   Dec. 31,    Mar. 31,   Jun. 30,   Sept. 30,   Dec. 31,
                                          -------     -------   --------    --------    --------   --------   ---------   --------
<S>                                        <C>         <C>        <C>         <C>         <C>        <C>         <C>        <C>
Revenues...............................   $ 2,240     $ 2,193   $  2,286    $  2,511    $  2,359   $  1,992   $   2,485   $  2,577
Cost of revenues.......................       540         411        457         441         541        506         674      1,093
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Gross profit...........................     1,700       1,782      1,829       2,070       1,818      1,486       1,811      1,484
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Selling and marketing..................       918       1,061        938         999       1,125      1,397       1,762      2,016
Research and development...............       441         386        434         564         534        569         414        845
General and administrative.............       483         422        462         463         397        489         533        682
Operating expenses.....................     1,842       1,869      1,834       2,026       2,056      2,455       2,709      3,543
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Operating income (loss)................      (142)        (87)        (5)         44        (238)      (969)       (898)    (2,059)
Financial income (expense), net........        16          22        (11)         97          28         (9)         27         32
Other income (loss)....................        --           6         --          --         (32)         2          15         15
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Income (loss) before taxes.............      (126)        (59)       (16)        141        (242)      (976)       (856)    (2,012)
Taxes on income (tax benefit)..........        --          (2)        98         102          --          2           1        263
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Net income (loss) before equity in
   earnings (loss) of affiliate........      (126)        (57)      (114)         39        (242)      (978)       (857)    (2,275)
Equity in results of affiliate.........       139          48        117          41          46         49         140        (10)
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Net income (loss)......................   $    13     $    (9)  $      3    $     80    $   (196)  $   (929)  $    (717)  $ (2,285)
                                          =======     =======   ========    ========    ========   ========   =========   ========

Revenues...............................     100.0%      100.0%     100.0%      100.0%      100.0%     100.0%      100.0%     100.0%
Cost of revenues.......................      24.1        18.7       20.0        17.6        22.9       25.4        27.1       42.4
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Gross profit...........................      75.9        81.3       80.0        82.4        77.1       74.6        72.9       57.6
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Selling and marketing..................      41.0        48.4       41.0        39.8        47.7       70.1        70.9       78.2
Research and development...............      19.7        17.6       19.0        22.5        22.6       28.6        16.7       32.8
General and administrative.............      21.6        19.2       20.2        18.4        16.8       24.5        21.4       26.5
Operating expenses.....................      82.3        85.2       80.2        80.7        87.2      123.2       109.0      137.5
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Operating income (loss)................      (6.4)       (3.9)      (0.2)        1.7       (10.1)     (48.6)      (36.1)     (79.9)
Financial income (expense), net........       0.7         1.0       (0.5)        3.9         1.2       (0.5)        1.1        1.2
Other income (loss)....................        --         0.3         --          --        (1.4)       0.1         0.6        0.6
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Income (loss) before taxes.............      (5.7)       (2.6)      (0.7)        5.6       (10.3)     (49.0)      (34.4)     (78.1)
Taxes on income (tax benefit)..........        --        (0.1)       4.3         4.1          --        0.1          --       10.2
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Net income (loss) before equity in                                                         (10.3)     (49.1)      (34.4)     (88.3)
   results of affiliate................      (5.7)       (2.5)      (5.0)        1.5
Equity in results of affiliate.........       6.2         2.2        5.1         1.6         1.9        2.5         5.5       (0.4)
                                          -------     -------   --------    --------    --------   --------   ---------   --------
Net income (loss)......................       0.5%       (0.3)%      0.1%        3.1%       (8.3)%    (46.6)%     (28.9)%    (88.7)%
                                          =======     =======   ========    ========    ========   ========   =========   ========
</TABLE>

Seasonality

      Our operating results are generally not characterized by a seasonal
pattern except that our volume of sales in Europe are generally lower in the
summer months.

Impact of Inflation and Devaluation on Results of Operations, Liabilities and
Assets

      The dollar cost of our operations in Israel is influenced by the extent to
which any increase in the rate of inflation in Israel is not offset, or is
offset on a lagging basis, by a devaluation of the NIS in relation to the
dollar. When the rate of inflation in Israel exceeds the rate of devaluation of
the NIS against the dollar, companies experience increases in the dollar cost of
their operations in Israel. Unless offset by a devaluation of the NIS, inflation
in Israel will have a negative effect on our profitability, as we receive
payments in dollars or dollar-linked NIS for most of our sales, while we incur a
portion of our expenses in NIS.


                                       39
<PAGE>

      In addition, since part of our sales are quoted in NIS, and a portion of
our expenses are incurred in NIS, our results may be adversely affected by a
change in the rate of inflation in Israel if the amount of our revenues in NIS
decreases and is less than the amount of our expenses in NIS (or if such
decrease is offset on a lagging basis) or if such change in the rate of
inflation is not offset, or is offset on a lagging basis, by a corresponding
devaluation of the NIS against the dollar and other foreign currencies.

      The following table presents information about the rate of inflation in
Israel, the rate of devaluation of the NIS against the dollar, and the rate of
inflation in Israel adjusted for the devaluation:

                                                               Israeli inflation
       Year ended      Israeli inflation    NIS devaluation      adjusted for
      December 31,          rate %              rate %           devaluation %
    ----------------  -------------------  ----------------  -------------------
          2000               0                  (2.7)                 --
          2001               1.4                 9.3                (7.2)
          2002               6.5                 7.3                (0.7)
          2003              (1.9)               (7.6)                6.2
          2004               1.2                (1.6)                2.8

      A devaluation of the NIS in relation to the dollar has the effect of
reducing the dollar amount of any of our expenses or liabilities which are
payable in NIS, unless those expenses or payables are linked to the dollar. This
devaluation also has the effect of decreasing the dollar value of any asset
which consists of NIS or receivables payable in NIS, unless the receivables are
linked to the dollar. Conversely, any increase in the value of the NIS in
relation to the dollar has the effect of increasing the dollar value of any
unlinked NIS assets and the dollar amounts of any unlinked NIS liabilities and
expenses.

      Because exchange rates between the NIS and the dollar fluctuate
continuously, with a historically declining trend in the value of the NIS,
exchange rate fluctuations, particularly larger periodic devaluations, may have
an impact on our profitability and period-to-period comparisons of our results.
We cannot assure you that in the future our results of operations may not be
materially adversely affected by currency fluctuations.

Conditions in Israel

      We are incorporated under the laws of, and our principal executive offices
and manufacturing and research and development facilities are located in, the
State of Israel. Accordingly, our operations in Israel are directly influenced
by political, economic and military conditions affecting Israel. Specifically,
we could be adversely affected by any major hostilities involving Israel, a full
or partial mobilization of the reserve forces of the Israeli army, the
interruption or curtailment of trade between Israel and its present trading
partners, and a significant downturn in the economic or financial condition of
Israel.


                                       40
<PAGE>

Political Conditions

      Since the establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors, and a state of
hostility, varying from time to time in intensity, has led to security and
economic problems for Israel. Since September 2000, there has been a marked
increase in violence, civil unrest and hostility, including armed clashes,
between the State of Israel and the Palestinians, and acts of terror have been
committed inside Israel and against Israeli targets in the West Bank and Gaza.
There is no indication as to how long the current hostilities will last or
whether there will be any further escalation. Any further escalation in these
hostilities or any future armed conflict, political instability or violence in
the region may have a negative effect on our business condition, harm our
results of operations and adversely affect our share price. Furthermore, there
are a number of countries that restrict business with Israel and with Israeli
companies. Restrictive laws or policies of those countries directed towards
Israel or Israeli businesses may have an adverse impact on our operations, our
financial results or the expansion of our business. No predictions can be made
as to whether or when a final resolution of the area's problems will be achieved
or the nature thereof and to what extent the situation will impact Israel's
economic development or our operations.

      In addition, some of our executive officers and employees in Israel are
obligated to perform annual reserve duty in the Israeli Defense Forces and may
be called for active duty under emergency circumstances at any time. If a
military conflict or war arises, these individuals could be required to serve in
the military for extended periods of time. Our operations could be disrupted by
the absence for a significant period of one or more of our executive officers or
key employees or a significant number of other employees due to military
service. Any disruption in our operations could adversely affect our business.

      To date, no executive officer or key employee has been recruited for
military service for any significant time period. Any further deterioration of
the hostilities between Israel and the Palestinian Authority into a full-scale
conflict might require more significant military reserve service by some of our
employees, which may have a material adverse effect on our business.

Economic Conditions

      In recent years Israel has been going through a period of recession in
economic activity, resulting in low growth rates and growing unemployment.
Although economic activity in Israel has improved recently, our operations could
be adversely affected if the economic conditions in Israel begin to deteriorate
again. In addition, due to significant economic measures proposed by the Israeli
Government, there have been several general strikes and work stoppages in 2003
and 2004, affecting all banks, airports and ports. These strikes have had an
adverse effect on the Israeli economy and on business, including our ability to
deliver products to our customers.

Trade Relations

      Israel is a member of the United Nations, the International Monetary Fund,
the International Bank for Reconstruction and Development and the International
Finance Corporation. Israel is a member of the World Trade Organization and is a
signatory to the General Agreement on Tariffs and Trade, which provides for
reciprocal lowering of trade barriers among its members. In addition, Israel has
been granted preferences under the Generalized System of Preferences from the
United States, Australia, Canada and Japan. These preferences allow Israel to
export products covered by such programs either duty-free or at reduced tariffs.


                                       41
<PAGE>

      Israel and the European Union Community concluded a Free Trade Agreement
in July 1975, which confers certain advantages with respect to Israeli exports
to most European countries and obligates Israel to lower its tariffs with
respect to imports from these countries over a number of years. In 1985, Israel
and the United States entered into an agreement to establish a Free Trade Area.
The Free Trade Area has eliminated all tariff and specified non-tariff barriers
on most trade between the two countries. On January 1, 1993, an agreement
between Israel and the European Free Trade Association, known as EFTA,
established a free-trade zone between Israel and the EFTA nations. In November
1995, Israel entered into a new agreement with the European Union, which
includes redefinement of rules of origin and other improvements, including
providing for Israel to become a member of the research and technology programs
of the European Union. In recent years, Israel has established commercial and
trade relations with a number of other nations, including China, India, Russia,
Turkey and other nations in Eastern Europe and Asia.

Effective Corporate Tax Rate

      Israeli companies are generally subject to income tax on their taxable
income. The applicable rate is 35% in 2004, 34% in 2005, 32% in 2006 and 30% in
2007 and thereafter. However, certain of our manufacturing facilities have been
granted "Approved Enterprise" status under the Law for the Encouragement of
Capital Investments, 1959, as amended, commonly referred to as the Investment
Law, and, consequently, are eligible, subject to compliance with specified
requirements, for tax benefits beginning when such facilities first generate
taxable income. Subject to certain restrictions, we are entitled to a tax
exemption in respect of income derived from our approved facilities for a period
of two years, commencing in the first year in which such income is earned, and
will be entitled to a reduced tax rate of 10%-25% for an additional five to
eight years if we qualify as a foreign investors' company. If we do not qualify
as a foreign investors' company, we will instead be entitled to a reduced rate
of 25% for an additional five, rather than eight, years.

      Our effective tax rates in Israel were 25% during the years 2002, 2003 and
2004. Our effective corporate tax rate may substantially increase.

      Our taxes outside Israel are dependent on our operations in each
jurisdiction as well as relevant laws and treaties. Under Israeli tax law, the
results of our foreign consolidated subsidiaries, which have generally been
unprofitable, cannot be consolidated for tax purposes with the results of
operations of the parent company.

B.    LIQUIDITY AND CAPITAL RESOURCES

      On December 31, 2004, we had $3.8 million in cash and cash equivalents,
$1.1 million in marketable securities and working capital of $2.8 million as
compared to $8.7 million in cash and cash equivalents, $1.6 million in
marketable securities and working capital of $9.4 million on December 31, 2003.
The sharp decrease in working capital in 2004 is mainly due to the use of cash
at the end of the year for the purchase of certain assets of Teleknowledge Group
Ltd. as well as for the increase in our business activity that resulted in
increased trade payables and accrued expenses and other liabilities. During
2004, we continued our stock buy back program purchasing 3,800 ordinary shares
through December 31, 2004 at a cost of $8,664, an average $2.28 per share. We
may use the repurchased shares for issuance upon exercise of employee stock
options or other corporate purposes. Based on our current financial situation,
we do not expect to continue this program during 2005.


                                       42
<PAGE>

      One of the principal factors affecting our working capital is the payment
cycle on our sales. Payment for goods shipped is generally received from 60 to
70 days after shipment. Any material change in the aging of our accounts
receivable could have an adverse effect on our working capital.

      Our operations used $2.6 million during the year ended December 31, 2004,
compared to $163,000 that was provided from operations in the year ended
December 31, 2003. The use of our funds in 2004 was primarily due to our net
loss for the year.

      We currently do not have significant capital spending or purchase
commitments, but we expect to continue to engage in capital spending consistent
with the level of our operations. We anticipate that our cash on hand and cash
flow from operations will be sufficient to meet our working capital and capital
expenditure requirements for at least 12 months. However, if we do not generate
sufficient cash from operations, we may be required to obtain additional
financing or to reduce level of expenditure. There can be no assurance that such
financing will be available in the future, or, if available, will be on terms
satisfactory to us.

C.    RESEARCH AND DEVELOPMENT

      Our product development plans are market-driven and address the major,
fast-moving trends that are influencing the telecommunications industry. We
intend to expand upon our existing family of telemanagement solutions by adding
new features and functions to address evolving market needs. We work closely
with our customers and prospective customers to determine their requirements and
design enhancements and new releases to meet their needs. Research and
development activities take place in our facilities in Israel. We are ISO
9001:1994 certified and we are currently in the process of upgrading the quality
system according to ISO 9001:2000.

      We are evaluating approaches to solutions which will permit an information
technology manager to effectively measure the quality of the services received
from their service providers and to ensure that the users within the
organization received such services according to their needs and the overall
policy and priorities of the organization.

      On December 31, 2004, we employed 47 persons in research and development.
As part of our product development team, we employ technical writers who prepare
user documentation for our products.

      We have committed substantial financial resources to research and
development for our telemanagement business. During 2002, 2003 and 2004, our
research and development expenditures were $2.1 million, $1.8 million and $2.4
million, respectively. In the past we enjoyed the aid of the Israeli Ministry of
Industry and Trade's Office of the Chief Scientist for selected research and
development projects. We did not receive any grants from the Office of the Chief
Scientist in 2002, 2003 or 2004.

      Under research and development agreements with the Office of the Chief
Scientist, we are required to pay royalties on the revenues derived from
products incorporating know-how developed with grants received from the Office
of the Chief Scientist and ancillary services in connection therewith, up to
100% to 150% of the dollar-linked value of the total grants, plus interest.
Under these agreements and existing laws and regulations, we are required to pay
royalties at a rate of 3%-5%. The obligation to pay these royalties is
contingent on actual sales of the products and in the absence of such sales, no
payment is required. Since June 1997, we have paid the Office of the Chief
Scientist royalties on all call accounting product sales at the applicable rates
at the time of payment. See Item 10E. "Additional Information - Taxation -
Grants under the Law for the Encouragement of Industrial Research and
Development, 1984."


                                       43
<PAGE>

      We have expensed royalties relating to the repayment of the Office of the
Chief Scientist grants in the amounts of $132,000, $146,000 and $181,000 for the
years ended December 31, 2002, 2003 and 2004, respectively.

      As of December 31, 2004, we had a contingent obligation to pay royalties
in the amount of approximately $7.4 million. The $3.45 million of grants
received after January 1999 are subject to interest at a rate equal to the 12
month LIBOR rate.

D.    TREND INFORMATION

      As a result of a less predictable business environment and the decline in
worldwide sales of PBX systems, we are unable to provide any guidance as to
current sales and profitability trends. We expect that our results will continue
to be impacted by a shift to a new line of products and increased marketing and
research and development expenditures.

E.    OFF-BALANCE SHEET ARRANGEMENTS

      We are not a party to any material off-balance sheet arrangements. In
addition, we have no unconsolidated special purpose financing or partnership
entities that are likely to create material contingent obligations.

F.    TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

      The following table summarizes our minimum contractual obligations and
commercial commitments, including obligations of discontinued operations, as of
December 31, 2004 and the effect we expect them to have on our liquidity and
cash flow in future periods.

<TABLE>
<CAPTION>
           Contractual Obligations                                       Payments due by Period
----------------------------------------------   -----------------------------------------------------------------
                                                              less than 1                     3-5       more than 5
                                                   Total          year       1-3 years       years         years
                                                 ---------     ---------     ---------     ---------     ---------
<S>                                              <C>           <C>           <C>           <C>           <C>
Long-term debt obligations ...................          --            --            --            --            --
Capital (finance) lease obligations ..........          --            --            --                          --
Operating lease obligations ..................   $ 529,000     $ 399,000     $ 130,000            --            --
Purchase obligations .........................          --            --            --            --            --
Other long-term liabilities reflected on our
     balance sheet under U.S. GAAP ...........          --            --            --            --            --
                                                 ---------     ---------     ---------     ---------     ---------
Total ........................................   $ 529,000     $ 399,000     $ 130,000            --            --
</TABLE>


                                       44
<PAGE>

ITEM 6.  DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

A.    DIRECTORS AND SENIOR MANAGEMENT

      Set forth below are the name, age, principal position and a biographical
description of each of our directors and executive officers:

    Name                         Age         Position with the Company
    ----                         ---    ----------------------------------
    Chaim Mer.................    57    Chairman of the Board
    Eytan Bar.................    39    President and Chief Executive Officer
    Shlomi Hagai..............    34    Corporate Chief Operating Officer and
                                        Chief Financial Officer
    Hanoch Magid..............    49    Vice President Sales and Marketing -
                                        Europe, Middle East and Africa
    Alon Aginsky..............    42    Director
    Isaac Ben-Bassat..........    51    Director
    Dr. Orna Berry............    55    Outside Director
    Dr. Yehoshua Gleitman.....    55    Outside Director
    Steven J. Glusband........    58    Director
    Yaacov Goldman............    50    Director

      Messrs. Mer, Aginsky, Ben-Bassat, Glusband and Goldman will serve as
directors until our 2005 Annual General Meeting of Shareholders. Dr. Gleitman
and Dr. Berry will serve as outside directors pursuant to the provisions of the
Israeli Companies Law for a three-year term until our 2007 annual general
meeting of shareholders and January 28, 2008, respectively, following which the
service of Dr. Gleitman as an outside director may not be extended and the
service of Dr. Berry as an outside director may be renewed for only one
additional three-year term.

      Chaim Mer has served as Chairman of our Board of Directors and a director
since our inception in December 1995. Mr. Mer has been the Chairman of the Board
of Directors of C. Mer Industries Ltd., a publicly traded company, since 1988
and served as its President and Chief Executive Officer from 1988 until January
2005. Mr. Mer holds a B.Sc. degree in Computer Sciences and Mathematics from the
Technion Israel Institute for Technology.

      Eytan Bar has served as our President and Chief Executive Officer since
December 2003. Prior to joining us, and between 2001 and 2003, Mr. Bar served as
General Manager of the CEM product division of NICE Systems Ltd. From 2000
through 2001, Mr. Bar served as Vice President of Professional Services at NICE
Systems Inc. From 1993 through 1999, Mr. Bar served as General Manager of STS
Software Systems Ltd., a company that developed a unique VoIP technology for
recording solutions.

      Shlomi Hagai has been our Corporate Chief Operating Officer and Chief
Financial Officer-Israel since March 2005. Prior to that and since 2000, Mr.
Hagai served as our financial controller. Prior to joining our company and since
1998, Mr. Hagai served as audit team manager in the Professional Department of
Ernst & Young Israel, supervising privately held and publicly traded companies
engaged in the hi-technology, industrial, services and infrastructure sectors.
Mr. Hagai is a certified public accountant since 1999 and holds a B.A. degree in
Business (majoring in accounting) from the College of Management and an LLM
degree from Bar-Ilan University.


                                       45
<PAGE>

      Hanoch Magid has been our Vice President Sales and Marketing - Europe,
Middle East and Africa since 2002. Prior to joining our company and since 2001,
Mr. Magid served as Vice President of Operating and Professional Services of
Xcitel Ltd., a start up company engaged in the field of mobile communication.
Prior to that and since 2000, Mr. Magid served as Chief Operating Officer of
Cellonet Interactive Mobile Commerce Ltd.. From 1992 to 2000, Mr. Magid served
in various positions of sales, operating and customer support at Scitex
Corporation Ltd. Mr. Magid holds a B.Sc degree in Mechanical Engineering from
the Ben Gurion University, Be'er Sheva.

      Alon Aginsky has been a director since June 1996. Since July 2000, Mr.
Aginsky has served as President and Chief Executive Officer of cVidya Inc.,
which is engaged in the development of a revenue assurance platform for next
generation service providers. Mr. Aginsky served as our Vice President Marketing
and Sales from October 1996 until April 1999, when he was appointed Manager of
C. Mer Industries Ltd. He served as President of MTS Inc., our U.S. based
marketing subsidiary from 1990 until September 1996. Mr. Aginsky holds a B.A.
degree in Business Administration from the New York Technology Institute.

      Isaac Ben-Bassat has been a director since our inception in December 1995.
He has been Executive Vice President and a director of C. Mer Industries Ltd.
since 1988. Mr. Ben-Bassat holds a B.Sc. degree in Civil Engineering from the
Technion, Israel Institute for Technology.

      Dr. Orna Berry has served as an outside director since January 2005. Dr.
Berry is a Venture Partner in Gemini Israel Funds Ltd. and since 2000 has served
as Chairperson of Lambda Crossing, Ltd. and Riverhead Networks, Inc., which was
sold to Cisco in March 2004. Dr. Berry served as the Chief Scientist of the
Ministry of Industry and Trade of the Government of Israel from 1997 to 2000 and
Co-President of Ornet Data Communications Technologies Ltd., a provider of
high-speed switches, which was acquired by Siemens AG, from 1993 to 1997. From
1992 to 1993, Dr. Berry served as a consultant to Intel Communications Division
and Elbit Systems, Ltd. Dr. Berry holds a B.A. in statistics and mathematics
from Haifa University, an M.A. in statistics and mathematics from Tel Aviv
University and a Ph.D. in computer science from the University of Southern
California.

      Dr. Yehoshua Gleitman has served as an outside director since July 2001.
Since March 2000, Dr. Gleitman has been Chief Executive Officer of SFKT, a
company whose activities include: venture capital management, finance and
investments in high-tech and telecommunications. Mr. Gleitman was Chief
Executive Officer of Ampal-American Israel Corporation, or Ampal, from May 1997
and Managing Director of Ampal's Israeli wholly owned subsidiaries and head of
Ampal's Israeli operations from April 1, 1997 until his resignation in July
1999. From August 1996 until February 1997, Mr. Gleitman was Director General of
the Israeli Ministry of Industry and Trade and was Chief Scientist at the
Ministry of Industry and Trade of the Government of Israel from January 1993
through February 1997. From 1991 through 1992, Mr. Gleitman was the general
manager of AIMS Ltd., and between 1990-1991, was an advisor in charge of
marketing and business for Ashtrom Ltd. Dr. Gleitman holds a Ph.D. and an M.Sc.
in Physical Chemistry and a B.Sc. from the Hebrew University of Jerusalem.


                                       46
<PAGE>

      Steven J. Glusband has served as a director since August 1, 1996. Mr.
Glusband has been a partner with Carter Ledyard & Milburn LLP, our U.S. counsel,
since March 1987. Mr. Glusband holds a B.B.A. degree from the City College of
the City University of New York, a J.D. degree from Fordham University School of
Law and an L.L.M. degree from the New York University School of Law.

      Yaacov Goldman has served as a director since May 2004. Mr. Goldman
provides consulting services to companies in strategic-financial areas, through
his wholly owned company, Maanit-Goldman Management & Investments (2002) Ltd.
Mr. Goldman serves as a director of Bank Leumi Le-Israel Ltd., Elron Electronic
Industries Ltd and Golden House Ltd. From March 2002 until October 2002, Mr.
Goldman served as consultant for Poalim Capital Markets and Investments Ltd.
From September 2000 until November 2001, Mr. Goldman served as Managing Director
of Argoquest Holdings, LLC, a U.S. based investment company focused on early
stage high-tech companies. From November 1981 until August 2000, Mr. Goldman was
associated with Kessleman & Kessleman, the Israeli member firm of
PricewaterhouseCoopers, and was a Partner and Senior Partner at such firm from
January 1991 through August 2000. Mr. Goldman is a Certified Public Accountant
(Israel) since 1981 and holds a B.A. degree in Economics and Accounting from Tel
Aviv University.

B.    COMPENSATION

            The following table sets forth all compensation we paid with respect
      to all of our directors and executive officers as a group for the year
      ended December 31, 2004.

<TABLE>
<CAPTION>
                                                       Salaries, fees,           Pension,
                                                      commissions and         retirement and
                                                           bonuses           similar benefits
                                                      ---------------        ----------------
<S>                                                       <C>                    <C>
      All directors and executive officers as a
      group, then consisting of sixteen (16)
      persons                                             $931,417               $195,386
</TABLE>

      All our executive officers work full time for us, except for Mr. Mer, who
is employed on a part-time basis. Chaim Mer, the Chairman of our Board of
Directors, devotes approximately 20% of his time to the management of our
company in consideration of which we pay him a monthly salary of $ 7,000 per
month (as approved by our Audit Committee and Board of Directors on November 8,
1999). We provide automobiles to our executive officers at our expense. During
the year ended December 31, 2004, we paid to each of our independent directors
an annual fee of approximately $8,400 and a per meeting attendance fee of $300,
except for Mr. Yaacov Goldman, an independent director and our financial expert,
to whom we paid an annual fee of approximately $11,040 and a per meeting
attendance fee of $400.

      As of December 31, 2004, our directors and executive officers as a group,
then consisting of sixteen persons, held options to purchase an aggregate
139,374 ordinary shares, having exercise prices ranging from $0.93 to $2.9. The
options vest over a four-year period. Of such options, options to purchase
131,041 ordinary shares were granted under our 2003 Israeli Share Option Plan
(of which, options to purchase 20,000 ordinary shares will expire in February
2006, options to purchase 6,666 ordinary shares will expire in September 2006
and 104,375 options to purchase will expire in December 2008) and options to
purchase 8,333 ordinary shares were granted under our 1996 Stock Option Plan
(all of which will expire in December 2008). See Item 6.E., "Directors, Senior
Management and Employees - Share Ownership - Stock Option Plans."


                                       47
<PAGE>

C.    BOARD PRACTICES

      Our Articles of Association provide for a Board of Directors consisting of
up to ten members or such other number as may be determined from time to time at
a general meeting of shareholders. Our Board of Directors is currently composed
of seven directors.

Election of Directors

      Pursuant to our articles of association, all of our directors are elected
at our annual general meeting of shareholders by a vote of the holders of a
majority of the voting power represented and voting at such meeting. All
directors (except the outside directors) hold office until the next annual
general meeting of shareholders and until their successors have been elected.
All the members of our Board of Directors (except the outside directors) may be
reelected upon completion of their term of office. All of our current directors
(except one of our outside directors) were elected by our shareholders at our
annual general meeting of shareholders of July 2004.

      We do not follow the requirements of the NASDAQ Marketplace Rules with
regard to the nomination process of directors, and instead, we follow Israeli
law and practice, in accordance with which our directors are recommended by our
board of directors for election by our shareholders. See below in this Item 6C.
"Directors, Senior Management and Employees - Board Practices - NASDAQ
Marketplace Rules and Home Country Practices."

Independent and Outside Directors

      The Israeli Companies Law requires Israeli companies with shares that have
been offered to the public in or outside of Israel to appoint at least two
outside directors. Outside directors must be Israeli residents, unless the
company's shares have been offered to the public outside of Israel or have been
listed on a stock exchange outside of Israel. No person may be appointed as an
outside director if the person or the person's relative, partner, employer or
any entity under the person's control has or had, on or within the two years
preceding the date of the person's appointment to serve as outside director, any
affiliation with the company or any entity controlling, controlled by or under
common control with the company. The term affiliation includes:

      o     an employment relationship;

      o     a business or professional relationship maintained on a regular
            basis;

      o     control; and

      o     service as an officer holder, excluding service as an outside
            director of a company that is offering its shares to the public for
            the first time.


                                       48
<PAGE>

      No person may serve as an outside director if the person's position or
other activities create, or may create, a conflict of interest with the person's
responsibilities as an outside director or may otherwise interfere with the
person's ability to serve as an outside director. If, at the time an outside
director is to be appointed, all current members of the board of directors are
of the same gender, then the outside director must be of the other gender.

      Outside directors are elected by shareholders. The shareholders voting in
favor of their election must include at least one-third of the shares of the
non-controlling shareholders of the company who voted on the matter. This
minority approval requirement need not be met if the total shareholdings of
those non-controlling shareholders who vote against their election represent 1%
or less of all of the voting rights in the company. Outside directors serve for
a three-year term, which may be renewed for only one additional three-year term.
Outside directors can be removed from office only by the same special percentage
of shareholders as can elect them, or by a court, and then only if the outside
directors cease to meet the statutory qualifications with respect to their
appointment or if they violate their duty of loyalty to the company.

      Any committee of the board of directors must include at least one outside
director and the audit committee must include all of the outside directors. An
outside director is entitled to compensation as provided in regulations adopted
under the Israeli Companies Law and is otherwise prohibited from receiving any
other compensation, directly or indirectly, in connection with such service.

      In addition, the NASDAQ Marketplace Rules currently require us to have at
least two independent directors on our board of directors and to establish an
audit committee. In general, under new NASDAQ Marketplace Rules promulgated
pursuant to the Sarbanes-Oxley Act of 2002, effective as of July 31, 2005, a
majority of our board of directors must qualify as independent directors within
the meaning of the NASDAQ Marketplace Rules and our audit committee must have at
least three members and be comprised only of independent directors each of whom
satisfies the respective "independence" requirements of the Securities and
Exchange Commission and NASDAQ. Our board of director has determined that Dr.
Yehoshua Gleitman and Dr. Orna Berry qualify both as independent directors under
the Securities and Exchange Commission and NASDAQ requirements and as outside
directors under the Israeli Companies Law requirements. Our board of directors
has further determined that Messrs. Alon Aginsky and Yaacov Goldman qualify as
independent directors under the Securities and Exchange Commission and NASDAQ
Stock Market requirements

Approval of Related Party Transactions Under Israeli Law

      The Israeli Companies Law codifies the fiduciary duties that "office
holders," including directors and executive officers, owe to a company. An
office holder's fiduciary duties consist of a duty of care and a duty of
loyalty. The duty of care requires an office holder to act at a level of care
that a reasonable office holder in the same position would employ under the same
circumstances. The duty of loyalty includes avoiding any conflict of interest
between the office holder's position in the company and any other position or
his personal affairs, avoiding any competition with the company, avoiding
exploiting any business opportunity of the company in order to receive personal
gain for the office holder or others, and disclosing to the company any
information or documents relating to the company's affairs which the office
holder has received due to his position as an office holder. Each person listed
as a director or executive officer in the table under Item 6A. "Directors,
Senior Management and Employees -- Directors and Senior Management" is an office
holder. Under the Israeli Companies Law, all arrangements as to compensation of
office holders who are not directors require approval of our board of directors,
and the compensation of office holders who are directors must be approved by our
audit committee, board of directors and shareholders.


                                       49
<PAGE>

      The Israeli Companies Law requires that an office holder promptly disclose
any personal interest that he or she may have and all related material
information known to him or her, in connection with any existing or proposed
transaction by us. In addition, if the transaction is an extraordinary
transaction, that is, a transaction other than in the ordinary course of
business, other than on market terms, or likely to have a material impact on the
company's profitability, assets or liabilities, the office holder must also
disclose any personal interest held by the office holder's spouse, siblings,
parents, grandparents, descendants, spouse's descendants and the spouses of any
of the foregoing, or by any corporation in which the office holder or a relative
is a 5% or greater shareholder, director or general manager or in which he or
she has the right to appoint at least one director or the general manager. Some
transactions, actions and arrangements involving an office holder (or a third
party in which an office holder has an interest) must be approved by the board
of directors or as otherwise provided for in a company's articles of
association, as not being adverse to the company's interest. In some cases,
including in the case of an extraordinary transaction, such a transaction,
action and arrangement must be approved by the audit committee and by the board
of directors itself, and further shareholder approval is required to approve the
terms of compensation of an office holder who is a director. An office holder
who has a personal interest in a matter, which is considered at a meeting of the
board of directors or the audit committee, may not be present during the board
of directors or audit committee discussions and may not vote on this matter,
unless the majority of the members of the board or the audit committee have a
personal interest, as the case may be.

      The Israeli Companies Law also provides that an extraordinary transaction
with a controlling shareholder or in which a controlling shareholder of the
company has a personal interest (including private offerings in which a
controlling shareholder has a personal interest) and a transaction with a
controlling shareholder or his relative regarding terms of service and
employment, must be approved by the audit committee, the board of directors and
shareholders. The shareholder approval for an extraordinary transaction must
include at least one-third of the shareholders who have no personal interest in
the transaction who voted on the matter. The transaction can be approved by
shareholders without this one-third approval, if the total shareholdings of
those shareholders who have no personal interest and voted against the
transaction do not represent more than one percent of the voting rights in the
company.

      However, under the Companies Regulations (Relief from Related Party
Transactions), 5760-2000, promulgated under the Israeli Companies Law and
amended in January 2002, certain transactions between a company and its
controlling shareholder(s) and certain transaction with its director(s)
regarding terms of compensation do not require shareholder approval.

      In addition, directors' compensation and employment arrangements do not
require the approval of the shareholders if both the audit committee and the
board of directors agree that such arrangements are for the benefit of the
company. If the director or the office holder is a controlling shareholder of
the company, then the employment and compensation arrangements of such director
or office holder do not require the approval of the shareholders provided that
certain criteria are met.


                                       50
<PAGE>

      The above exemptions will not apply if one or more shareholders, holding
at least 1% of the issued and outstanding share capital of the company or of the
company's voting rights, objects to the grant of such relief, provided that such
objection is submitted to the company in writing not later than seven (7) days
from the date of the filing of a report regarding the adoption of such
resolution by the company pursuant to the requirements of the Israeli Securities
Law. If such objection is duly and timely submitted, then the compensation
arrangement of the directors will require shareholders' approval as detailed
above.

      The Israeli Companies Law provides that an acquisition of shares in a
public company must be made by means of a tender offer if as a result of the
acquisition the purchaser would become a 25% or greater shareholder of the
company. This rule does not apply if there is already another 25% or greater
shareholder of the company. Similarly, the Israeli Companies Law provides that
an acquisition of shares in a public company must be made by means of a tender
offer if as a result of the acquisition the purchaser would hold greater than a
45% shareholder of the company, unless there is another shareholder holding more
than a 45% interest in the company. These requirements do not apply if, in
general, the acquisition (1) was made in a private placement that received
shareholder approval, (2) was from a 25% or greater shareholder of the company
which resulted in the acquiror becoming a 25% or greater shareholder of the
company, or (3) was from a shareholder holding more than a 45% interest in the
company which resulted in the acquiror becoming a holder of more than a 45%
interest in the company.

      If, as a result of an acquisition of shares, the acquiror will hold more
than 90% of a company's outstanding shares, the acquisition must be made by
means of a tender offer for all of the outstanding shares. If less than 5% of
the outstanding shares are not tendered in the tender offer, all the shares that
the acquirer offered to purchase will be transferred to the acquirer. The
Israeli Companies Law provides for appraisal rights if any shareholder files a
request in court within three months following the consummation of a full tender
offer. If more than 5% of the outstanding shares are not tendered in the tender
offer, then the acquiror may not acquire shares in the tender offer that will
cause his shareholding to exceed 90% of the outstanding shares

      Regulations under the Israeli Companies Law provide that the Israeli
Companies Law's tender offer rules do not apply to a company whose shares are
publicly traded outside of Israel, if pursuant to the applicable foreign
securities laws and stock exchange rules there is a restriction on the
acquisition of any level of control of the company, or if the acquisition of any
level of control of the company requires the purchaser to make a tender offer to
the public shareholders.

Exculpation, Indemnification and Insurance of Directors and Officers

      Exculpation of Office Holders. The Israeli Companies Law provides that an
Israeli company cannot exculpate an office holder from liability with respect to
a breach of his duty of loyalty, but may, if permitted by its articles of
association, exculpate in advance an office holder from his liability to the
company, in whole or in part, with respect to a breach of his duty of care.
However, a company may not exculpate in advance a director from his liability to
the company with respect to a breach of his duty of care in the event of
distributions. Our Articles of Association permit us to exempt an officer holder
for his liability, in whole or in part, for damage caused due to the breach of
the duty of care, subject to the provisions of the Israeli Companies Law.


                                       51
<PAGE>

      o     a breach of his duty of care to us or to another person;

      o     breach of his duty of loyalty to us, provided that the office holder
            acted in good faith and had reasonable cause to assume that his act
            would not prejudice our interests; or

      o     a financial liability imposed upon him in favor of another person.

      Office Holders' Insurance. Our Articles of Association provide that,
subject to the provisions of the Israeli Companies Law, we may enter into a
contract for the insurance of the liability of an office holderr with respect to
an act performed by him in his capacity as an officer, for:

      o     a breach of his duty of care to us or to another person;

      o     breach of his duty of loyalty to us, provided that the office holder
            acted in good faith and had reasonable cause to assume that his act
            would not prejudice our interests; or

      o     a financial liability imposed upon him in favor of another person.

      Indemnification of Office Holders. The Israeli Companies Law provides that
a company may, if permitted by its Articles of Association, with respect to an
act performed by an office holder in such capacity, (i) undertake in advance to
indemnify an officer, provided that the undertaking shall be restricted to types
of events that the board of directors shall deem, at the time the undertaking to
indemnify is made, to have been foreseeable due to the company's activities, and
limited to a sum or standard determined to be reasonable under the
circumstances; and (ii) indemnify an officer retroactively; against:

      o     a financial liability imposed on the office holder in favor of
            another person by any judgment, including a settlement or an
            arbitration award approved by a court;

      o     reasonable litigation expenses, including attorney's fees, incurred
            by the office holder as a result of an investigation or proceeding
            instituted against him by a competent authority, provided that such
            investigation or proceeding concluded without the filing of an
            indictment against him or the imposition of any financial liability
            in lieu of criminal proceedings, or concluded without the filing of
            an indictment against him and a financial liability was imposed on
            him in lieu of criminal proceedings with respect to a criminal
            offense that does not require proof of criminal intent; and

      o     reasonable litigation expenses, including attorneys' fees, expended
            by such office holder or charged to him by a court, in a proceeding
            we instituted against him or instituted on our behalf or by another
            person, or in a criminal charge from which he was acquitted or in
            which he was convicted of an offense that does not require proof of
            criminal intent.


                                       52
<PAGE>

      Our Articles of Association provide that we may indemnify an office holder
to the fullest extent permitted under the Israeli Companies Law.

      Limitations on Exculpation, Insurance and Indemnification. These
provisions are specifically limited in their scope by the Israeli Companies Law,
which provides that a company may not indemnify an office holder, nor exculpate
an office holder, nor enter into an insurance contract which would provide
coverage for any monetary liability, incurred as a result of certain improper
actions.

      Pursuant to the Companies Law, exculpation of, procurement of insurance
coverage for, and an undertaking to indemnify or indemnification of, our office
holders must be approved by our audit committee and our board of directors and,
if such office holder is a director, also by our shareholders.

      Our audit committee, board of directors and shareholders resolved to
indemnify our office holders, pursuant to a standard indemnification agreement
that provides for indemnification of an office holder in an amount up to $3
million. We currently maintain a directors' and officers' liability insurance
policy with a per claim and aggregate coverage limit of $5 million including
legal costs incurred in Israel.

Directors' Service Contracts

      We do not have any service contracts with our directors. Our directors are
not entitled to any benefits upon termination of their service as our directors.

Audit Committee

      Our audit committee, which was established in accordance with Section 114
of the Israeli Companies Law and Section 3(a)(58)(A) of the Securities Exchange
Act of 1934, assists our board of directors in overseeing the accounting and
financial reporting processes of our company and audits of our financial
statements, including the integrity of our financial statements, compliance with
legal and regulatory requirements, our independent public accountants'
qualifications and independence, the performance of our internal audit function
and independent public accountants, finding any defects in the business
management of our company for which purpose the audit committee may consult with
our independent auditors and internal auditor, proposing to the board of
directors ways to correct such defects, approving related-party transactions as
required by Israeli law, and such other duties as may be directed by our board
of directors.

      Our audit committee consists of four board members who satisfy the
respective "independence" requirements of the Securities and Exchange
Commission, NASDAQ and Israeli Law for audit committee members. Our audit
committee is currently composed of Dr. Yehoshua Gleitman, Dr. Orna Berry and
Messrs. Alon Aginsky and Yaacov Goldman. Our Board of Directors has determined
that Mr. Goldman qualifies as a financial expert. The audit committee meets at
least once each quarter.


                                       53
<PAGE>

      The responsibilities of the audit committee also include approving
related-party transactions as required by law. Under Israeli law an audit
committee may not approve an action or a transaction with a controlling
shareholder, or with an office holder, unless at the time of approval two
outside directors are serving as members of the audit committee and at least one
of the outside directors was present at the meeting in which an approval was
granted.

Internal Audit

      The Israeli Companies Law also requires the board of directors of a public
company to appoint an internal auditor nominated by the audit committee. A
person who does not satisfy the Israeli Companies Law's independence
requirements may not be appointed as an internal auditor. The role of the
internal auditor is to examine, among other things, the compliance of the
company's conduct with applicable law and orderly business practice. Mr. Shaul
Sofer, CPA (Israel), serves as our internal auditor.

NASDAQ Marketplace Rules and Home Country Practices

      NASDAQ Marketplace Rule 4350, or Rule 4350, was recently amended to permit
foreign private issuers, such as our company, to follow certain home country
corporate governance practices without the need to seek individual exemptions
from NASDAQ. Instead, a foreign private issuer must provide NASDAQ with a letter
from outside counsel in its home country certifying that the issuer's corporate
governance practices are not prohibited by home country law. On June 21, 2005,
we provided NASDAQ with a notice of non-compliance with Rule 4350. We do not
comply with the following requirements of Rule 4350, and instead follow Israeli
law and practice in respect of such requirements:

      o     The requirements regarding the directors nominations process.
            Instead, we follow Israeli law and practice in accordance with which
            our directors are recommended by our board of directors for election
            by our shareholders. See above in this Item 6C. "Directors, Senior
            Management and Employees - Board Practices - Election of Directors."

D.    EMPLOYEES

      On December 31, 2004, we and our consolidated subsidiaries employed 153
persons, of which 47 persons were employed in research and development, 45 in
training and technical support, 35 in marketing and sales and 26 in operations
and administration. As of December 31, 2004, 86 of our employees were located in
Israel, 39 of our employees were located in the United States, 9 of our
employees were located in Hong Kong, 2 of our employees were located in Holland
and 17 of our employees were located in Brazil.

      On December 31, 2003, we and our consolidated subsidiaries employed 86
persons, of which 23 persons were employed in research and development, 31 in
training and technical support, 15 in marketing and sales and 17 in operations
and administration.

      On December 31, 2002, we and our consolidated subsidiaries employed 90
persons, of which 27 persons were employed in research and development, 31 in
training and technical support, 15 in marketing and sales and 17 in operations
and administration.


                                       54
<PAGE>

      Certain provisions of the collective bargaining agreements between the
Histadrut (General Federation of Labor in Israel) and the Coordination Bureau of
Economic Organizations (including the Industrialists Association) are applicable
to our employees by order of the Israeli Ministry of Labor. These provisions
concern mainly the length of the workday, minimum daily wages for professional
workers, contributions to a pension fund, insurance for work-related accidents,
procedures for dismissing employees, determination of severance pay and other
conditions of employment. We generally provide our employees with benefits and
working conditions beyond the required minimums.

      Cost of living adjustments of employees' wages are determined on a
nationwide basis and are legally binding. Under the current inflation rates,
these adjustments compensate employees for approximately 40% of the change in
the cost of living, with certain lag factors in implementation. Israeli
employers and employees are required to pay predetermined amounts to the
National Insurance Institute, which is similar to the United States Social
Security Administration. In 2004, payments to the National Insurance Institute
amounted to approximately 14.5% of wages, of which approximately two-thirds was
contributed by employees with the balance contributed by the employer.

      Pursuant to Israeli law, we are legally required to pay severance benefits
upon certain circumstances, including the retirement or death of an employee or
the termination of employment of an employee without due cause. We partly
satisfy this obligation by contributing approximately 8.3% of between 80%-100%
of the employee's annual gross salary to a fund known as "Managers' Insurance."
This fund provides a combination of savings plans, insurance and severance pay
benefits to the employee, giving the employee a lump sum payment upon retirement
and a severance payment, if legally entitled, upon termination of employment.
The remaining part of this obligation is presented in our balance sheet as
"provision of severance pay."

E.    SHARE OWNERSHIP

      The following table sets forth certain information as of June 27, 2005
regarding the beneficial ownership of our ordinary shares by each of our
directors and executive officers.

                                           Number of           Percentage of
                                        Ordinary Shares         Outstanding
    Name                             Beneficially Owned(1)   Ordinary Shares(2)
    ----                             ---------------------   ------------------
Chaim Mer.......................           2,000,954(3)            41.81%
Eytan Bar ......................              93,750(4)             1.92%
Shlomi Hagai....................                 625(4)               *
Hanoch Magid ...................              26,666(4)               *
Alon Aginsky....................              16,918                  *
Isaac Ben-Bassat................             689,214(5)            14.40%
Dr. Orna Berry..................                  --                  --
Dr. Yehoshua Gleitman...........                  --                  --
Steven J. Glusband..............               9,333(6)               *
Yaacov Goldman..................                  --                  --


                                       55
<PAGE>

----------
* Less than 1%.

(1)   Beneficial ownership is determined in accordance with the rules of the
      Securities and Exchange Commission and generally includes voting or
      investment power with respect to securities. Ordinary shares relating to
      options currently exercisable or exercisable within 60 days of the date of
      this table are deemed outstanding for computing the percentage of the
      person holding such securities but are not deemed outstanding for
      computing the percentage of any other person. Except as indicated by
      footnote, and subject to community property laws where applicable, the
      persons named in the table above have sole voting and investment power
      with respect to all shares shown as beneficially owned by them.

(2)   The percentages shown are based on 4,785,405 ordinary shares (excluding
      10,800 ordinary shares held in treasury) issued and outstanding as of June
      27, 2005.

(3)   Mr. Chaim Mer and his wife, Mrs. Dora Mer, are the holders of 244,821
      ordinary shares, and are the beneficial owners of 1,744,453 ordinary
      shares through their controlling interest in Mer Ofekim Ltd., 11,539
      ordinary shares through their controlling interest in Mer Services Ltd.,
      95 ordinary shares through their controlling interest in Mer & Co. (1982)
      Ltd. and 46 ordinary shares through their controlling interest in C. Mer
      Industries Ltd.

(4)   Subject to currently exercisable stock options.

(5)   Includes 630,045 ordinary shares held by Ron Dan Investments Ltd., a
      corporation controlled by Mr. Ben-Bassat.

(6)   Includes 8,333 ordinary shares subject to currently exercisable stock
      options.

Stock Option Plans

1996 Stock Option Plan

      Under our 1996 Stock Option Plan, as amended, or the 1996 Plan, options to
purchase up to 400,000 ordinary shares may be granted to our employees,
management, officers and directors or those of our subsidiaries. Any options
which are canceled or forfeited within the option period will become available
for future grants. The 1996 Plan will terminate in 2006, unless earlier
terminated by the Board of Directors.

      The 1996 Plan is administered by the Board of Directors or an Option
Committee which may be appointed by the Board of Directors, which has the
authority, subject to applicable law, to determine the persons to whom options
will be granted, the number of ordinary shares to be covered by each option the
time or times at which options will be granted or exercised, and the terms and
conditions of the options. The exercise price of options granted under the 1996
Plan may not be less than 100% of the fair market value of our ordinary shares
on the date of the grant of incentive stock options and 75% in the case of
options not designated as incentive stock options. Fair market value is the mean
between the highest and lowest quoted selling prices on the date of grant of our
shares traded on NASDAQ or a stock exchange on which such shares are principally
traded. According to the 1996 Plan, we may provide loans to employees to assist
them in purchasing the shares upon exercise of an option on terms and conditions
approved by the Board of Directors and subject to applicable law. Such loans
have never been granted.


                                       56
<PAGE>

      Options granted under the 1996 Plan will generally be exercisable under
such circumstances as the Board or Option Committee determines. Such options
will not be transferable by an optionee other than by will or by laws of descent
and distribution, and during an option holder's lifetime will be exercisable
only by such option holder or by his or her legal representative. Options
granted under the 1996 Plan will terminate at such time and under such
circumstances as the Board or Option Committee determines.

      During 2004, options to purchase 10,000 ordinary shares were granted under
our 1996 Plan, with an average exercise price of $2.2, and no options were
exercised into ordinary shares. At December 31, 2004, options to purchase 59,600
ordinary shares were outstanding under the 1996 Plan, exercisable at an average
exercise price of $2.11 per share.

Section 102 Stock Option Plan

      In 1996 we adopted a Section 102 Stock Option Plan, as amended, or the
1996 102 Plan, providing for the grant of options to our Israeli employees,
management, officers and directors or those of our subsidiaries. The 1996 102
Plan was adopted pursuant to Section 102 of the Israeli Income Tax Ordinance
[New Version] - 1961, or Section 102, and provided recipients with tax
advantages under the Israeli Income Tax Ordinance. As of January 1, 2003,
Section 102 was amended, pursuant to which certain new tax advantages are
afforded with respect to option grants to employees and directors. In order to
enable employees and directors to benefit from such tax advantages with respect
to future grants of options and issuance of shares upon exercise thereof, such
grants have to be performed under a share option plan that is adjusted to the
amended Section 102, and therefore we adopted our 2003 Israeli Share Option
Plan. We do not intend to grant any more options under the 1996 102 Plan and the
ordinary shares that remained available for grant under the 1996 102 Plan were
rolled-over into our 2003 Israeli Share Option Plan for issuance thereunder.

      Options granted under our 1996 102 Plan are exercisable under such
circumstances as the Board of Directors or Option Committee determined.
According to the 1996 102 Plan, we may provide loans to employees to assist them
in purchasing the shares upon exercise of an option on terms and conditions
approved by the Board of Directors and subject to applicable law. Such loans
have never been granted. Options granted under the this plan are not
transferable by an optionee other than by will or by laws of descent and
distribution, and during an option holder's lifetime will be exercisable only by
such option holder or by his or her legal representative.

      During 2004, no options were granted under the 1996 102 Plan and options
to purchase 17,333 ordinary shares were exercised. At December 31, 2004, options
to purchase 189,500 ordinary shares were outstanding under the 1996 102 Plan,
exercisable at an average exercise price of $2.11 per share.


                                       57
<PAGE>

2003 Israeli Share Option Plan

      Under our 2003 Israeli Share Option Plan, or the 2003 Plan, options to
purchase up to 893,915 ordinary shares may be granted to directors, employees,
consultants, advisors, service providers, controlling shareholders and other
persons not employed by us or by our affiliates. Any options which are canceled
or forfeited within the option period will become available for future grants.
The 2003 Plan will terminate in 2013, unless earlier terminated by the Board of
Directors.

      Options to Israeli employees, directors and officers, other than
controlling shareholders (as such term is defined in the Israeli Income Tax
Ordinance), under the 2003 Plan may only be granted under Section 102. Under
amended Section 102, options granted pursuant to Section 102 may be designated
as "Approved 102 Options" or "Unapproved 102 Options." An Approved 102 Option
may either be classified as a capital gains option or an ordinary income option.
We elected to initially grant our options pursuant to Section 102 as capitals
gain options. Such election is effective as of the first date of grant of such
capital gains options under the 2003 Plan and shall remain in effect at least
until the lapse of one year following the end of the tax year during which we
first granted capital gains options. All Approved 102 Options (or the ordinary
shares issued upon exercise thereof) must be held in trust by a trustee for the
requisite holding period under Section 102 in order to benefit from the certain
tax advantages. We may also grant Unapproved 102 Options, which do not have any
tax benefit and are not held by a trustee. Options granted under Section 102 are
taxed on the date of sale of the exercised ordinary shares and/or the date of
the release of the options or such exercised ordinary shares from the trust.

      The 2003 Plan is administered by the Board of Directors or a committee of
the Board of Directors, if appointed, which has the authority, subject to
applicable law, to determine, the persons to whom options will be granted, the
terms and conditions of the respective options, including the time and the
extent to which the options may be exercised, may designate the type of options,
make an election as to the type of Approved 102 Option. The exercise price of
options granted under the 2003 Plan will be based on the fair market value of
our ordinary shares and are determined by the Board of Directors or the
committee at the time of the grant.

      Options granted under the 2003 Plan are not assignable or transferable by
an optionee, other than by will or by laws of descent and distribution, and
during the lifetime of an optionee may be exercised only by the optionee or by
the optionee's legal representative. Such options may be exercised as long as
the optionee is employed by, or providing services to us or any of our
affiliates, to the extent the options have vested.

      During 2004, options to purchase an aggregate of 216,000 ordinary shares
were granted under the 2003 Plan at an average exercise price of $2.29 per
share. No options were exercised into ordinary shares in 2004. At December 31,
2004, there were options to purchase 506,500 ordinary shares were outstanding
under the 2003 Plan, having an exercise price of $2.11 per share.

Warrants

      On February 7, 2001, we issued five-year warrants to purchase 25,000 of
our ordinary shares to Investec Bank (Mauritius) Ltd. in connection with certain
financial services performed on our behalf. The warrants had an exercise price
of $4.95 per ordinary share for warrants exercised until February 2004, and from
thereafter until February 2006, the exercise price is $5.625 per ordinary share.


                                       58
<PAGE>

ITEM 7.  MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

A.    MAJOR SHAREHOLDERS

      The following table sets forth certain information as of June 27, 2005
regarding the beneficial ownership by all shareholders known to us to own
beneficially 5.0% or more of our ordinary shares:

                                       Number of             Percentage of
                                    Ordinary Shares           Outstanding
Name                             Beneficially Owned(1)     Ordinary Shares(2)
----                             ---------------------     ------------------

Chaim Mer and Dora Mer......         2,000,954 (3)              41.81%
Isaac Ben-Bassat............           689,214 (4)              14.40%

-----------
(1)   Beneficial ownership is determined in accordance with the rules of the
      Securities and Exchange Commission and generally includes voting or
      investment power with respect to securities. Ordinary shares relating to
      options currently exercisable or exercisable within 60 days of the date of
      this table are deemed outstanding for computing the percentage of the
      person holding such securities but are not deemed outstanding for
      computing the percentage of any other person. Except as indicated by
      footnote, and subject to community property laws where applicable, the
      persons named in the table above have sole voting and investment power
      with respect to all shares shown as beneficially owned by them.

(2)   The percentages shown are based on 4,785,504 ordinary shares (excluding
      10,800 ordinary shares held in treasury) issued and outstanding as of June
      27, 2005

(3)   Mr. Chaim Mer and his wife, Mrs. Dora Mer, are the holders of 244,821
      ordinary shares, and are the beneficial owners of 1,744,453 ordinary
      shares through their controlling interest in Mer Ofekim Ltd., 11,539
      ordinary shares through their controlling interest in Mer Services Ltd.,
      95 ordinary shares through their controlling interest in Mer & Co. (1982)
      Ltd. and 46 ordinary shares through their controlling interest in C. Mer
      Industries Ltd.

(4)   Includes 630,045 ordinary shares held by Ron Dan Investments Ltd., a
      corporation controlled by Mr. Ben-Bassat.

      Based on a review of the information provided to us by our transfer agent,
as of June 28, 2005, there were 21 holders of record of our ordinary shares, of
which seven record holders holding approximately 46.54% of our ordinary shares
had registered addresses in the United States and 14 record holders holding
approximately 53.46% of our ordinary shares had registered addresses in Israel.
These numbers are not representative of the number of beneficial holders of our
shares nor are they representative of where such beneficial holders reside,
since many of these ordinary shares were held of record by brokers or other
nominees (including one U.S. nominee company, CEDE & Co., which held
approximately 46.46% of our outstanding ordinary shares as of such date).


                                       59
<PAGE>

B.    RELATED PARTY TRANSACTIONS

      Ms. Dora Mer, the wife of Chaim Mer, provides legal services to us and
receives a monthly retainer of $5,000. The conditions of retaining the services
of Ms. Mer were approved by our Board of Directors and Audit Committee.

      Our subsidiaries, MTS Asia Ltd. and MTS IntegraTRAK, entered into an
agreement with C. Mer Industries Ltd., or C. Mer, pursuant to which they
distribute and support certain of C. Mer's products and provide certain services
on behalf of C. Mer. Generally, C. Mer compensates MTS Asia Ltd. for these
activities at cost plus 10% and compensates MTS IntegraTRAK at cost plus 5%. C.
Mer is a publicly traded company controlled by Mr. Chaim Mer, and Mr. Mer has
been the Chairman of its Board of Directors since 1988 and served as its
President and Chief Executive Officer from 1988 until January 2005.

      Presently, the only service provided to us by C. Mer is our participation
in its umbrella liability insurance coverage We believe that the terms under
which C. Mer provides such participation to us is on a basis no less favorable
than could be obtained from an unaffiliated third party.

C.    INTERESTS OF EXPERTS AND COUNSEL

      Not applicable.

ITEM 8.  FINANCIAL INFORMATION

A.    CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION

      See the consolidated financial statements, including the notes thereto,
and the exhibits listed in Item 19 hereof and incorporated herein by this
reference.

Export Sales

      See Note 16 of our Consolidated Financial Statements.

Legal Proceedings

      On April 18, 2005, Amdocs (Israel) Ltd. and Amdocs Ltd. filed a complaint
in the Tel Aviv District Court naming our company, our chief executive officer
and others as defendants (Civil File No. 32419-05/05). The complaint alleges,
among other things, that professional and commercial information belonging to
the plaintiffs was transferred to the defendants for use in our company's
activity. The plaintiffs are seeking an injunction prohibiting the defendants
from making any use of the information and trade secrets that were allegedly
transferred, and mandatory injunctions requiring the return of any such
information and the payment of estimated damages of NIS 14,775,000
(approximately $3,360,000). Due to the preliminary stage of the litagation
proceeding, we cannot currently advise as to the outcome of the lawsuit. We
intend to vigorously defend this action


                                       60
<PAGE>

Tax assessment

      In April 2000, the tax authorities in Israel issued to us a demand for a
tax payment in the amount of approximately NIS 6,000,000 (approximately
$1,350,000) for the period of 1997 to 1999. We have appealed to the Israeli
district court in respect of this tax demand. Based on the opinion of our legal
counsel, we believe that certain defenses can be raised against the demand of
the tax authorities. We believe that the outcome of this matter will not have a
material adverse effect on our financial position or results of operations. We
made a provision for this tax demand in the amount of $464,000, based on the
current evidence and the opinion of our legal counsel, which we believe is
adequate.

Dividend Distribution Policy

      We have never paid cash dividends to our shareholders. We intend to retain
future earnings for use in our business and do not anticipate paying cash
dividends on our ordinary shares in the foreseeable future. Any future dividend
policy will be determined by the Board of Directors and will be based upon
conditions then existing, including our results of operations, financial
condition, current and anticipated cash needs, contractual restrictions and
other conditions as the Board of Directors may deem relevant.

      According to the Israeli Companies Law, a company may distribute dividends
out of its profits (within the meaning of the Israeli Companies Law), so long as
the company reasonably believes that such dividend distribution will not prevent
the company from paying all its current and future debts. In the event cash
dividends are declared, such dividends will be paid in NIS.

B.    SIGNIFICANT CHANGES

ITEM 9.  THE OFFER AND LISTING

A.    OFFER AND LISTING DETAILS

Annual Stock Information

      The following table sets forth, for each of the years indicated, the range
of high ask and low bid prices of our ordinary shares on the NASDAQ SmallCap
Market.

            Year                             High          Low
            ----                             ----          ---
            2004........................     $4.00        $1.90
            2003........................     $3.56        $0.87
            2002........................     $1.65        $0.75
            2001........................     $4.63        $0.90
            2000........................    $17.75        $2.50

Quarterly Stock Information

      The following table sets forth, for each of the full financial quarters in
the years indicated, the range of high ask and low bid prices of our ordinary
shares on the NASDAQ SmallCap Market.


                                       61
<PAGE>

         2003                                 High           Low
         ----                                 ----           ---
         First Quarter................       $1.05         $0.87
         Second Quarter...............       $1.90         $0.97
         Third Quarter................       $2.65         $1.65
         Fourth Quarter...............       $3.56         $2.01

         2004
         ----
         First Quarter................       $4.00         $2.99
         Second Quarter...............       $3.62         $2.61
         Third Quarter................       $2.71         $1.90
         Fourth Quarter...............       $3.33         $2.08

Monthly Stock Information

      The following table sets forth, for each of the most recent six months,
the range of high ask and low bid prices of our ordinary shares on the NASDAQ
SmallCap Market.

         Month                               High            Low
         -----                               ----            ---
         December 2004..................    $3.33          $2.95
         January 2005...................    $3.44          $3.20
         February 2005..................    $3.49          $3.15
         March 2005.....................    $4.00          $3.56
         April 2005.....................    $3.83          $3.20
         May 2005.......................    $3.71          $3.20

B.    PLAN OF DISTRIBUTION

      Not applicable.

C.    MARKETS

      Our ordinary shares were listed on the NASDAQ National Market in
connection with our initial public offering on May 21, 1997. On December 23,
1998, the listing of our ordinary shares was transferred to the NASDAQ SmallCap
Market (symbol: MTSL).

D.    SELLING SHAREHOLDERS

      Not applicable.

E.    DILUTION

      Not applicable.

F.    EXPENSE OF THE ISSUE

      Not applicable.


                                       62
<PAGE>

ITEM 10. ADDITIONAL INFORMATION

A.    SHARE CAPITAL

      Not applicable.

B.    MEMORANDUM AND ARTICLES OF ASSOCIATION

Purposes and Objects of the Company

      We are a public company registered under the Israel Companies Law,
1999-5759, or the Israeli Companies Law, as MER Telemanagement Solutions Ltd.,
registration number 520042904. Our objects and purposes, as provided by our
Articles of Association, are to carry on any lawful activity.

      On February 1, 2000, the Israeli Companies Law came into effect and
superseded most of the provisions of the Israeli Companies Ordinance (New
Version), 5743-1983, except for certain provisions which relate to bankruptcy,
dissolution and liquidation of companies. Under the Israeli Companies Law,
various provisions, some of which are detailed below, overrule the current
provisions of our Articles of Association.

The Powers of the Directors

      Under the provisions of the Israeli Companies Law and our Articles of
Association, a director cannot participate in a meeting nor vote on a proposal,
arrangement or contract in which he or she is materially interested. In
addition, our directors cannot vote compensation to themselves or any members of
their body without the approval of our audit committee and our shareholders at a
general meeting. See Item 6C. "Directors, Senior Management and Employees -
Board Practices - Approval of Related Party Transactions Under Israeli Law."

      The authority of our directors to enter into borrowing arrangements on our
behalf is not limited, except in the same manner as any other transaction by us.

      Under our articles of association, retirement of directors from office is
not subject to any age limitation and our directors are not required to own
shares in our company in order to qualify to serve as directors.

Rights Attached to Shares

      Our authorized share capital consists of 12,000,000 ordinary shares of a
nominal value of NIS 0.01 each. All outstanding ordinary shares are validly
issued, fully paid and non-assessable.

      The rights attached to the ordinary shares are as follows:

      Dividend rights. Holders of our ordinary shares are entitled to the full
amount of any cash or share dividend subsequently declared. The board of
directors may declare interim dividends and propose the final dividend with
respect to any fiscal year only out of the retained earnings, in accordance with
the provisions of the Israeli Companies Law. Our Articles of Association provide
that the declaration of a dividend requires approval by an ordinary resolution
of the shareholders, which may decrease but not increase the amount proposed by
the board of directors. See Item 8A. "Financial Information - Consolidated and
Other Financial Information - Dividend Distribution." If after one year a
dividend has been declared and it is still unclaimed, the board of directors is
entitled to invest or utilize the unclaimed amount of dividend in any manner to
our benefit until it is claimed. We are not obligated to pay interest or linkage
differentials on an unclaimed dividend.


                                       63
<PAGE>

      Voting rights. Holders of ordinary shares have one vote for each ordinary
share held on all matters submitted to a vote of shareholders. Such voting
rights may be affected by the grant of any special voting rights to the holders
of a class of shares with preferential rights that may be authorized in the
future.

      The quorum required for an ordinary meeting of shareholders consists of at
least two shareholders present in person or represented by proxy who hold or
represent, in the aggregate, at least one third of the voting rights of the
issued share capital. A meeting adjourned for lack of a quorum generally is
adjourned to the same day in the following week at the same time and place or
any time and place as the directors designate in a notice to the shareholders.
At the reconvened meeting, the required quorum consists of any two members
present in person or by proxy.

      An ordinary resolution, such as a resolution for the declaration of
dividends, requires approval by the holders of a majority of the voting rights
represented at the meeting, in person, by proxy or by written ballot, and voting
thereon. Under our Articles of Association, a special resolution, such as
amending our memorandum of association or articles of association, approving any
change in capitalization, winding-up, authorization of a class of shares with
special rights, or other changes as specified in our Articles of Association,
requires approval of a special majority, representing the holders of no less
than 65% of the voting rights represented at the meeting in person, by proxy or
by written ballot, and voting thereon.

      Pursuant to our articles of association, our directors are elected at our
annual general meeting of shareholders by a vote of the holders of a majority of
the voting power represented and voting at such meeting. See Item 6C.
"Directors, Senior Management and Employees - Board Practices - Election of
Directors."

      Rights to share in our company's profits. Our shareholders have the right
to share in our profits distributed as a dividend and any other permitted
distribution. See this Item 10B. "Additional Information - Memorandum and
Articles of Association - Rights Attached to Shares - Dividend Rights."

      Rights to share in surplus in the event of liquidation. In the event of
our liquidation, after satisfaction of liabilities to creditors, our assets will
be distributed to the holders of ordinary shares in proportion to the nominal
value of their holdings. This right may be affected by the grant of preferential
dividend or distribution rights to the holders of a class of shares with
preferential rights that may be authorized in the future.

      Liability to capital calls by our company. Under our memorandum of
association and the Israeli Companies Law, the liability of our shareholders is
limited to the par value of the shares held by them.


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<PAGE>

      Limitations on any existing or prospective major shareholder. See Item 6C.
"Directors and Senior Management -Board Practices - Approval of Related Party
Transactions Under Israeli Law."

Changing Rights Attached to Shares

      According to our Articles of Association, in order to change the rights
attached to any class of shares, unless otherwise provided by the terms of the
class, such change must be adopted by a general meeting of the shareholders and
by a separate general meeting of the holders of the affected class with a
majority of 75% of the voting power participating in such meeting.

Annual and Extraordinary Meetings

      The Board of Directors must convene an annual meeting of shareholders at
least once every calendar year, within fifteen months of the last annual
meeting. Notice of at least twenty-one days prior to the date of the meeting is
required. An extraordinary meeting may be convened by the board of directors, as
it decides or upon a demand of any two directors or 25% of the directors,
whichever is less, or of one or more shareholders holding in the aggregate at
least 5% of our issued capital. An extraordinary meeting must be held not more
than thirty-five days from the publication date of the announcement of the
meeting. See Item 10B. "Additional Information -- Memorandum and Articles of
Association -- Rights Attached to Shares--Voting Rights."

Limitations on the Rights to Own Securities in Our Company

      Neither our memorandum of association or our articles of association nor
the laws of the State of Israel restrict in any way the ownership or voting of
shares by non-residents, except with respect to subjects of countries, which are
in a state of war with Israel.

Provisions Restricting Change in Control of Our Company

      The Israeli Companies Law requires that mergers between Israeli companies
be approved by the board of directors and general meeting of shareholders of
both parties to the transaction. The approval of the board of directors of both
companies is subject to such boards' confirmations that there is no reasonable
doubt that after the merger the surviving company will be able to fulfill its
obligations towards its creditors. Each company must notify its creditors about
the contemplated merger. Under the Israeli Companies Law, our Articles of
Association are deemed to include a requirement that such merger be approved by
an extraordinary resolution of the shareholders, as explained above. The
approval of the merger by the general meetings of shareholders of the companies
is also subject to additional approval requirements as specified in the Israeli
Companies Law and regulations promulgated thereunder. See also Item 6C.
"Directors, Senior Management and Employees - Board Practices - Approval of
Related Party Transactions Under Israeli Law."

Disclosure of Shareholders Ownership

      The Israeli Securities Law and regulations promulgated thereunder do not
require a company whose shares are publicly traded solely on a stock exchange
outside of Israel, as in the case of our company, to disclose its share
ownership.


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<PAGE>

Changes in Our Capital

      Changes in our capital are subject to the approval of the shareholders at
a general meeting by a special majority of 65% of the votes of shareholders
participating and voting in the general meeting.

C.    MATERIAL CONTRACTS

      None.

D.    EXCHANGE CONTROLS

      Israeli law and regulations do not impose any material foreign exchange
restrictions on non-Israeli holders of our ordinary shares. In May 1998, a new
"general permit" was issued under the Israeli Currency Control Law, 1978, which
removed most of the restrictions that previously existed under such law, and
enabled Israeli citizens to freely invest outside of Israel and freely convert
Israeli currency into non-Israeli currencies.

      Non-residents of Israel who purchase our ordinary shares will be able to
convert dividends, if any, thereon, and any amounts payable upon our
dissolution, liquidation or winding up, as well as the proceeds of any sale in
Israel of our ordinary shares to an Israeli resident, into freely repatriable
dollars, at the exchange rate prevailing at the time of conversion, provided
that the Israeli income tax has been withheld (or paid) with respect to such
amounts or an exemption has been obtained.

E.    TAXATION

      On January 1, 2003, a comprehensive tax reform took effect in Israel.
Pursuant to the reform, resident companies are subject to Israeli tax on income
accrued or derived in Israel or abroad. In addition, the concept of "controlled
foreign corporation" was introduced according to which an Israeli company may
become subject to Israeli taxes on certain income of a non-Israeli subsidiary if
the subsidiary's primary source of income is passive income (such as interest,
dividends, royalties, rental income or capital gains). The tax reform also
substantially changed the system of taxation of capital gains.

      The following is a discussion of Israeli and United States tax
consequences material to our shareholders. To the extent that the discussion is
based on new tax legislation which has not been subject to judicial or
administrative interpretation, the views expressed in the discussion might not
be accepted by the tax authorities in question. The discussion is not intended,
and should not be construed, as legal or professional tax advice and does not
exhaust all possible tax considerations.

      Holders of our ordinary shares should consult their own tax advisors as to
the United States, Israeli or other tax consequences of the purchase, ownership
and disposition of ordinary shares, including, in particular, the effect of any
foreign, state or local taxes.

General Corporate Tax Structure

      Israeli companies are subject to "Company Tax" on their taxable income.
The applicable rate is 35% in 2004, 34% in 2005, 32% in 2006 and 30% in 2007 and
thereafter. However, the effective tax rate payable by a company, which derives
income from an approved enterprise (as further discussed below), may be
considerably less.


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<PAGE>

Tax Benefits Under the Law for the Encouragement of Capital Investments, 1959

      The Law for the Encouragement of Capital Investments, 1959, commonly
referred to as the Investment Law, provides that a proposed capital investment
in eligible facilities may, upon application to the Investment Center of the
Ministry of Industry and Trade of the State of Israel, be designated as an
approved enterprise. Each certificate of approval for an approved enterprise
relates to a specific investment program delineated both by its financial scope,
including its capital sources, and by its physical characteristics, e.g., the
equipment to be purchased and utilized pursuant to the program. An approved
enterprise is entitled to benefits including Israeli Government cash grants and
tax benefits in specified development areas. The tax benefits derived from any
such certificate of approval relate only to taxable income attributable to the
specific approved enterprise. If a company has more than one approval or only a
portion of its capital investments is approved, its effective tax rate is the
result of a weighted average of the applicable rates.

      Taxable income of a company derived from an approved enterprise is subject
to corporate tax at the maximum rate of 25% (rather than the regular corporate
tax rate) for the benefit period. This period is ordinarily seven years (or ten
years if the company qualifies as a foreign investors' company as described
below) commencing with the year in which the approved enterprise first generates
taxable income, and is limited to twelve years from commencement of production
or 14 years from the date of approval, whichever is earlier. Tax benefits under
the Investments Law also apply to income generated from the grant of a usage
right with respect to know-how developed by the approved enterprise, income
generated from royalties, and income derived from a service which is auxiliary
to such usage right or royalties, provided that such income is generated within
the approved enterprise's ordinary course of business. The Investment Law also
provides that a company that has an approved enterprise within Israel will be
eligible for a reduced tax rate and is entitled to claim accelerated
depreciation on buildings, machinery and equipment used by the approved
enterprise during the first five years of use.

      A company owning an approved enterprise may elect to forego entitlement to
the grants otherwise available under the Investment Law and in lieu thereof
participate in an alternative track of benefits. Under the alternative track of
benefits, a company's undistributed income derived from an approved enterprise
will be exempt from company tax for a period of two years from the first year of
taxable income and such company will be eligible for a reduced tax rate for the
remainder, if any, of the otherwise applicable benefits period.

      A company that has an approved enterprise program is eligible for further
tax benefits if it qualifies as a foreign investors' company. A foreign
investors' company is a company that more than 25% of its share capital and
combined share and loan capital is owned by non-Israeli residents. A company,
which qualifies as a foreign investors' company and has an approved enterprise
program is eligible for tax benefits for a ten-year benefit period. The company
tax rate applicable to income from the approved enterprise earned in the benefit
period (distributed or not) is as follows:


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<PAGE>

                                                            The company tax
         For a company with foreign investment of           rate is
         ---------------------------------------------      ---------------
         over 25% but less than 49% ............                 25%
         49% or more but less than 74%..........                 20%
         74% or more but less than 90%..........                 15%
         90% or more............................                 10%

In addition, the dividend recipient is taxed at the reduced rate applicable to
dividends from approved enterprises income (15%), if the dividend, deriving from
the approved enterprises, is distributed during the tax benefit period or within
12 years thereafter, yet, no time limit is applicable to dividends from a
foreign investment company. The company must withhold this tax at source,
regardless of whether the dividend is converted into foreign currency. However,
if retained tax-exempt income is distributed in a manner other than upon the
complete liquidation of the company, the company would be taxed at the reduced
corporate tax rate applicable to such profits (between 10%-25%). Our company is
not obliged to distribute exempt retained profits under the alternative track of
benefits, and may generally decide from which source of income to declare
dividends. We currently intend to reinvest any income derived from our approved
enterprise programs and not to distribute such income as a dividend.

      C. Mer Industries Ltd. was granted approved enterprise status with respect
to five investment projects and chose the alternative track with respect to each
of these projects. Subsequent to our incorporation, C. Mer Industries Ltd.
transferred four continuing approved programs to us. A fifth and sixth program
were also granted approval. See Item 5A. "Operating and Financial Review and
Prospects - Operating Results - Effective Corporate Tax Rate."

      The benefits available to an approved enterprise are conditional upon the
fulfillment of conditions stipulated in the Investment Law and its regulations
and the criteria set forth in the specific certificate of approval, as described
above. In the event that a company does not meet these conditions, its tax
benefits could be canceled, in whole or in part, and it would be required to
refund the amount of tax benefits, with the addition of the Israeli consumer
price index linkage adjustment and interest.

      Recent Amendment of the Investments Law

      On April 1, 2005, an amendment to the Investments Law came into force.
Pursuant to the amendment, a company's facility will be granted the status of
"Privileged Enterprise" only if it is proven to be an industrial facility (as
defined in the Investments Law) that contributes to the economic independence of
the Israeli economy and is a competitive facility that contributes to the
Israeli gross domestic product. The amendment provides that the Israeli Tax
Authority and not the Investment Center will be responsible for a Privileged
Enterprise under the alternative track of benefits, referred to as a Benefiting
Facility. A company wishing to receive the tax benefits afforded to a Benefiting
Facility is required to select the tax year from which the period of benefits
under the Investment Law are to commence by simply notifying the Israeli Tax
Authority within 12 months of the end of that year. In order to be recognized as
owning a Benefiting Facility, a company is required to meet a number of
conditions set forth in the amendment, including making a minimal investment in
manufacturing assets for the Benefiting Facility and having completed a
cooling-off period of three years from the company's previous year of
commencement of benefits under the Investments Law.


                                       68
<PAGE>

      Pursuant to the amendment, a company with a Benefiting Facility is
entitled, in each tax year, to accelerated depreciation for the manufacturing
assets used by the Benefiting Facility and to certain tax benefits, provided
that no more than 12 to 14 years have passed since the beginning of the year of
commencement of benefits under the Investments Law. The tax benefits granted to
a Benefiting Factory are determined according one of the following new tax
routes:

      (a) Similar to the currently available alternative track, exemption from
corporate tax on undistributed income for a period of two to ten years,
depending on the geographic location of the Benefiting Facility within Israel,
and a reduced corporate tax rate of 10 to 25% for the remainder of the benefits
period, depending on the level of foreign investment in each year. Benefits may
be granted for a term of from seven to ten years, depending on the level of
foreign investment in the company. If the company pays a dividend out of income
derived from the Benefiting Facility during the tax exemption period, such
income will be subject to corporate tax at the applicable rate (10%-25%). The
company is required to withhold tax at the source at a rate of 15% from any
dividends distributed from income derived from the Benefiting Facility.

      (b) A special tax track enabling companies owning facilities in certain
geographical locations in Israel to pay corporate tax at the rate of 11.5% on
income of the Benefiting Facility. The benefits period is ten years. Upon
payment of dividends, the company is required to withhold tax at source at a
rate of 15% for Israeli residents and at a rate of 4% for foreign residents.

      (c) A special tax track that provides a full exemption from corporate tax
and from tax with respect to dividends for companies with an annual income of at
least NIS 13-20 billion that have invested a total of between NIS 600-900
million in facilities in certain geographical locations in Israel.

      Generally, a company that is Abundant in Foreign Investment (as defined in
the Investments Law) is entitled to an extension of the benefits period by an
additional five years, depending on the rate of its income that is derived in
foreign currency.

      The amendment changes the definition of "foreign investment" in the
Investments Law such that a "Foreign Investors' Company" is a company that meets
the following main conditions:

      o     Foreign residents have invested at least NIS 5.0 million
            (approximately US$ 1.1 million) in the company; and

      o     Foreign investment includes the purchase of the company's shares
            from another party, not only investment directly in the company,
            provided that the company's paid-up share capital exceeds NIS 5.0
            million (approximately US$ 1.1million);

      If foreign investors become new Israeli residents after a Privileged
Enterprise (or Approved Enterprise) was established, this will not affect the
status of the Foreign Investors' Company until the end of its period of
benefits. This also applies to an expansion of the enterprise effected within
five years after their migration to Israel.


                                       69
<PAGE>

      A Foreign Investors' Company' that owns an Approved Enterprise or a
Privileged Enterprise outside the Development Areas may enjoy up to three extra
years of tax benefit, meaning up to 10 years in total, instead of seven years.
In addition, reduced company tax rates of 10% - 20% are available for a Foreign
Investors Company that is 49% or more foreign owned.

      The amendment will apply to approved enterprise programs in which the year
of commencement of benefits under the Investments Law is 2004 or later, unless
such programs received approval from the Investment Center on or prior to
December 31, 2004, in which case the provisions of the amendment will not apply.

Grants under the Law for the Encouragement of Industrial Research and
Development, 1984

      The Government of Israel encourages research and development projects
through the Office of Chief Scientist of the Israeli Ministry of Industry, Trade
and Labor, or the Office of the Chief Scientist, pursuant to the Law for the
Encouragement of Industrial Research and Development, 1984, and the regulations
promulgated thereunder, commonly referred to as the Research Law. Grants
received under such programs are repaid through a mandatory royalty based on
revenues from products incorporating know-how developed with the grants. This
government support is conditioned upon the ability of the participant to comply
with certain applicable requirements and conditions specified in the Office of
the Chief Scientist's programs and with the provisions of the Research Law.

      Under the Research Law, research and development programs which meet
specified criteria and are approved by a research committee of the Office of the
Chief Scientist of the Israeli Ministry of Industry and Trade are eligible for
grants of up to 50% of certain of the project's approved expenditure, as
determined by the research committee.

      In exchange, the recipient of such grants is required to pay the Office of
the Chief Scientist royalties from the revenues derived from products
incorporating technology developed within the framework of the approved research
and development program or derived from such program (inlcuding ancillary
services in connection with such program), usually up to100% -150% of the U.S.
dollar-linked value of the total grants received in respect of such program,
plus interest. See Item 5C. "Operating and Financial Review and Prospects -
Research and Development, Patents and Licenses" for additional details on the
grants that we have received and our contingent liability to the Office of the
Chief Scientist.

      The terms of the Israeli Government participation generally requires that
the products developed with such grants be manufactured in Israel. However,
under regulations promulgated under the Research Law, upon the approval of the
Chief Scientist, some of the manufacturing volume may be performed outside
Israel, provided that the grant recipient pays royalties at an increased rate.
As of April 1, 2003, the Research Law also allows for the approval of grants in
cases in which the applicant declares that part of the manufacturing will be
performed outside of Israel or by non-Israeli residents and the research
committee is convinced that this is essential for the execution of the program.
The Research Law also provides that know-how developed under an approved
research and development program may not be transferred to third parties in
Israel without the prior approval of the research committee. The Research Law
further provides that the know-how developed under an approved research and
development program may not be transferred to any third parties outside Israel.
No approval is required for the sale or export of any products resulting from
such research and development.


                                       70
<PAGE>

      However, in June 2005, an amendment to the Research Law became effective,
which amendment was intended to make the Research Law more compatible with the
global business environment by, among other things, relaxing restrictions on the
transfer of manufacturing rights outside Israel and on the transfer of Office of
the Chief Scientist-funded know-how outside of Israel. The amendment permits the
Office of the Chief Scientist, among other things, to approve the transfer of
manufacturing rights outside Israel in exchange for an import of different
manufacturing into Israel as a substitute, in lieu of demanding the recipient to
pay increased royalties as described above. The amendment further permits, under
certain circumstances and subject to the Office of the Chief Scientist's prior
approval, the transfer outside Israel of know-how that has been funded by Office
of the Chief Scientist, generally in the following cases: (a) the grant
recipient pays to the Office of the Chief Scientist a portion of the
consideration paid for such funded know-how (according to certain formulas), (b)
the grant recipient receives know-how from a third party in exchange for its
funded know-how, or (c) such transfer of funded know-how arises in connection
with certain types of cooperation in research and development activities. To our
knowledge, the Israeli government intends to amend the royalty regulations
promulgated under the Research Law to reflect the foregoing amendment.

      The Research Law imposes reporting requirements with respect to certain
changes in the ownership of a grant recipient. The law requires the grant
recipient and its controlling shareholders and interested parties to notify the
Office of the Chief Scientist of any change in control of the recipient or a
change in the holdings of the means of control of the recipient that results in
a non-Israeli becoming an interested party directly in the recipient and
requires the new interested party to undertake to the Office of the Chief
Scientist to comply with the Research Law. In addition, the rules of the Office
of the Chief Scientist may require prior approval of the Office of the Chief
Scientist or additional information or representations in respect of certain of
such events. For this purpose, "control" is defined as the ability to direct the
activities of a company other than any ability arising solely from serving as an
officer or director of the company. A person is presumed to have control if such
person holds 50% or more of the means of control of a company. "Means of
control" refers to voting rights or the right to appoint directors or the chief
executive officer. An "interested party" of a company includes a holder of 5% or
more of its outstanding share capital or voting rights, its chief executive
officer and directors, someone who has the right to appoint its chief executive
officer or at least one director, and a company with respect to which any of the
foregoing interested parties owns 25% or more of the outstanding share capital
or voting rights or has the right to appoint 25% or more of the directors.
Accordingly, any non-Israeli who acquires 5% or more of our ordinary shares will
be required to notify the Office of the Chief Scientist that it has become an
interested party and to sign an undertaking to comply with the Research Law.
Additionally, procedures regulated under the Research Law require the grant
recipient to obtain the approval of the Office of the Chief Scientist prior to a
change in the holdings of the recipient or change in the holdings of the means
of control of the recipient if the recipient's shares are being issued to a
non-Israeli person or entity and require the new non-Israeli party to undertake
to the Office of the Chief Scientist to comply with the Research Law.

      The funds available for grants from the Office of the Chief Scientist were
reduced in 1998, however the Israeli authorities have indicated in the past that
the government may increase grants from the Office of the Chief Scientist in the
future. We did not receive any grants from the Office of the Chief Scientist
during 2004, and we currently do not expect to receive any grants during 2005.


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<PAGE>

Tax Benefits and Grants for Research and Development

      Israeli tax law allows, under specific conditions, a tax deduction in the
year incurred for expenditures, including capital expenditures, relating to
scientific research and development projects, if the expenditures are approved
by the relevant Israeli Government ministry, determined by the field of
research, and the research and development is for the promotion of the company
and is carried out by or on behalf of the company seeking such deduction.
Expenditures not so approved are deductible over a three-year period.

Tax Benefits Under the Law for the Encouragement of Industry (Taxes), 1969

      According to the Law for the Encouragement of Industry (Taxes), 1969, or
the Industry Encouragement Law, an Industrial Company is a company resident in
Israel, at least 90% of the income of which, in a given tax year, determined in
Israeli currency (exclusive of income from some government loans, capital gains,
interest and dividends), is derived from an Industrial Enterprise owned by it.
An "Industrial Enterprise" is defined as an enterprise whose major activity in a
given tax year is industrial production activity.

      Under the Industry Encouragement Law, Industrial Companies are entitled to
the following preferred corporate tax benefits:

      o     amortization of purchases of know-how and patents over an eight-year
            period for tax purposes;

      o     right to elect, under specified conditions, to file a consolidated
            tax return with additional related Israeli Industrial Companies.

      Eligibility for benefits under the Industry Encouragement Law is not
subject to receipt of prior approval from any governmental authority. We cannot
assure you that we will continue to qualify as an Industrial Company or that the
benefits described above will be available to us in the future.

Special Provisions Relating to Taxation under Inflationary

      The Income Tax Law (Inflationary Adjustments), 1985, generally referred to
as the Inflationary Adjustments Law, represents an attempt to overcome the
problems presented to a traditional tax system by an economy undergoing rapid
inflation. The Inflationary Adjustments Law is highly complex. Its features,
which are material to us, can be summarized as follows:

      There is a special tax adjustment for the preservation of equity whereby
some corporate assets are classified broadly into fixed assets and non-fixed
assets. Where a company's equity, as defined in such law, exceeds the
depreciated cost of fixed assets, a deduction from taxable income that takes
into account the effect of the applicable annual rate of inflation on such
excess is allowed up to a ceiling of 70% of taxable income in any single tax
year, with the unused portion permitted to be carried forward on a linked basis.
If the depreciated cost of fixed assets exceeds a company's equity, then such
excess multiplied by the applicable annual rate of inflation is added to taxable
income.


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<PAGE>

      o     Subject to specific limitations, depreciation deductions on fixed
            assets and losses carried forward are adjusted for inflation based
            on the increase in the consumer price index.

      o     Capital gains on specific marketable securities are exempt from tax
            for individuals until December 31, 2002 and from January 1, 2003,
            individuals are subject to a 15% tax rate on the real capital gains,
            companies are subject to a 35% in 2004, 34% in 2005, 32% in 2006 and
            30% in 2007 and thereafter tax rate on the real capital gains and
            dealers in securities are subject to the regular tax rules
            applicable to business income in Israel.

Capital Gains Tax on Sales of Our Ordinary Shares

      Under regulations promulgated under the Israeli Tax Ordinance, sales of
our ordinary shares until December 31, 2002, are exempt from Israeli capital
gains for individuals so long as they are quoted on NASDAQ or listed on a stock
exchange in another country and we qualify as an Industrial Company. We cannot
assure you that we qualify or will maintain such qualification or our status as
an Industrial Company. Notwithstanding the foregoing, dealers in securities in
Israel are taxed at regular tax rates applicable to business income. From
January 1, 2003, when the Israeli tax reform came into effect, individuals are
subject to a 15% tax rate on the real capital gains derived on or after January
1, 2003 from the sale of shares in Israeli companies publicly traded on a
recognized stock exchange outside of Israel.

      Pursuant to the Convention Between the government of the United States of
America and the government of Israel with respect to Taxes on Income, as amended
(the "Treaty"), the sale, exchange or disposition of ordinary shares by a person
who qualifies as a resident of the United States within the meaning of the
Treaty and who is entitled to claim the benefits afforded to such person by the
Treaty generally will not be subject to the Israeli capital gains tax unless
such Treaty U.S. Resident holds, directly or indirectly, shares representing 10%
or more of our voting power during any part of the 12-month period preceding
such sale, exchange or disposition, subject to particular conditions. A sale,
exchange or disposition of ordinary shares by a Treaty U.S. Resident who holds,
directly or indirectly, shares representing 10% or more of our voting power at
any time during such preceding 12-month period would be subject to such Israeli
tax, to the extent applicable; however, under the Treaty, such Treaty U.S.
Resident would be permitted to claim a credit for such taxes against the U.S.
federal income tax imposed with respect to such sale, exchange or disposition,
subject to the limitations in U.S. laws applicable to foreign tax credits. The
Treaty does not relate to U.S. state or local taxes.

Taxation of Non-Resident Holders of Shares

      Non-residents of Israel are subject to income tax on income accrued or
derived from sources in Israel. Such sources of income include passive income
such as dividends, royalties and interest, as well as non-passive income from
services rendered in Israel. On distributions of dividends other than bonus
shares or stock dividends, income tax at the rate of 25% (12.5% for dividends
not generated by an approved enterprise if the non-resident is a U.S.
corporation that holds 10% of our voting power, and 15% for dividends generated
by an approved enterprise) is withheld at source, unless a different rate is
provided by a treaty between Israel and the shareholder's country of residence.
Under the Treaty, the maximum tax on dividends paid to a holder of ordinary
shares who is a Treaty U.S. Resident will be 25%. However, under the Investment
Law, dividends generated by an approved enterprise are taxed at the rate of 15%.


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<PAGE>

      Under an amendment to the Inflationary Adjustments Law, non-Israeli
entities might be subject to Israeli taxes on the sale of traded securities in
an Israeli company, subject to the provisions of any applicable double taxation
treaty.

Foreign Exchange Regulations

      Dividends (if any) paid to the holders of our ordinary shares, and any
amounts payable with respect to our ordinary shares upon dissolution,
liquidation or winding up, as well as the proceeds of any sale in Israel of the
ordinary shares to an Israeli resident, may be paid in non-Israeli currency or,
if paid in Israeli currency, may be converted into freely reparable U.S. dollars
at the rate of exchange prevailing at the time of conversion, however, Israeli
income tax is required to have been paid or withheld on these amounts.

Recent Tax Reform Legislation

On January 1, 2003, the Law for Amendment of the Income Tax Ordinance (amendment
No.132), 2002, commonly referred to as the Tax Reform, came into effect,
following its enactment by the Israeli parliament on July 24, 2002. On December
17, 2002, the Israeli parliament approved a number of amendments to the Tax
Reform, which came into effect on January 1, 2003. Other regulations and decrees
relating to the Tax Reform were executed as well.

The Tax Reform, aimed at broadening the categories of taxable income and
reducing the tax rates imposed on employment income, introduced the following,
among other things:

      o     Reduction of the tax rate levied on capital gains (other than gains
            deriving from the sale of listed securities) derived after January
            1, 2003, to a general rate of 25% for both individuals and
            corporations. Regarding assets acquired prior to January 1, 2003,
            the reduced tax rate will apply to a proportionate part of the gain,
            in accordance with the holding periods of the asset, before or after
            January 1, 2003, on a linear basis;

      o     Imposition of Israeli tax on all income of Israeli residents,
            individuals and corporations, regardless of the territorial source
            of income, including income derived from passive sources such as
            interest, dividends and royalties;

      o     Introduction of controlled foreign corporation (CFC) rules into the
            Israeli tax structure. Generally under such rules, an Israeli
            resident who holds, directly or indirectly, 10% or more of the
            rights in a foreign corporation whose shares are not publicly
            traded, in which more than 50% of rights are held directly or
            indirectly by Israeli residents, which has undistributed profits and
            a majority of whose income in a tax year is considered passive
            income, will be liable for tax on the portion of such income
            attributed to his or her holdings in such corporation, as if such
            income were distributed to him or her as a dividend;


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<PAGE>

      o     Imposition of capital gains tax on capital gains realized by
            individuals as of January 1, 2003, from the sale of shares of
            publicly traded companies (which was previously exempt from capital
            gains tax in Israel). For information with respect to the
            applicability of Israeli capital gains taxes on the sale of ordinary
            shares, see "Capital Gains Tax Applicable to Shareholders" below;
            and

      o     Introduction of a new regime for the taxation of shares and options
            issued to employees, officers and directors.

United States Federal Income Tax Consequences

      The following is a summary of certain material U.S. federal income tax
consequences that apply to U.S. Holders who hold ordinary shares as capital
assets. This summary is based on the United States Internal Revenue Code of
1986, as amended, or the Code, Treasury regulations promulgated thereunder,
judicial and administrative interpretations thereof, and the U.S.-Israel Tax
Treaty, all as in effect on the date hereof and all of which are subject to
change either prospectively or retroactively. This summary does not address all
tax considerations that may be relevant with respect to an investment in
ordinary shares. This summary does not account for the specific circumstances of
any particular investor, such as:

      o     broker-dealers,

      o     financial institutions,

      o     certain insurance companies,

      o     regulated investment companies,

      o     investors liable for alternative minimum tax,

      o     tax-exempt organizations,

      o     non-resident aliens of the U.S. or taxpayers whose functional
            currency is not the U.S. dollar,

      o     persons who hold the ordinary shares through partnerships or other
            pass-through entities,

      o     persons who acquired their ordinary shares through the exercise or
            cancellation of employee stock options or otherwise as compensation
            for services,

      o     certain expatriates or former long-term residents of the United
            States,

      o     investors that own or have owned, directly, indirectly or by
            attribution, 10 percent or more of our voting shares, and


                                       75
<PAGE>

      o     investors holding ordinary shares as part of a straddle or
            appreciated financial position or a hedging or conversion
            transaction.

      If a partnership or an entity treated as a partnership for U.S. federal
income tax purposes owns ordinary shares, the U.S. federal income tax treatment
of a partner in such a partnership will generally depend upon the status of the
partner and the activities of the partnership. A partnership that owns ordinary
shares and the partners in such partnership should consult their tax advisors
about the U.S. federal income tax consequences of holding and disposing of
ordinary shares.

      This summary does not address the effect of any U.S. federal taxation
other than U.S. federal income taxation. In addition, this summary does not
include any discussion of state, local or foreign taxation.

      You are urged to consult your tax advisors regarding the foreign and
United States federal, state and local tax considerations of an investment in
ordinary shares.

      For purposes of this summary, a U.S. Holder is any beneficial owner of
ordinary shares that is:

      o     an individual who is a citizen or, for U.S. federal income tax
            purposes, a resident of the United States;

      o     a corporation or other entity created or organized in or under the
            laws of the United States or any political subdivision thereof;

      o     an estate whose income is subject to U.S. federal income tax
            regardless of its source; or

      o     a trust that (a) is subject to the primary supervision of a court
            within the United States and the control of one or more U.S. persons
            or (b) has a valid election in effect under applicable U.S. Treasury
            regulations to be treated as a U.S. person.

Taxation of Dividends

      Subject to the discussion below under the heading "Passive Foreign
Investment Companies," the gross amount of any distributions received with
respect to ordinary shares, including the amount of any Israeli taxes withheld
therefrom, will constitute dividends for U.S. federal income tax purposes, to
the extent of our current and accumulated earnings and profits as determined for
U.S. federal income tax purposes. You will be required to include this amount of
dividends in gross income as ordinary income. Distributions in excess of our
earnings and profits will be treated as a non-taxable return of capital to the
extent of your tax basis in the ordinary shares, and any amount in excess of
your tax basis will be treated as gain from the sale of ordinary shares. See
"--Disposition of Ordinary Shares" below for the discussion on the taxation of
capital gains. Dividends will not qualify for the dividends-received deduction
generally available to corporations under Section 243 of the Code.


                                       76
<PAGE>

      Dividends that we pay in NIS, including the amount of any Israeli taxes
withheld therefrom, will be included in your income in a U.S. dollar amount
calculated by reference to the exchange rate in effect on the day such dividends
are received. A U.S. Holder who receives payment in NIS and converts NIS into
U.S. dollars at an exchange rate other than the rate in effect on such day may
have a foreign currency exchange gain or loss that would be treated as ordinary
income or loss. U.S. Holders should consult their own tax advisors concerning
the U.S. tax consequences of acquiring, holding and disposing of NIS.

      Subject to complex limitations, any Israeli withholding tax imposed on
such dividends will be a foreign income tax eligible for credit against a U.S.
Holder's U.S. federal income tax liability, subject to certain limitations set
out in the Code (or, alternatively, for deduction against income in determining
such tax liability). The limitations set out in the Code include computational
rules under which foreign tax credits allowable with respect to specific classes
of income cannot exceed the U.S. federal income taxes otherwise payable with
respect to each such class of income. Dividends generally will be treated as
foreign-source passive income or financial services income for United States
foreign tax credit purposes. U.S. Holders should note that recently enacted
legislation eliminates the "financial services income" category with respect to
taxable years beginning after December 31, 2006. Under this legislation, the
foreign tax credit limitation categories will be limited to "passive category
income" and "general category income." A U.S. Holder will be denied a foreign
tax credit with respect to Israeli income tax withheld from dividends received
on the ordinary shares to the extent such U.S. Holder has not held the ordinary
shares for at least 16 days of the 30-day period beginning on the date which is
15 days before the ex-dividend date or to the extent such U.S. Holder is under
an obligation to make related payments with respect to substantially similar or
related property. Any days during which a U.S. Holder has substantially
diminished its risk of loss on the ordinary shares are not counted toward
meeting the 16-day holding period required by the statute. Further, there are
special rules for computing the foreign tax credit limitation of a taxpayer who
receives dividends subject to a reduced tax rate. The rules relating to the
determination of the foreign tax credit are complex, and you should consult with
your personal tax advisors to determine whether and to what extent you would be
entitled to this credit.

      Subject to certain limitations, "qualified dividend income" received by a
noncorporate U.S. Holder in tax years beginning on or after January 1, 2003 and
on or before December 31, 2008 will be subject to tax at a reduced maximum tax
rate of 15 percent. The rate reduction does not apply to dividends received from
passive foreign investment companies, see discussion below. Distributions
taxable as dividends paid on the ordinary shares should qualify for the 15
percent rate provided that either: (i) we are entitled to benefits under the
income tax treaty between the United States and Israel (the "Treaty") or (ii)
the ordinary shares are readily tradable on an established securities market in
the United States and certain other requirements are met. We believe that we are
entitled to benefits under the Treaty and that the ordinary shares currently are
readily tradable on an established securities market in the United States.
However, no assurance can be given that the ordinary shares will remain readily
tradable. The rate reduction does not apply unless certain holding period
requirements are satisfied. With respect to the ordinary shares, the U.S. Holder
must have held such shares for at least 61 days during the 121-day period
beginning 60 days before the ex-dividend date. The rate reduction also does not
apply in respect of certain hedged positions or in certain other situations. The
legislation enacting the reduced tax rate contains special rules for computing
the foreign tax credit limitation of a taxpayer who receives dividends subject
to the reduced tax rate. U.S. Holders of ordinary shares should consult their
own tax advisors regarding the effect of these rules in their particular
circumstances.


                                       77
<PAGE>

Disposition of Ordinary Shares

      If you sell or otherwise dispose of ordinary shares, you will recognize
gain or loss for U.S. federal income tax purposes in an amount equal to the
difference between the amount realized on the sale or other disposition and the
adjusted tax basis in ordinary shares. Subject to the discussion below under the
heading "Passive Foreign Investment Companies," such gain or loss generally will
be capital gain or loss and will be long-term capital gain or loss if you have
held the ordinary shares for more than one year at the time of the sale or other
disposition. In general, any gain that you recognize on the sale or other
disposition of ordinary shares will be U.S.-source for purposes of the foreign
tax credit limitation; losses will generally be allocated against U.S. source
income. Deduction of capital losses is subject to certain limitations under the
Code.

      In the case of a cash basis U.S. Holder who receives NIS in connection
with the sale or disposition of ordinary shares, the amount realized will be
based on the U.S. dollar value of the NIS received with respect to the ordinary
shares as determined on the settlement date of such exchange. A U.S. Holder who
receives payment in NIS and converts NIS into United States dollars at a
conversion rate other than the rate in effect on the settlement date may have a
foreign currency exchange gain or loss that would be treated as ordinary income
or loss.

      An accrual basis U.S. Holder may elect the same treatment required of cash
basis taxpayers with respect to a sale or disposition of ordinary shares,
provided that the election is applied consistently from year to year. Such
election may not be changed without the consent of the Internal Revenue Service,
or the IRS. In the event that an accrual basis U.S. Holder does not elect to be
treated as a cash basis taxpayer (pursuant to the Treasury regulations
applicable to foreign currency transactions), such U.S. Holder may have a
foreign currency gain or loss for U.S. federal income tax purposes because of
differences between the U.S. dollar value of the currency received prevailing on
the trade date and the settlement date. Any such currency gain or loss would be
treated as ordinary income or loss and would be in addition to gain or loss, if
any, recognized by such U.S. Holder on the sale or disposition of such ordinary
shares.

Passive Foreign Investment Companies

      There is a substantial risk that we are a passive foreign investment
company, or PFIC, for U.S. federal income tax purposes. Our treatment as a PFIC
could result in a reduction in the after-tax return to the U.S. Holders of our
ordinary shares and may cause a reduction in the value of such shares.

      For U.S. federal income tax purposes, we will be classified as a PFIC for
any taxable year in which either (i) 75% or more of our gross income is passive
income, or (ii) at least 50% of the average value of all of our assets for the
taxable year produce or are held for the production of passive income. For this
purpose, cash is considered to be an asset which produces passive income.
Passive income generally includes dividends, interest, royalties, rents,
annuities and the excess of gains over losses from the disposition of assets
which produce passive income. As a result of our substantial cash position and
the decline in the value of our stock, we believe that we became a PFIC in 2004
under a literal application of the asset test that looks solely to market value.


                                       78
<PAGE>

      If we are a PFIC, dividends will not qualify for the reduced maximum tax
rate, discussed above, and, unless you timely elect to "mark-to-market" your
ordinary shares, as described below:

      o     you will be required to allocate income recognized upon receiving
            certain dividends or gain recognized upon the disposition of
            ordinary shares ratably over the holding period for such ordinary
            shares,

      o     the amount allocated to each year during which we are considered a
            PFIC other than the year of the dividend payment or disposition
            would be subject to tax at the highest individual or corporate tax
            rate, as the case may be, in effect for that year and an interest
            charge would be imposed with respect to the resulting tax liability
            allocated to each such year,

      o     the amount allocated to the current taxable year and any taxable
            year before we became a PFIC would be taxable as ordinary income in
            the current year, and

      o     you will be required to make an annual return on IRS Form 8621
            regarding distributions received with respect to ordinary shares and
            any gain realized on your ordinary shares.

      The PFIC provisions discussed above apply to U.S. persons who directly or
indirectly hold stock in a PFIC. Both direct and indirect shareholders of PFICs
are subject to the rules described above. Generally, a U.S. person is considered
an indirect shareholder of a PFIC if it is:

      o     A direct or indirect owner of a pass-through entity, including a
            trust or estate, that is a direct or indirect shareholder of a PFIC,

      o     A shareholder of a PFIC that is a shareholder of another PFIC, or

      o     A 50%-or-more shareholder of a foreign corporation that is not a
            PFIC and that directly or indirectly owns stock of a PFIC.

      An indirect shareholder may be taxed on a distribution paid to the direct
owner of the PFIC and on a disposition of the stock indirectly owned. Indirect
shareholders are strongly urged to consult their tax advisors regarding the
application of these rules.

      If we cease to be a PFIC in a future year, a U.S. Holder may avoid the
continued application of the tax treatment described above by electing to be
treated as if it sold its ordinary shares on the last day of the last taxable
year in which we were a PFIC. Any gain would be recognized and subject to tax
under the rules described above. Loss would not be not recognized. A U.S.
Holder's basis in its ordinary shares would be increased by the amount of gain,
if any, recognized on the sale. A U.S. Holder would be required to treat its
holding period for its ordinary shares as beginning on the day following the
last day of the last taxable year in which we were a PFIC.


                                       79
<PAGE>

      If the ordinary shares are considered "marketable stock" and if you elect
to "mark-to-market" your ordinary shares, you would not be subject to the rules
described above. Instead, you will generally include in income any excess of the
fair market value of the ordinary shares at the close of each tax year over your
adjusted basis in the ordinary shares. If the fair market value of the ordinary
shares had depreciated below your adjusted basis at the close of the tax year,
you may generally deduct the excess of the adjusted basis of the ordinary shares
over its fair market value at that time. However, such deductions generally
would be limited to the net mark-to-market gains, if any, that you included in
income with respect to such ordinary shares in prior years. Income recognized
and deductions allowed under the mark-to-market provisions, as well as any gain
or loss (to the extent of net mark-to-market gains) on the disposition of
ordinary shares with respect to which the mark-to-market election is made, is
treated as ordinary income or loss. Loss on a disposition, to the extent in
excess of net mark-to-market gains, would be treated as capital loss. Our
ordinary shares should be considered "marketable stock" if they traded at least
15 days during each calendar quarter of the relevant calendar year in more than
de minimis quantities.

      A U.S. Holder of ordinary shares will not be able to avoid the tax
consequences described above by electing to treat us as a qualified electing
fund, or QEF, because we do not intend to prepare the information that U.S.
Holders would need to make a QEF election.

Backup Withholding and Information Reporting

      Payments in respect of ordinary shares may be subject to information
reporting to the U.S. Internal Revenue Service and to U.S. backup withholding
tax at a rate equal to the fourth lowest income tax rate applicable to
individuals which, under current law, is 28%. Backup withholding will not apply,
however, if you (i) are a corporation or come within certain exempt categories,
and demonstrate the fact when so required, or (ii) furnish a correct taxpayer
identification number and make any other required certification.

      Backup withholding is not an additional tax. Amounts withheld under the
backup withholding rules may be credited against a U.S. Holder's U.S. tax
liability, and a U.S. Holder may obtain a refund of any excess amounts withheld
under the backup withholding rules by filing the appropriate claim for refund
with the IRS.

      Any U.S. Holder who holds 10% or more in vote or value of our ordinary
shares will be subject to certain additional United States information reporting
requirements.

U.S. Gift and Estate Tax

      An individual U.S. Holder of ordinary shares will be subject to U.S. gift
and estate taxes with respect to ordinary shares in the same manner and to the
same extent as with respect to other types of personal property.

F.    DIVIDEND AND PAYING AGENTS

      Not applicable.


                                       80
<PAGE>

G.    STATEMENT BY EXPERTS

      Not applicable.

H.    DOCUMENTS ON DISPLAY

      We are subject to the reporting requirements of the United States
Securities Exchange Act of 1934, as amended, as applicable to "foreign private
issuers" as defined in Rule 3b-4 under the Exchange Act, and in accordance
therewith, we file annual and interim reports and other information with the
Securities and Exchange Commission.

      As a foreign private issuer, we are exempt from certain provisions of the
Exchange Act. Accordingly, our proxy solicitations are not subject to the
disclosure and procedural requirements of Regulation 14A under the Exchange Act,
transactions in our equity securities by our officers and directors are exempt
from reporting and the "short-swing" profit recovery provisions contained in
Section 16 of the Exchange Act. In addition, we are not required under the
Exchange Act to file periodic reports and financial statements as frequently or
as promptly as U.S. companies whose securities are registered under the Exchange
Act. However, we distribute annually to our shareholders an annual report
containing financial statements that have been examined and reported on, with an
opinion expressed by, an independent public accounting firm, and we file reports
with the Securities and Exchange Commission on Form 6-K containing unaudited
financial information for the first three quarters of each fiscal year.

      This annual report and the exhibits thereto and any other document we file
pursuant to the Exchange Act may be inspected without charge and copied at
prescribed rates at the following Securities and Exchange Commission public
reference rooms: 450 Fifth Street, N.W., Judiciary Plaza, Room 1024, Washington,
D.C. 20549; and on the Securities and Exchange Commission Internet site
(http://www.sec.gov) and on our website www.mtsint.com. You may obtain
information on the operation of the Securities and Exchange Commission's public
reference room in Washington, D.C. by calling the Securities and Exchange
Commission at 1-800-SEC-0330. The Exchange Act file number for our Securities
and Exchange Commission filings is 0-28950.

      The documents concerning our company, which, referred to in this annual
report, may also be inspected at our offices located at 22 Zarhin Street,
Ra'anana 43662, Israel.

I.    SUBSIDIARY INFORMATION

      Not applicable.

ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

Exposure To Market Risks

      We are exposed to a variety of risks, including changes in interest rates
affecting primarily the interest received on short-term deposits, and foreign
currency fluctuations. We do not use derivative financial instruments to hedge
against such exposure.


                                       81
<PAGE>

Interest Rate Risk

      Our exposure to market risk for changes in interest rates relates
primarily to our short term deposits. Our short term deposits are held in
dollars and bear annual interest of 1.5% to 2.0%, which is based upon the London
Inter Bank Offered Rate (LIBOR). We place our short term deposits with major
financial center U.S. banks. For purposes of specific risk analysis, we use
sensitivity analysis to determine the impact that market risk exposure may have
on the financial income derived from our short term deposits. The potential loss
to us over one year that would result from a hypothetical change of 10% in the
LIBOR rate would be approximately $20,000.

Foreign Currency Exchange Risk

      We have operations in several countries in connection with the sale of our
products. A substantial portion of our sales and expenditures are denominated in
dollars. We have mitigated, and expect to continue to mitigate, a portion of our
foreign currency exposure through salaries, marketing and support operations in
which all costs are local currency based. As a result, our results of operations
and cash flows can be affected by fluctuations in foreign currency exchange
rates (primarily the Euro). A hypothetical 10% movement in foreign currency
rates (primarily the Euro) against the dollar, with all other variables held
constant on the expected sales, would result in a decrease or increase in
expected 2005 sales of $200,000.

ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES

      Not applicable.

                                     PART II

ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES

      None.

ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF
         PROCEEDS

      Not applicable.

ITEM 15. CONTROLS AND PROCEDURES

      Our management, including our chief executive officer and chief financial
officer, evaluated the effectiveness of our disclosure controls and procedures
(as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered
by this annual report on Form 20-F. Based upon that evaluation, our chief
executive officer and chief financial officer have concluded that, as of such
date, our disclosure controls and procedures were effective to ensure that
information required to be disclosed by our company in reports that we file or
submit under the U.S. Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission's rules and forms and that such information
was made known to them by others within the company, as appropriate to allow
timely decisions regarding required disclosure.


                                       82
<PAGE>

      There were no changes to our internal control over financial reporting
that occurred during the period covered by this annual report on Form 20-F that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.

      All internal control systems no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective may not
prevent or detect misstatements and can provide only reasonable assurance with
respect to financial statement preparation and presentation. Also, projections
of any evaluation of effectiveness to future periods are subject to the risk
that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate.

ITEM 16. [RESERVED]

ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT

      Our board of directors has determined that Mr. Yaacov Goldman meets the
definition of an audit committee financial expert, as defined in Item 401 of
Regulation S-K.

ITEM 16B. CODE OF ETHICS

      We have adopted a code of ethics that applies to our chief executive
officer and all senior financial officers of our company, including the chief
financial officer, chief accounting officer or controller, or persons performing
similar functions. Our code of ethics has been filed as an exhibit to this
annual report. Written copies are available upon request. If we make any
substantive amendment to the code of ethics or grant any waivers, including any
implicit waiver, from a provision of the codes of ethics, we will disclose the
nature of such amendment or waiver on our website.

ITEM 16C. PRINCIPAL ACCOUNTING FEES AND SERVICES

Fees Paid to Independent Public Accountants

      The following table sets forth, for each of the years indicated, the fees
paid to our independent public accountants and the percentage of each of the
fees out of the total amount paid to the accountants.

                                         Year Ended December 31,
                            ----------------------------------------------------
                                     2003                       2004
                            ----------------------------------------------------
       Services Rendered        Fees     Percentages      Fees       Percentages
      --------------------  -----------  ----------   ------------  -----------
      Audit (1)             $    45,500        61.0%   $    60,195         79.0%
      Audit-related (2)             484         1.0%            --           --
      Tax (3)                    28,700        38.0%        11,000         12.0%
      Other (4)                      --          --          7,841          9.0%
      Total                 $    74,684       100.0%   $    79,036        100.0%
                            -----------  ----------   ------------  -----------
-------------

(1)   Audit fees consist of services that would normally be provided in
      connection with statutory and regulatory filings or engagements, including
      services that generally only the independent accountant can reasonably
      provide.


                                       83
<PAGE>

(2)   Audit-related fees relate to attestation services that are required by
      statute or regulation.

(3)   Tax fees relate to services performed by the tax division for tax
      compliance, planning, and advice.

(4)   Other fees relate to products and services provided by the independent
      accountant, other than the services reported under the categories above

Pre-Approval Policies and Procedures

      Our audit committee has adopted a policy and procedures for the
pre-approval of audit and non-audit services rendered by our independent public
accountants, Kost Forer Gabbay & Kasierer, a member firm of Ernst & Young
Global. Pre-approval of an audit or non-audit service may be given as a general
pre-approval, as part of the audit committee's approval of the scope of the
engagement of our independent auditor, or on an individual basis. Any proposed
services exceeding general pre-approved levels also require specific
pre-approval by our audit committee. The policy prohibits retention of the
independent public accountants to perform the prohibited non-audit functions
defined in Section 201 of the Sarbanes-Oxley Act or the rules of the Securities
and Exchange Committee, and also requires the audit committee to consider
whether proposed services are compatible with the independence of the public
accountants. All the services provided by our independent accountants in 2004
were approved in advance by our Audit Committee.

ITEM 16D. EXEMPTIONS FROM THE LISTING REQUIREMENTS AND STANDARDS FOR AUDIT
          COMMITTEE

      Not applicable.

ITEM 16E. PURCHASE OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATES AND
          PURCHASERS

Issuer Purchase of Equity Securities

      The following table sets forth, for each of the months indicated, the
total number of shares purchased by us or on our behalf or any affiliated
purchaser, the average price paid per share, the number of shares purchased as
part of a publicly announced repurchase plan or program, the maximum number of
shares or approximate dollar value that may yet be purchase under the plans or
programs.


                                       84
<PAGE>

<TABLE>
<CAPTION>
                                                                                                 Maximum Number (or
                                                                           Total Number of       Approximate Dollar
                                                                         Shares Purchased as      Value) of Shares
                                                                           Part of Publicly        that May Yet Be
                             Total Number of      Average Price Paid      Announced Plans or     Purchased Under the
     Period in 2004         Shares Purchased           per Share               Programs           Plans or Programs
----------------------    --------------------    ------------------     -------------------     -------------------
<S>                                   <C>                    <C>                   <C>                    <C>
January.............                    ---                    ---                 391,610                208,390
February............                    ---                    ---                 391,610                208,390
March...............                    ---                    ---                 391,610                208,390
April...............                    ---                    ---                 391,610                208,390
May.................                    ---                    ---                 391,610                208,390
June................                    ---                    ---                 391,610                208,390
July................                    ---                    ---                 391,610                208,390
August..............                  3,800                  $2.28                 395,410                204,590
September...........                    ---                    ---                 395,410                204,590
October.............                    ---                    ---                 395,410                204,590
November............                    ---                    ---                 395,410                204,590
December............                    ---                    ---                 395,410                204,590
</TABLE>

1. Under our stock repurchase program, which was publicly announced in December
2000, our officers were authorized to repurchase up to 300,000 of our ordinary
shares. In May 2003 our board of directors increased the number of shares to be
repurchased under our stock repurchase program to 600,000 ordinary shares.
Through June 27, 2005, we have repurchased 395,410 ordinary shares, at a total
cost of $486,000. Of such shares, 384,610 ordinary shares were cancelled.

                                    PART III

ITEM 17. FINANCIAL STATEMENTS

      We have elected to furnish financial statements and related information
specified in Item 18.

ITEM 18. FINANCIAL STATEMENTS

Consolidated Financial Statements.

Index to Consolidated Financial Statements. ............................F-1

         Report of Independent Registered Public Accounting Firm........F-2

         Consolidated Balance Sheets....................................F-3-4

         Consolidated Statements of Operations..........................F-5

         Statements of Changes in Shareholders' Equity..................F-6

         Consolidated Statements of Cash Flows..........................F-7 - 8

         Notes to Consolidated Financial Statements.....................F-9 - 38

         Appendix to Consolidated Financial Statements..................F-39


                                       85
<PAGE>

ITEM 19. EXHIBITS

         Index to Exhibits

         Exhibit      Description
         -------      -----------

         1.1      Memorandum of Association of the Registrant (1)

         1.2      Articles of Association of the Registrant (1)

         2.1      Specimen of Ordinary Share Certificate (1)

         4.1      Asset Purchase Agreement dated December 30, 2004 among the
                  Registrant and Teleknowledge Group Ltd.

         4.2      1996 Employee Stock Option Plan (1)

         4.3      Section 102 Stock Option Plan (1)

         4.4      2003 Israeli Share Option Plan (2)

         4.5      Form of Consultant's Warrant (3)

         8.1      List of Subsidiaries of the Registrant

         10.1     Consent of Kost Forer Gabbay & Kasierer, a Member of Ernst &
                  Young Global

         10.2     Consent of BDO Audiberia Auditores, S.L.

         14.1     Code of Ethics (4)

         12.1     Certification of Chief Executive Officer pursuant to Rule
                  13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act,
                  as amended.

         12.2     Certification of Chief Financial Officer pursuant to Rule
                  13a-14(a) and Rule 15d-14(a) of the Securities Exchange Act,
                  as amended.

         13.1     Certification of Chief Executive Officer pursuant to 18 U.S.C.
                  Section1350, as adopted pursuant to Section 906 of the
                  Sarbanes-Oxley Act of 2002.

         13.2     Certification of Chief Financial Officer pursuant to 18 U.S.C.
                  Section 1350, as adopted pursuant to Section 906 of the
                  Sarbanes-Oxley Act of 2002.


                                       86
<PAGE>

         -----------------

         (1)      Filed as an exhibit to our registration statement on Form F-1,
                  registration number 333-05814, filed with the Securities and
                  Exchange Commission, and incorporated herein by reference.

         (2)      Filed as Exhibit 10.3 to our Annual Report on Form 20-F for
                  the year ended December 31, 2003, and incorporated herein by
                  reference.

         (3)      Filed as Exhibit 10.5 to our Annual Report on Form 20-F for
                  the year ended December 31, 2002, and incorporated herein by
                  reference.

         (4)      Filed as Exhibit 14.1 to our Annual Report on Form 20-F for
                  the year ended December 31, 2003, and incorporated herein by
                  reference.


                                       87
<PAGE>

             MER TELEMANAGEMENT SOLUTIONS LTD. AND ITS SUBSIDIARIES

                        CONSOLIDATED FINANCIAL STATEMENTS

                             AS OF DECEMBER 31, 2004

                            U.S. DOLLARS IN THOUSANDS


                                      INDEX

                                                                      Page
                                                                  --------------

Report of Independent Registered Public Accounting Firm                F-2

Consolidated Balance Sheets                                         F-3 - F-4

Consolidated Statements of Operations                                  F-5

Statements of Changes in Shareholders' Equity                          F-6

Consolidated Statements of Cash Flows                               F-7 - F-8

Notes to Consolidated Financial Statements                         F-9 - F-38

Appendix to Consolidated Financial Statements                         F-39

                               - - - - - - - - - -


                                      F-1
<PAGE>

[ERNST & YOUNG LOGO]
                          Kost Forer Gabbay & Kasierer     Phone: 972-3-6232525
                          3 Aminadav St.                   Fax:   972-3-5622555
                          Tel-Aviv 67067, Israel

             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

                             To the Shareholders of

                        Mer Telemanagement Solutions Ltd.

      We have  audited  the  accompanying  consolidated  balance  sheets  of Mer
Telemanagement  Solutions  Ltd.  ("the  Company")  and  its  subsidiaries  as of
December  31,  2003  and  2004,  and  the  related  consolidated  statements  of
operations, changes in shareholders' equity and cash flows for each of the three
years in the period ended December 31, 2004. These financial  statements are the
responsibility of the Company's management.  Our responsibility is to express an
opinion on these financial  statements based on our audits. We did not audit the
financial  statements  of Jusan SA, a 50% owned  affiliate,  for the year  ended
December 31, 2004, whose Company's investments constitute $ 2,119 thousand as of
December 31, 2004 and its equity in revenues  constitute $ 225  thousand.  Those
statements  were audited by other auditors whose report has been furnished to us
and our opinion,  insofar as it relates to amounts  emanating from the financial
statements  of such investee  companies,  is based solely on the said reports of
the other auditors.

      We conducted  our audits in  accordance  with the  standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain  reasonable  assurance about whether the
financial statements are free of material  misstatement.  We were not engaged to
perform an audit of the Company's internal control over financial reporting. Our
audits included  consideration of internal control over financial reporting as a
basis for designing audit procedures that are appropriate in the  circumstances,
but not for the purpose of  expressing  an opinion on the  effectiveness  of the
Company's internal control over financial reporting.  Accordingly, we express no
such  opinion.  An audit also  includes  examining,  on a test  basis,  evidence
supporting the amounts and  disclosures in the financial  statements,  assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall  financial  statement  presentation.  We believe that our
audits  and the  report of other  auditors  provide a  reasonable  basis for our
opinion.

      In our opinion,  based on our audit and the report of the other  auditors,
the consolidated  financial  statements referred to above present fairly, in all
material  respects,  the consolidated  financial position of the Company and its
subsidiaries as of December 31, 2003 and 2004, and the  consolidated  results of
their  operations and their cash flows for each of the three years in the period
ended December 31, 2004, in conformity with U.S. generally  accepted  accounting
principles.

                                           /s/Kost Forer Gabbay and Kasierer
Tel-Aviv, Israel                              KOST FORER GABBAY & KASIERER
February 7, 2005                            A Member of Ernst & Young Global


                                      F-2
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------
U.S. dollars in thousands

<TABLE>
<CAPTION>
                                                                                   December 31,
                                                                             -----------------------
                                                                                2003          2004
                                                                             ---------     ---------
<S>                                                                          <C>           <C>
     ASSETS

CURRENT ASSETS:
   Cash and cash equivalents                                                 $   8,684     $   3,814
   Marketable securities (Note 3)                                                1,644         1,057
   Trade receivables (net of allowance for doubtful accounts of $350 and
     $370 as of December 31, 2003 and 2004, respectively)                        1,391         1,348
   Other accounts receivable and prepaid expenses (Note 4)                         566           391
   Inventories (Note 5)                                                            193           178
                                                                             ---------     ---------

 Total current assets                                                           12,478         6,788
 -----                                                                       ---------     ---------

 LONG-TERM INVESTMENTS:
   Investments in an affiliate (Note 6)                                          1,859         2,119
   Long-term loans, net of current maturities (Note 7)                              95            45
   Severance pay fund                                                              564           535
   Other investments (Note 8)                                                      368           373
                                                                             ---------     ---------

 Total long-term investments                                                     2,886         3,072
 -----                                                                       ---------     ---------

 PROPERTY AND EQUIPMENT, NET (Note 9)                                              482           581
                                                                             ---------     ---------

 OTHER ASSETS:
   Goodwill (Note 10a)                                                           2,024         3,415
   Other intangible assets, net (Note 10b)                                         206         1,394
   Deferred income taxes (Note 13)                                                 106            73
                                                                             ---------     ---------

 Total other assets                                                              2,336         4,882
 -----                                                                       ---------     ---------

 Total assets                                                                $  18,182     $  15,323
 -----                                                                       =========     =========
</TABLE>

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


                                      F-3
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)

<TABLE>
<CAPTION>
                                                                                    December 31,
                                                                              ------------------------
                                                                               *) 2003          2004
                                                                              ---------      ---------
<S>                                                                           <C>            <C>
     LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
  Current maturities of long-term loans                                       $       8      $      --
  Trade payables                                                                    393            719
  Accrued expenses and other liabilities (Note 11)                                1,421          2,042
  Deferred revenues                                                               1,219          1,254
                                                                              ---------      ---------

Total current liabilities                                                         3,041          4,015
-----                                                                         ---------      ---------

LONG-TERM LIABILITIES:
  Accrued severance pay                                                             677            651
                                                                              ---------      ---------

Total long-term liabilities                                                         677            651
-----                                                                         ---------      ---------

COMMITMENTS AND CONTINGENT LIABILITIES (Note 12)

SHAREHOLDERS' EQUITY (Note 15):
  Share capital -
    Ordinary shares of NIS 0.01 par value - Authorized: 12,000,000 shares
      as of December 31, 2003 and 2004; Issued: 4,631,471 and 4,648,804
      shares as of December 31, 2003 and 2004, respectively; Outstanding:
      4,624,471 and 4,638,004 shares as of December 31, 2003 and 2004,
      respectively                                                                   14             14
  Additional paid-in capital                                                     12,877         12,879
  Treasury shares (7,000 and 10,800 shares as of December 31, 2003 and
      2004, respectively)                                                           (20)           (29)
  Deferred stock compensation                                                      (274)          (208)
  Accumulated other comprehensive income                                             87            348
  Retained earnings (accumulated deficit)                                         1,780         (2,347)
                                                                              ---------      ---------

Total shareholders' equity                                                       14,464         10,657
-----                                                                         ---------      ---------

Total liabilities and shareholders' equity                                    $  18,182      $  15,323
-----                                                                         =========      =========
</TABLE>

*) Reclassification.

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


                                      F-4
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share and per share data)

<TABLE>
<CAPTION>
                                                                 Year ended December 31,
                                                       ---------------------------------------------
                                                           2002             2003             2004
                                                       -----------      -----------      -----------
<S>                                                    <C>              <C>              <C>
Revenues (Note 16):
  Products sales                                       $     7,397      $     6,944      $     7,070
  Services                                                   2,390            2,286            2,343
                                                       -----------      -----------      -----------

Total revenues                                               9,787            9,230            9,413
-----                                                  -----------      -----------      -----------

Cost of revenues:
  Products sales                                             1,655            1,523            2,407
  Services                                                     241              326              407
                                                       -----------      -----------      -----------

Total cost of revenues                                       1,896            1,849            2,814
-----                                                  -----------      -----------      -----------

Gross profit                                                 7,891            7,381            6,599
                                                       -----------      -----------      -----------

Operating expenses:
  Research and development                                   2,127            1,825            2,362
  Selling and marketing                                      3,954            3,916            6,300
  General and administrative                                 1,858            1,830            2,101
                                                       -----------      -----------      -----------

Total operating expenses                                     7,939            7,571           10,763
-----                                                  -----------      -----------      -----------

Operating loss                                                 (48)            (190)          (4,164)
Financial income, net (Note 17a)                               134              124               78
Other income (expenses), net (Note 17b)                       (140)               6               --
                                                       -----------      -----------      -----------

Loss before taxes on income                                    (54)             (60)          (4,086)
Taxes on income (Note 13)                                       52              198              266
                                                       -----------      -----------      -----------

Loss before equity in earnings of affiliate                   (106)            (258)          (4,352)
Equity in earnings of affiliate                                236              345              225
                                                       -----------      -----------      -----------

Net income (loss)                                      $       130      $        87      $    (4,127)
                                                       ===========      ===========      ===========

Net earnings (loss) per share:

Basic net earnings (loss) per Ordinary share           $      0.03      $      0.02      $     (0.89)
                                                       ===========      ===========      ===========

Diluted net earnings (loss) per Ordinary share         $      0.03      $      0.02      $     (0.89)
                                                       ===========      ===========      ===========

Weighted average number of Ordinary shares used in
   computing basic net earning (loss) per share          4,709,796        4,617,099        4,634,413
                                                       ===========      ===========      ===========

Weighted average number of Ordinary shares used in
   computing diluted net earning (loss) per share        4,709,796        4,628,249        4,634,413
                                                       ===========      ===========      ===========
</TABLE>

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


                                      F-5
<PAGE>

<TABLE>
<CAPTION>
                                                                                            MER TELEMANAGEMENT SOLUTIONS LTD.
                                                                                                         AND ITS SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
-----------------------------------------------------------------------------------------------------------------------------
U.S. dollars in thousands

                                                                                                                 Accumulated
                                                                     Additional                    Deferred         other
                                                        Share         paid-in       Treasury        stock       comprehensive
                                                       capital        capital        shares      compensation   income (loss)
                                                    ------------   ------------   ------------   ------------   ------------
<S>                                                 <C>            <C>            <C>            <C>            <C>
Balance as of January 1, 2002                       $         15   $     12,846   $       (158)  $         --   $       (410)
  Purchase of treasury shares                                 --             --           (172)            --             --
  Other comprehensive income:
    Unrealized losses on available-for-sale
      marketable securities, net                              --             --             --             --             (3)
    Foreign currency translation adjustments                  --             --             --             --            202

  Total other comprehensive income
  Net income                                                  --             --             --             --             --
                                                    ------------   ------------   ------------   ------------   ------------
  Total comprehensive income

Balance as of December 31, 2002                               15         12,846           (330)            --           (211)
  Exercise of options                               *)        --             --             --             --             --
  Employee stock based compensation                           --   **)      487             --    **)    (487)             --
  Amortization of deferred stock compensation                 --             --             --            213             --
  Retirement of treasury shares                               (1)          (456)           457             --             --
  Purchase of treasury shares                                 --             --           (147)            --             --
  Other comprehensive income:
    Unrealized gains on available-for-sale
      marketable securities, net                              --             --             --             --            109
    Foreign currency translation adjustments                  --             --             --             --            196
    Loss from cash flows hedging transaction                  --             --             --             --             (7)

  Total other comprehensive income
  Net income                                                  --             --             --             --             --
                                                    ------------   ------------   ------------   ------------   ------------
  Total comprehensive income

Balance as of December 31, 2003                               14         12,877            (20)          (274)            87
  Exercise of options                               *)        --              2             --             --             --
  Amortization of deferred stock compensation                 --             --             --             66             --
  Purchase of treasury shares                                 --             --             (9)            --             --
  Other comprehensive income:
    Unrealized gains on available-for-sale
      marketable securities, net                              --             --             --             --             83
    Foreign currency translation adjustments                  --             --             --             --            171
    Gain from cash flows hedging transaction                  --             --             --             --              7

  Total other comprehensive income
  Net loss                                                    --             --             --             --             --
                                                    ------------   ------------   ------------   ------------   ------------
  Total comprehensive loss

Balance as of December 31, 2004                     $         14   $     12,879   $        (29)          (208)  $        348
                                                    ============   ============   ============   ============    ============

Accumulated unrealized gains from
  available-for-sale marketable securities                                                                      $         86
Accumulated foreign currency
  translation adjustments                                                                                                262
                                                                                                                ------------
                                                                                                                $        348
                                                                                                                ============

<CAPTION>
                                                      Retained
                                                      earnings        Total           Total
                                                    (accumulated   comprehensive   shareholders'
                                                      Deficit)     income (loss)     equity
                                                    ------------   ------------    ------------
<S>                                                 <C>            <C>             <C>
Balance as of January 1, 2002                       $      1,563                   $     13,856
  Purchase of treasury shares                                 --                           (172)
  Other comprehensive income:
    Unrealized losses on available-for-sale
      marketable securities, net                              --   $         (3)             (3)
    Foreign currency translation adjustments                  --            202             202
                                                                   ------------
  Total other comprehensive income                                          199
  Net income                                                 130            130             130
                                                    ------------   ------------    ------------
  Total comprehensive income                                       $        329
                                                                   ============
Balance as of December 31, 2002                            1,693                         14,013
  Exercise of options                                                              *)        --
  Employee stock based compensation                           --                             --
  Amortization of deferred stock compensation                 --                            213
  Retirement of treasury shares                               --                             --
  Purchase of treasury shares                                 --                           (147)
  Other comprehensive income:
    Unrealized gains on available-for-sale
      marketable securities, net                              --   $        109             109
    Foreign currency translation adjustments                  --            196             196
    Loss from cash flows hedging transaction                  --             (7)             (7)
                                                                   ------------
  Total other comprehensive income                                                          298
  Net income                                                  87             87              87
                                                    ------------   ------------    ------------
  Total comprehensive income                                       $        385
                                                                   ============
Balance as of December 31, 2003                            1,780                         14,464
  Exercise of options                                         --                              2
  Amortization of deferred stock compensation                 --                             66
  Purchase of treasury shares                                 --                             (9)
  Other comprehensive income:
    Unrealized gains on available-for-sale
      marketable securities, net                              --   $         83              83
    Foreign currency translation adjustments                  --            171             171
    Gain from cash flows hedging transaction                  --              7               7
                                                                   ------------
  Total other comprehensive income                                          261
  Net loss                                                (4,127)        (4,127)         (4,127)
                                                    ------------   ------------    ------------
  Total comprehensive loss                                         $     (3,866)
                                                                   ============
Balance as of December 31, 2004                     $     (2,347)                  $     10,657
                                                    ============                   ============
</TABLE>

*) Represents an amount lower than $1.
**) Reclassification.
The accompanying notes are an integral part of the consolidated financial
statements.


                                      F-6
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------
U.S. dollars in thousands

<TABLE>
<CAPTION>
                                                                              Year ended December 31,
                                                                      ---------------------------------------
                                                                         2002           2003           2004
                                                                      ---------      ---------      ---------
<S>                                                                   <C>            <C>            <C>
Cash flows from operating activities:
-------------------------------------
  Net income (loss)                                                   $     130      $      87      $  (4,127)
  Adjustments required to reconcile net income (loss) to net cash
    provided by (used in) operating activities:
      Loss (gain) on sale of available-for-sale and trading
        marketable securities, net                                          140             (6)            --
      Loss on sale of property and equipment                                  6             39              1
      Equity in earnings of affiliate                                      (236)          (345)          (225)
      Proceeds from trading securities, net                                  81             --             --
      Depreciation and amortization                                         501            401            399
      Deferred income taxes, net                                             29             23             33
      Employee stock-based compensation                                      --            213             66
      Accrued severance pay, net                                             (2)           (47)             2
      Decrease (increase) in trade receivables                              (87)          (132)           144
      Decrease (increase) in other accounts receivable and
        prepaid expenses                                                    215            (89)           175
      Decrease in inventories                                                82             47             15
      Increase (decrease) in trade payables                                (149)            43            326
      Increase (decrease) in accrued expenses and other
        liabilities                                                        (419)           (99)           611
      Increase (decrease) in deferred revenues                              187             35            (41)
      Others                                                                 11             (7)            --
                                                                      ---------      ---------      ---------

Net cash provided by (used in) operating activities                         489            163         (2,621)
                                                                      ---------      ---------      ---------

Cash flows from investing activities:
-------------------------------------
  Changes in related parties account, net                                   108             --             20
  Proceeds from sale of property and equipment                               26              5             22
  Purchase of property and equipment                                       (166)          (171)          (293)
  Capitalization of research and development costs                           --             --           (386)
  Investment in leasing deposit                                              --             --             (5)
  Proceeds from realization of short-term bank deposits                   1,942             --             --
  Investment in available for sale marketable securities                 (1,512)          (969)          (220)
  Investment in held-to-maturity marketable securities                     (476)            --             --
  Proceeds from sale of available-for-sale marketable securities          2,508            318            891
  Proceeds from redemption of held-to-maturity marketable
    securities                                                              201            275             --
  Acquisition of certain assets and liabilities of Teleknowledge
    (a)                                                                      --             --         (2,445)
  Dividend from an affiliate                                                190            100            136
  Others                                                                    (12)            16             50
                                                                      ---------      ---------      ---------

Net cash provided by (used in) investing activities                       2,809           (426)        (2,230)
                                                                      ---------      ---------      ---------
</TABLE>

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


                                      F-7
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
--------------------------------------------------------------------------------
U.S. dollars in thousands

<TABLE>
<CAPTION>
                                                                    Year ended December 31,
                                                           ---------------------------------------
                                                              2002           2003           2004
                                                           ---------      ---------      ---------
<S>                                                        <C>            <C>            <C>
Cash flows from financing activities:
-------------------------------------
  Changes in related parties, net                                  4             51             --
  Repayment of long-term loans                                   (55)            (8)            (8)
  Proceeds from exercise of options and warrants                  --      *)     --              2
  Purchase of treasury shares                                   (172)          (147)            (9)
                                                           ---------      ---------      ---------

Net cash used in financing activities                           (223)          (104)           (15)
                                                           ---------      ---------      ---------

Effect of exchange rate changes on cash and cash
   equivalents                                                    --            (11)            (4)
                                                           ---------      ---------      ---------

Increase (decrease) in cash and cash equivalents               3,075           (378)        (4,870)
Cash and cash equivalents at the beginning of the year         5,987          9,062          8,684
                                                           ---------      ---------      ---------

Cash and cash equivalents at the end of the year           $   9,062      $   8,684      $   3,814
                                                           =========      =========      =========

Supplemental disclosure of cash flows activities:
-------------------------------------------------
  Cash paid during the year for:
  Interest                                                 $      10      $       1      $       1
                                                           =========      =========      =========

  Income taxes                                             $      58      $      49      $      25
                                                           =========      =========      =========

      (a)   In conjunction with acquisition,
            the fair values of assets acquired
            and liabilities assumed at the date
            of acquisition were as follow (see
            Note 1c):

      Working capital (excluding cash and cash
        equivalents)                                                                     $      24
      Estimated fair value of assets acquired and
        liabilities assumed at the acquisition date:
      Property and equipment                                                                    40
      Goodwill                                                                               1,391
      Developed technology                                                                     690
      Customer relationship                                                                    300
                                                                                         ---------

                                                                                         $   2,445
                                                                                         =========
</TABLE>

*) Represents an amount lower than $ 1.
The accompanying notes are an integral part of the consolidated financial
statements.


                                      F-8
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 1:- GENERAL

      a.    Mer  Telemanagement  Solutions  Ltd.  (the  "Company"  or "MTS") was
            incorporated  on December 27, 1995. MTS and its  subsidiaries  ("the
            Group") designs, develops, markets and supports a comprehensive line
            of telecommunication management and customer care & billing ("CC&B")
            solutions that enable business  organizations  and other enterprises
            to improve the efficiency and performance of all IP operations,  and
            reduce  associated costs. The Group products include call accounting
            and  management  products,  fault  management  systems and web based
            management  solutions  for  converged  voice,  voice  over  Internet
            Protocol,  IP data  and  video  and  CC&B  solutions.  As for  MTS's
            subsidiaries, see Note 18.

      b.    MTS's  products  are  designed  to  provide   telecommunication  and
            information  technology managers with tools to reduce  communication
            costs,  recover charges payable by third parties,  and to detect and
            prevent  abuse and  misuse of  telephone  networks  including  fault
            telecommunication usage.

            The Group  markets  its  products  worldwide  through  distributors,
            business telephone  switching systems  manufacturers and vendors and
            its direct  sales force.  Several  international  private  automatic
            branch exchange ("PBX") manufacturers market the Group's products as
            part of  their  PBX  selling  efforts  or on an  Original  Equipment
            Manufacturer  ("OEM") basis.  The Group is highly dependent upon the
            active  marketing  and  distribution  of its OEM's.  If the Group is
            unable to effectively  manage and maintain a  relationship  with its
            OEM  or any  event  negatively  affecting  such  dealer's  financial
            condition,  could  cause a material  adverse  effect on the  Group's
            results of operations  and  financial  position.  In 2002,  2003 and
            2004, one major  customer  generated 36%, 40% and 38% of the Group's
            revenues, respectively.

            Certain  components  and  subassemblies   included  in  the  Group's
            products are  obtained  from a single  source or a limited  group of
            suppliers and subcontractors.  If such supplier fails to deliver the
            necessary  components or subassemblies,  the Company may be required
            to seek  alternative  sources of supply.  A change in supplier could
            result in manufacturing delays, which could cause a possible loss of
            sales  and,  consequently,  could  adversely  affect  the  Company's
            results of operations and financial position.

            MTS's shares are listed for trade on the Nasdaq SmallCap Market.

      c.    On December  30,  2004,  the Company  and  Teleknowledge  Group Ltd.
            ("Teleknowledge")  consummated an Assets  Purchase  Agreement  ("the
            Agreement").  TeleKnowledge  is a leading  provider of carrier-class
            billing and rating  solutions.  The  integration of  Teleknowledge's
            billing  solution  enables MTS to offer an end-to-end  customer care
            and billing solution.  Under the terms of the Agreement, the Company
            acquired  certain assets and  liabilities of  Teleknowledge  for the
            following consideration:

            1.    An initial consideration of $2,374 in cash.

            2.    Additional  contingent  consideration  of up to an  amount  of
                  $3,650   based  on  post   acquisition   revenue   performance
                  (calculated as 10% of renewal  maintenance fees and 20% of all
                  other  revenues  from  sales  which   included   Teleknowledge
                  products), over a period of three years. Such payments will be
                  recorded  as  additional  goodwill,   during  the  contingency
                  period, when actual revenue performance will be evaluated.


                                      F-9
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 1:- GENERAL (Cont.)

            3.    In addition,  the Company incurred  transaction costs totaling
                  $71.

            Prior  to  the  acquisition,   MTS  and  Teleknowledge  had  an  OEM
            relationship.  The commercial  arrangements  and  transactions  were
            settled before the date of the acquisition.

            The  acquisition  was  accounted  for under the  purchase  method of
            accounting  in  accordance  with  SFAS 141,  "Business  Combination"
            ("SFAS 141"). Accordingly,  the purchase price has been allocated to
            the  assets  acquired  and  the  liabilities  assumed  based  on the
            estimated fair value at the date of  acquisition.  The excess of the
            purchase  price  over the  estimated  fair  value of the net  assets
            acquired has been recorded as goodwill.

            Based  upon  a  valuation  of the  tangible  and  intangible  assets
            acquired and the liabilities  assumed, the Company has allocated the
            total cost of the acquisition to  Teleknowledge's  net assets at the
            date of acquisition, as follows:

               Trade receivables                                       $   100
               Property and equipment                                       40
                Intangible assets:
                   Developed technology (four-year useful life)            690
                   Customer relationship (six-year useful life)            300
                   Goodwill                                              1,391
                                                                       -------

                Total assets acquired                                    2,521
                                                                       -------
                Liabilities assumed:
                   Deferred revenues                                       (76)
                                                                       -------

                Total liabilities assumed                                  (76)
                                                                       -------

                Net assets acquired                                    $ 2,445
                                                                       =======

            The valuation of the Company's developed technology was based on the
            income  approach,  which reflects the future economic  benefits from
            Teleknowledge  products. The value assigned to customer relationship
            was based on the cost approach.  Under this  approach,  the customer
            relationship  was valued by calculating the savings  realized by the
            Company through  obtaining a pre-existing  customer  relationship of
            Teleknowledge.


                                      F-10
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 1:- GENERAL (Cont.)

            Pro forma results:

            The following  unaudited  proforma  information  does not purport to
            represent what the Company's  results of operations  would have been
            had the acquisitions  occurred on January 1, 2003 and 2004, nor does
            it purport to represent the results of operations of the Company for
            any future period.

<TABLE>
<CAPTION>
                                                                          Year ended December 31,
                                                                       ---------------------------
                                                                           2003            2004
                                                                       -----------     -----------
<S>                                                                    <C>             <C>
             Revenues                                                  $    10,128     $    10,542
                                                                       ===========     ===========

             Net loss from continuing operations                       $   (10,247)    $ *) (4,931)
                                                                       ===========     ===========
             Basic and diluted net loss per share for continuing
               operations                                              $     (2.22)    $     (1.06)
                                                                       ===========     ===========
            Weighted average number of Ordinary shares in
               computation of basic and diluted net loss per share       4,617,099       4,634,413
                                                                       ===========     ===========
</TABLE>

            *) Net of capital gain from sale of Teleknowledge to MTS.

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES

      The  consolidated  financial  statements  have been prepared in accordance
      with generally accepted accounting  principles in the United States ("U.S.
      GAAP").

      a.    Use of estimates:

            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. Actual results could differ from
            those estimates.

      b.    Financial statements in U.S. dollars:

            The  majority  of the  revenues  of the  Company  and certain of its
            subsidiaries are generated in U.S.  dollars  ("dollar") or linked to
            the dollar. In addition,  a substantial portion of the Company's and
            certain of its subsidiaries' costs is incurred in dollars. Company's
            management  believes that the dollar is the primary  currency of the
            economic  environment  in  which  the  Company  and  certain  of its
            subsidiaries operate. Thus, the functional and reporting currency of
            the Company and certain of its subsidiaries is the dollar.

            Accordingly,  monetary accounts  maintained in currencies other than
            the dollar are remeasured  into dollars in accordance  with SFAS No.
            52, "Foreign Currency Translation". All transaction gains and losses
            of the  remeasurement  of monetary balance sheet items are reflected
            in the consolidated  statements of operations as financial income or
            expenses, as appropriate.


                                      F-11
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

            The financial  statements of foreign  subsidiaries  and  affiliates,
            whose  functional  currency  has been  determined  to be their local
            currency,  have been translated into dollars. Assets and liabilities
            have  been  translated  using  the  exchange  rates in effect at the
            balance  sheet date.  Statements  of  operations  amounts  have been
            translated  using the  average  exchange  rate for the  period.  The
            resulting  translation  adjustments  are  reported as a component of
            shareholders'  equity  in  accumulated  other  comprehensive  income
            (loss).

      c.    Principles of consolidation:

            The consolidated  financial  statements  include the accounts of MTS
            and its  wholly-owned  subsidiaries.  Intercompany  transactions and
            balances, including profits from intercompany sales not yet realized
            outside the Group, have been eliminated upon consolidation.

      d.    Cash equivalents:

            The Company considers all short-term highly liquid  investments that
            are readily  convertible  to cash with original  maturities of three
            months or less to be cash equivalents.

      e.    Marketable securities:

            The Company  accounts for investments in debt and equity  securities
            (other  than  those   accounted  for  under  the  equity  method  of
            accounting)  in accordance  with  Statement of Financial  Accounting
            Standard No. 115,  "Accounting  for Certain  Investments in Debt and
            Equity Securities" ("SFAS No. 115").

            Management   determines   the   classification   of  investments  in
            marketable  debt and equity  securities  at the time of purchase and
            reevaluates such designations as of each balance sheet date.

            As of December 31, 2004 and 2003,  all  marketable  securities  were
            designated as available-for-sale.  Accordingly, these securities are
            stated at fair value,  with unrealized  gains and losses reported in
            accumulated other comprehensive  income (loss), a separate component
            of shareholders'  equity, net of taxes. Realized gains and losses on
            sales of  investments,  as determined  on a specific  identification
            basis, are included in the consolidated Statement of Operations.

      f.    Inventories:

            Inventories  are  stated  at the  lower  of  cost or  market  value.
            Inventories write-offs are provided to cover risks arising from slow
            moving items or  technological  obsolescence.  Cost is determined as
            follows: Raw materials - using the "first in, first out" method with
            the addition of allocable  indirect  manufacturing  costs.  Finished
            products  are  recorded on the basis of direct  manufacturing  costs
            with the addition of allocable indirect manufacturing costs.


                                      F-12
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

      g.    Investments in an affiliate:

            In these financial  statements,  affiliated  company is company held
            50% (which is not a  subsidiary),  where the  Company  can  exercise
            significant  influence  over  operating and financial  policy of the
            affiliate.

            The investment in affiliated  company is accounted for by the equity
            method, in accordance with Accounting Principle Board Opinion No.18,
            "The Equity Method of Accounting  for  Investments in Common Stock",
            ("APB No.18").  Profits on intercompany  sales, not realized through
            sales to third parties, were eliminated.  The excess of the purchase
            price over the fair value of net tangible  assets  acquired has been
            attributed to goodwill.

            Goodwill is no longer  amortized,  but is reviewed annually (or more
            frequently if  circumstances  indicate  impairment has occurred) for
            impairment  in  accordance  with  the  provisions  of  Statement  of
            Financial   Accounting   Standard  No.  142,   "Goodwill  and  Other
            Intangible Assets" ("SFAS No. 142"). Before the adoption of SFAS No.
            142, goodwill was amortized on a straight-line  basis over 10 years,
            in accordance with APB Opinion No.17, "Intangible Assets".

            Under APB 18, a loss in value of an  investment  accounted for under
            the equity method,  which is other than a temporary decline,  should
            be recognized as a realized loss,  establishing a new carrying value
            for the  investment.  Factors the Company  considers  in making this
            evaluation  include:  the length of time and the extent to which the
            market value has been less than cost,  the  financial  condition and
            near-term  prospects  of the  issuer,  including  cash  flows of the
            investee and any specific  events which may influence the operations
            of the issuer and the  intent and  ability of the  Company to retain
            its  investments  for a period of time  sufficient  to allow for any
            anticipated  recovery in market  value.  A current  fair value of an
            investment that is less than its carrying amount may indicate a loss
            in value of the  investment.  No  impairment  losses  were  recorded
            during 2004.

      h.    Investment in other companies:

            The investment in these companies is stated at cost, since the Group
            does not have the ability to  exercise  significant  influence  over
            operating and financial policies of those investments. The Company's
            investments in other companies are reviewed for impairment  whenever
            events or changes in circumstances indicate that the carrying amount
            of an investment  may not be  recoverable,  in  accordance  with APB
            No.18. As of December 31, 2004,  based on  management's  most recent
            analyses, no impairment losses have been identified.


                                      F-13
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

      i.    Property and equipment:

            Property  and  equipment  are  stated  at cost,  net of  accumulated
            depreciation.  Depreciation  is calculated  using the  straight-line
            method,  over  the  estimated  useful  lives of the  assets,  at the
            following annual depreciation rates:

                                                                  %
                                                      --------------------------

            Computers and peripheral equipment                    33
            Office furniture and equipment                      6 - 20
            Motor vehicles                                        15
            Leasehold improvements                     Over the shorter term of
                                                      the lease agreement or the
                                                          life of the asset

      j.    Impairment of long-lived assets:

            The Company's long-lived assets and certain identifiable intangibles
            are  reviewed  for  impairment  in  accordance   with  Statement  of
            Financial   Accounting   Standard  No.  144,   "Accounting  for  the
            Impairment  or  Disposal of  Long-Lived  Assets"  ("SFAS No.  144"),
            whenever  events  or  changes  in  circumstances  indicate  that the
            carrying amount of an asset may not be  recoverable.  Recoverability
            of assets to be held and used is  measured  by a  comparison  of the
            carrying  amount of an asset to the future  undiscounted  cash flows
            expected  to  be  generated  by  the  assets.  If  such  assets  are
            considered  to be  impaired,  the  impairment  to be  recognized  is
            measured  by the amount by which the  carrying  amount of the assets
            exceeds the fair value of the assets.  As of December 31,  2004,  no
            impairment losses have been identified.

      k.    Goodwill and other intangible assets:

            Goodwill  represents  excess  of the  costs  over the net  assets of
            business  acquired.  Under  SFAS No.  142,  goodwill  acquired  in a
            business  combination  on  or  after  July  1,  2001,  will  not  be
            amortized.  Goodwill that arose from  acquisitions  prior to July 1,
            2001 was amortized  until  December 31, 2001,  by the  straight-line
            method, over 10 years.

            SFAS No.  142  requires  goodwill  to be tested  for  impairment  on
            adoption and at least annually thereafter or between annual tests in
            certain circumstances,  and written down when impaired,  rather than
            being amortized as previous accounting standards required.  Goodwill
            is  tested  for  impairment  by  comparing  the  fair  value  of the
            reporting  unit with its carrying  value.  Fair value is  determined
            using  discounted  cash  flows.  Significant  estimates  used in the
            methodologies   include  estimates  of  future  cash  flows,  future
            short-term and long-term  growth rates, and weighted average cost of
            capital.  As of December 31, 2004,  no  impairment  losses have been
            identified. As for application of SFAS No. 142, see Note 10a.

            Developed  technology is amortized  over a weighted  average of four
            years and customer relationship is amortized over a weighted average
            of six years .


                                      F-14
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

      l.    Revenue recognition:

            The Company generates  revenues from licensing the rights to use its
            software  products  directly to  end-users  and  indirectly  through
            resellers and OEM's (who are considered end users). The Company also
            generates  revenues from rendering  maintenance,  service bureau and
            support.

            Revenues from software  license  agreements are recognized  when all
            criteria  outlined in  Statement  of Position  No.  97-2,  "Software
            Revenue  Recognition"  ("SOP No. 97-2") as amended are met.  Revenue
            from  license  fees is  recognized  when  persuasive  evidence of an
            agreement  exists,   delivery  of  the  product  has  occurred,   no
            significant  obligations with regard to implementation  remain,  the
            fee is fixed or determinable  and  collectibility  is probable.  The
            Company generally does not grant a right of return to its customers.

            Where software  arrangements  involve multiple elements,  revenue is
            allocated  to each  undelivered  element  based on  vendor  specific
            objective  evidence  ("VSOE") of the fair values of each undelivered
            element in the arrangement, in accordance with the "residual method"
            prescribed by SOP No. 98-9,  "Modification of SOP No. 97-2, Software
            Revenue Recognition With Respect to Certain Transactions".  The VSOE
            used by the Company to allocate the sales price to support  services
            and  maintenance  is based on the renewal  rate  charged  when these
            elements are sold separately. License revenues are recorded based on
            the  residual  method.   Under  the  residual  method,   revenue  is
            recognized for the delivered  elements when (1) there is VSOE of the
            fair  values of all the  undelivered  elements,  and (2) all revenue
            recognition  criteria of SOP No. 97-2,  as amended,  are  satisfied.
            Under  the  residual  method  any  discount  in the  arrangement  is
            allocated to the delivered element.

            Revenues from  maintenance and support  services are recognized over
            the life of the  maintenance  agreement  or at the time that support
            services are rendered.

            Deferred   revenues   include   unearned   amounts   received  under
            maintenance and support contracts, not yet recognized as revenues.

      m.    Research and development costs:

            Statement of Financial  Accounting Standards No. 86, "Accounting for
            the Costs of  Computer  Software  to be Sold,  Leased  or  Otherwise
            Marketed"  ("SFAS  No.  86"),  requires  capitalization  of  certain
            software  development  costs  subsequent  to  the  establishment  of
            technological   feasibility.   Based  on  the   Company's   and  its
            subsidiaries product development process,  technological feasibility
            is established upon completion of a working model.


                                      F-15
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

            Research and development costs incurred in the process of developing
            product  improvements  or new  products,  are  generally  charged to
            expenses  as  incurred,  net of  participation  of the Office of the
            Chief Scientist of Israel's Ministry of Industry and Trade.

            Significant  costs  incurred  by the  Company  and its  subsidiaries
            between  completion  of the working model and the point at which the
            product is ready for general release, have been capitalized.

            Capitalized  software  costs are  amortized  by the  greater  of the
            amount  computed  using the: 1) ratio of the current gross  revenues
            from sales of the  software to the total of current and  anticipated
            future  gross  revenues  from  sales  of  that  software,  or 2) the
            straight-line  method over the estimated  useful life of the product
            (three  years).  The Company  assesses  the  recoverability  of this
            intangible  asset on a  regular  basis by  determining  whether  the
            amortization  of the asset over its remaining  life can be recovered
            through  undiscounted  future operating cash flows from the specific
            software product sold. Based on its most recent analyses, management
            believes  that no  impairment of  capitalized  software  development
            costs exists as of December 31, 2004.

      n.    Government grants:

            Royalty-bearing  grants  from the  Government  of Israel for funding
            certain approved research and development projects are recognized at
            the time the Company is entitled to such grants, on the basis of the
            related  costs  incurred and recorded as a deduction of research and
            development costs.

      o.    Income taxes:

            The Company  accounts for income taxes, in accordance with Statement
            of Financial  Accounting  Standard No. 109,  "Accounting  for Income
            Taxes" ("SFAS No. 109").  This  statement  prescribes the use of the
            liability method whereby  deferred tax assets and liability  account
            balances  are  determined  based on  differences  between  financial
            reporting and tax bases of assets and  liabilities  and are measured
            using the enacted tax rates and laws that will be in effect when the
            differences  are  expected  to  reverse.  Valuation  allowances  are
            provided to reduce deferred tax assets to their estimated realizable
            value.

      p.    Accounting for stock-based compensation:

            The  Company  has  elected  to follow  Accounting  Principles  Board
            Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB No.
            25")  and  FASB  Interpretation  No.  44,  "Accounting  for  Certain
            Transactions   Involving  Stock  Compensation"  ("FIN  No.  44")  in
            accounting  for its employee  stock option plans.  Under APB No. 25,
            when the exercise price of the Company's  stock options is less than
            the  market  price of the  underlying  shares  on the date of grant,
            compensation expense is recognized.


                                      F-16
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

            The  Company   adopted  the   disclosure   provisions  of  Financial
            Accounting  Standards  Board  Statement  No.  148,  "Accounting  for
            Stock-Based  Compensation  - Transition and  Disclosure"  ("SFAS No.
            148"),  which  amended  certain  provisions  of SFAS 123 to  provide
            alternative  methods of  transition  for an entity that  voluntarily
            changes to the fair value based method of accounting for stock-based
            employee  compensation,  effective  as of the  beginning  2003.  The
            Company  continues  to  apply  the  provisions  of APB  No.  25,  in
            accounting for stock-based compensation.

            Pro forma information  regarding the Company's net income (loss) and
            net  earnings  (loss) per share is  required by SFAS No. 123 and has
            been  determined  as if the Company had  accounted  for its employee
            stock  options  under the fair value method  prescribed  by SFAS No.
            123.

            The  fair  value  for  options  granted  in  2002,  2003 and 2004 is
            amortized  over their  vesting  period and  estimated at the date of
            grant using a Black-Scholes options pricing model with the following
            weighted average assumptions:

<TABLE>
<CAPTION>
                                                                Year ended December 31,
                                                        -----------------------------------------
                                                           2002            2003            2004
                                                        ---------       ---------       ---------
<S>                                                     <C>             <C>             <C>
            Dividend                                            0%              0%              0%
            Average risk-free interest rates                    2%              2%           2.79%
            Average expected life (in years)                    4             2.5            4.71
            Volatility                                       66.8%           71.8%          53.37%

            Pro forma information under SFAS No. 123, is as follows:

<CAPTION>
                                                                Year ended December 31,
                                                        -----------------------------------------
                                                           2002            2003            2004
                                                        ---------       ---------       ---------
<S>                                                     <C>             <C>             <C>
            Net income (loss), available to
              ordinary shares as reported               $     130       $      87       $  (4,127)
            Add: Stock-based employee compensation
              - intrinsic value                                --             213              66
            Deduct: Total stock-based compensation
              expense determined under fair value
              method for all awards, net of related
              tax effect                                     (177)           (346)           (274)
                                                        ---------       ---------       ---------

            Pro forma net loss                          $     (47)      $     (46)      $  (4,335)
                                                        =========       =========       =========
            Basic and diluted net earnings (loss)
              per share, as reported                    $    0.03       $    0.02       $   (0.89)
                                                        =========       =========       =========
            Basic and diluted net loss per share,
              pro forma                                 $   (0.01)      $      --       $   (0.94)
                                                        =========       =========       =========
</TABLE>


                                      F-17
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

            The Company applies Statement of Financial  Accounting  Standard No.
            123, "Accounting for Stock-Based  Compensation" ("SFAS No. 123") and
            Emerging Issues Task Force No. 96-18 ("EITF No. 96-18"), "Accounting
            for Equity  Instruments  That are Issued to Other Than Employees for
            Acquiring,  or in Conjunction with Selling,  Goods or Services" with
            respect to options  issued to  non-employees.  SFAS No. 123 requires
            use of an option  valuation  model to measure  the fair value of the
            options at the measurement date.

      q.    Warranty costs:

            The Company  provides free warranty for up to one year for end-users
            and up to 15  months  for the "OEM"  distributors.  A  provision  is
            recorded for probable costs in connection  with these services based
            on the Company's experience.

            The Company estimates the costs that may be incurred under its basic
            limited warranty and records a liability in the amount of such costs
            at the time product  revenue is recognized.  Factors that affect the
            Company's  warranty  liability  include  the  number of sold  units,
            historical and anticipated  rates of warranty  claims,  and cost per
            claim.  The  Company  periodically  assesses  the  adequacy  of  its
            recorded warranty  liabilities and adjusts the amounts as necessary.
            No changes in the Company's  product  liability were recorded during
            the period and the provision  for the year ending  December 31, 2004
            amounted to $ 22.

      r.    Fair value of financial instruments:

            The  following  methods  and  assumptions  were used by the Group in
            estimating its fair value disclosures for financial instruments:

            The   carrying   amounts  of  cash  and  cash   equivalents,   trade
            receivables,   other   accounts   receivable   and  trade   payables
            approximate their fair value, due to the short-term maturity of such
            instruments.

            The fair value for  marketable  securities is based on quoted market
            prices (see Note 3).

            Long-term loans - The carrying  amounts of the Company's  borrowings
            under its long-term agreements,  both as a lender and as a borrower,
            approximate their fair value.

      s.    Severance pay:

            The Company's  liability for severance pay is calculated pursuant to
            Israel's  Severance  Pay Law based on the most recent  salary of the
            employees multiplied by the number of years of employment, as of the
            balance sheet date. Employees are entitled to one month's salary for
            each  year  of  employment  or  a  portion  thereof.  The  Company's
            liability  for all of its  employees  is fully  provided  by monthly
            deposits  with  insurance  policies and by an accrual.  The value of
            these  policies  is recorded  as an asset in the  Company's  balance
            sheet.


                                      F-18
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

            The deposited  funds may be withdrawn  only upon the  fulfillment of
            the  obligation  pursuant  to  Israel's  Severance  Pay Law or labor
            agreements.  The value of the  deposited  funds is based on the cash
            surrendered  value  of  these  policies,   and  includes  immaterial
            profits.

            Severance  expenses for the years ended December 31, 2002,  2003 and
            2004 amounted to approximately $ 104, $ 13 and $ 164, respectively.

      t.    Concentrations of credit risk:

            Financial  instruments  that  potentially  subject  the  Company  to
            concentrations  of credit risk consist  principally of cash and cash
            equivalents, trade receivables,  marketable securities and long-term
            loans.

            Cash and cash  equivalents  are deposited with major banks in Israel
            and major banks in United  States.  Such deposits in the U.S. may be
            in  excess  of   insured   limit  and  are  not   insured  in  other
            jurisdictions.  Management believes that the financial  institutions
            that hold the  Company's  investments  are  financially  sound,  and
            accordingly,  minimal  credit  risk  exists  with  respect  to these
            investments.

            The trade  receivables  of the Company are mainly derived from sales
            to  customers  in the U.S.  and Europe  (see Note 16).  The  Company
            performs ongoing credit evaluations of its customers.  The allowance
            for doubtful  accounts is determined  with respect to specific debts
            that are doubtful of collection  according to management  estimates.
            In certain circumstances, the Company may require letters of credit,
            other collateral or additional guarantees.

            The Company's  marketable  securities  include mainly investments in
            corporate  debts and  mutual  funds.  Management  believes  that the
            portfolio is well diversified, and accordingly,  minimal credit risk
            exists with respect to these marketable securities.

            The Company has no  off-balance-sheet  concentration  of credit risk
            such as  foreign  exchange  contracts,  option  contracts  or  other
            foreign hedging arrangements.

      u.    Basic and diluted net earnings (loss) per share:

            Basic  net  earnings  (loss)  per  share  is  computed  based on the
            weighted average number of Ordinary shares  outstanding  during each
            year. Diluted net earnings (loss) per share is computed based on the
            weighted average number of Ordinary shares  outstanding  during each
            year, plus potential  Ordinary shares considered  outstanding during
            the year,  in  accordance  with  Statement of  Financial  Accounting
            Standard No. 128, "Earnings Per Share" ("SFAS No. 128").

            The total  number  of  shares  related  to the  outstanding  options
            excluded  from the  calculation  of diluted net earnings  (loss) per
            share was 757,580  766,141 and 667,101 for the years ended  December
            31, 2002, 2003 and 2004, respectively.


                                      F-19
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

      v.    Derivatives and hedging:

            To protect  against the  reduction  in value of  forecasted  foreign
            currency cash flows  resulting from export sales over the next year,
            the Company hedged portions of its forecasted revenue denominated in
            foreign currencies with forward contracts.  During 2004, the Company
            realized all its forward derivatives.

            Financial  Accounting Standards Board Statement No. 133, "Accounting
            for Derivative Instruments and Hedging Activities" ("SFAS No. 133"),
            requires companies to recognize all of their derivative  instruments
            as either  assets  or  liabilities  in the  statement  of  financial
            position at fair value. The accounting for changes in the fair value
            (i.e.,  gains or  losses)  of a  derivative  instrument  depends  on
            whether it has been  designated  and  qualifies as part of a hedging
            relationship and further, on the type of hedging  relationship.  For
            those  derivative  instruments  that are  designated  and qualify as
            hedging   instruments,   a  company  must   designate   the  hedging
            instrument,  based upon the exposure  being hedged,  as a fair value
            hedge,  cash flow hedge or a hedge of a net  investment in a foreign
            operation.

            For derivative instruments that are designated and qualify as a cash
            flow hedge (i.e.,  hedging the exposure to  variability  in expected
            future cash flows that is  attributable to a particular  risk),  the
            effective  portion of the gain or loss on the derivative  instrument
            is  reported  as a  component  of  other  comprehensive  income  and
            reclassified into earnings in the same line item associated with the
            forecasted  transaction  in the same period or periods  during which
            the hedged transaction affects earnings.  The remaining gain or loss
            on the derivative  instrument in excess of the cumulative  change in
            the present  value of future cash flows of the hedged item,  if any,
            is recognized in other income/expense in current earnings during the
            period of change.

            During  2004 and 2003,  there  were no  significant  gains or losses
            recognized in earning for hedge ineffectivness.

      w.    Impact of recently issued accounting standards:

            On December16, 2004, the FASB issued FASB Statement No. 123 (revised
            2004), "Share Based Payment",  which is a revision of FASB Statement
            No.  123,  "Accounting  for Stock Based  Compensation".  SFAS 123(R)
            supersedes  APB  Opinion  No. 25,  "Accounting  for Stock  Issued to
            Employees",  and amends FASB  Statement  No. 95,  "Statement of Cash
            Flow". Generally,  the approach adopted by SFAS 123(R) is similar to
            the  approach  described  in  Statement  123.  However,  SFAS 123(R)
            requires all share-based payments to employees,  including grants of
            employee  stock  options,  to be recognized in the income  statement
            based on their  fair  value.  Pro forma  disclosure  is no longer an
            alternative.

            SFAS  123(R)  must be adopted  by no later than July 1, 2005.  Early
            adoption is permitted in periods in which financial  statements have
            not yet been  issued.  The  Company  expects to adopt SFAS 123(R) on
            July 1, 2005.


                                      F-20
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (Cont.)

            SFAS 123(R) permits  companies to adopt its requirement using one of
            the two methods:

            1.    A "modified  prospective" method in which compensation cost is
                  recognized  beginning with the effective date (a) based on the
                  requirements  of  SFAS  123(R)  for all  share-based  payments
                  granted  after  the  effective  date  and  (b)  based  on  the
                  requirements   of  SFAS  123(R)  for  all  awards  granted  to
                  employees prior to the effective date of SFAS 123R that remain
                  unvested on the effective date.

            2.    A  "modified   retrospective"   method   which   includes  the
                  requirements  of the  modified  prospective  method  described
                  above,  but also  permits  entities  to  restate  based on the
                  amounts  previously  recognized under SFAS 123(R) for purposes
                  of  pro  forma  disclosures  either:  (a)  all  prior  periods
                  presented or (b) prior interim period of the year of adoption.

                  As permitted by SFAS 123, the Company  currently  accounts for
                  share based  payments to employees  using the APB 25 intrinsic
                  value   method  and,   as  such,   generally   recognizes   no
                  compensation cost for employee stock options. Accordingly, the
                  adoption  of  SFAS  123(R)  fair  value  method  will  have  a
                  significant  impact on the  Company's  result  of  operations,
                  although  it will  have no  impact  on the  Company's  overall
                  financial position.  The impact of the adoption of SFAS 123(R)
                  cannot be  predicted  at this time  because it will  depend on
                  levels of share based payments granted in the future. However,
                  had the  Company  adopted  SFAS 123(R) in prior  periods,  the
                  impact of that Standard would have  approximated the impact of
                  SFAS 123 as  described  in the  disclosure  of pro  forma  net
                  income and earnings (loss) per share in above.

                  In November  2004,  the FASB  issued  Statement  of  Financial
                  Accounting Standard No. 151, "Inventory Costs, an Amendment of
                  ARB No. 43, Chapter 4" ("SFAS151"). SFAS 151 amends Accounting
                  Research  Bulletin  ("ARB") No. 43, Chapter 4, to clarify that
                  abnormal  amounts of idle facility  expense,  freight handling
                  costs and wasted materials  (spoilage) should be recognized as
                  current-period  charges.  In addition,  SFAS 151 requires that
                  allocation  of  fixed  production  overheads  to the  costs of
                  conversion  be  based on  normal  capacity  of the  production
                  facilities. SFAS 151 is effective for inventory costs incurred
                  during fiscal years beginning after June 15, 2005. The Company
                  does not  expect  that the  adoption  of SFAS 151 will  have a
                  material  effect  on its  financial  position  or  results  of
                  operations.

                  Reclassification:

                  Certain  amounts  from prior years  referring  to the employee
                  stock based  compensation  have been  reclassified  to conform
                  current periods representation.


                                      F-21
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 3:- MARKETABLE SECURITIES

      The  following  is a summary of the  Company's  investment  in  marketable
      securities:

<TABLE>
<CAPTION>
                                             December 31, 2003                                    December 31, 2004
                            ---------------------------------------------------   -------------------------------------------------
                                            Gross        Gross                                    Gross       Gross
                             Amortized    unrealized   unrealized    Fair market  Amortized    unrealized   unrealized   Fair market
                               cost         gains        losses         value        cost         gains       losses        value
                            ----------   ----------    ----------    ----------   ----------   ----------   ----------   ----------
<S>                         <C>          <C>           <C>           <C>          <C>          <C>          <C>          <C>
      Available-for-sale:
       Mutual funds         $      623   $        5    $       --    $      628   $      506   $       60   $       --   $      566
       Equity securities            51           12            --            63           25            8           33
       Corporate bonds             702           --            (8)          694          368            8           --          376
       Israeli Government
        debts                      265           --            (6)          259           72           10                        82
                            ----------   ----------    ----------    ----------   ----------   ----------   ----------   ----------

                            $    1,641   $       17    $      (14)   $    1,644   $      971   $       86   $       --   $    1,057
                            ==========   ==========    ==========    ==========   ==========   ==========   ==========   ==========
</TABLE>

      The  gross  realized   gains  (losses)  on  sales  of   available-for-sale
      securities  totaled  $ 6 and $ 0 in 2003 and 2004,  respectively.  The net
      adjustment to  unrealized  holding  gains  (losses) on  available-for-sale
      securities  included  as a separate  component  of  shareholders'  equity,
      "Accumulated other  comprehensive  gains (losses)" amounted to $ 109 and $
      83 in 2003 and 2004, respectively.

      The amortized cost and fair value of debt and marketable equity securities
      as of December 31, 2004, by contractual maturity, are shown below.

                                                          December 31, 2004
                                                       -----------------------
                                                       Amortized    Fair market
                                                          cost         value
                                                       ----------   ----------

      Matures in one year                              $      368   $      376
      Matures after one year through nine years                72           82
      Equity securities and mutual funds                      531          599
                                                       ----------   ----------

      Total                                            $      971   $    1,057
                                                       ==========   ==========


                                      F-22
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 4:- OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES

                                                            December 31,
                                                       -----------------------
                                                           2003         2004
                                                       ----------   ----------

      Government authorities                            $      232   $      117
      Prepaid expenses                                         103          149
      Deferred income taxes (1)                                 66           66
      Others                                                   165           59
                                                        ----------   ----------

                                                        $      566   $      391
                                                        ==========   ==========

      (1) See Note 13f

NOTE 5:- INVENTORIES

      Raw materials                                     $       73   $       76
      Finished products                                        120          102
                                                        ----------   ----------

                                                        $      193   $      178
                                                        ==========   ==========

      The Company  periodically  assesses its inventory  valuation in accordance
      with its revenues forecasts,  technological  obsolescence,  and the market
      conditions.  Marked down  inventory that is expected to be sold at a price
      lower than the carrying value is not material.

NOTE 6:- INVESTMENTS IN AFFILIATE

      a.    Composed as follows:

                                                                December 31,
                                                           ---------------------
                                                              2003        2004
                                                           ---------   ---------

        Investment in Jusan S.A. (50% owned)
          Equity, net (1)                                  $   1,824   $   2,084
          Goodwill                                                35          35
                                                           ---------   ---------

                                                           $   1,859   $   2,119
                                                           =========   =========

        (1) Investment as of purchase date                 $   1,171   $   1,171
            Foreign currency translation adjustments             143         316
            Accumulated net earnings                             510         597
                                                           ---------   ---------

                                                           $   1,824   $   2,084
                                                           =========   =========

        Dividend received from Jusan S.A. during the year  $     100   $     136
                                                           =========   =========


                                      F-23
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 6:- INVESTMENTS IN AFFILIATE (Cont.)

      b.    Summarized financial information of Jusan S.A. (50% owned):

                                                             December 31,
                                                        ----------------------
                                                           2003         2004
                                                        ---------    ---------

         Current assets                                 $   5,266    $   5,552
         Non-current assets                             $      99    $      68
         Current liabilities                            $  (1,861)   $  (1,438)

                                                  Year ended December 31,
                                           ------------------------------------
                                              2002         2003         2004
                                           ----------   ----------   ----------

         Revenues                          $    6,848   $    6,049   $    6,892
         Gross profit                      $    3,260   $    3,079   $    3,158
         Net income                        $      708   $      594   $      444

NOTE 7:- LONG-TERM LOANS

      a.    Composed as follows:

                                                              December 31,
                                                        -----------------------
                                                           2003         2004
                                                        ----------   ----------

            Loans to others in NIS - unlinked (1)       $      131   $       84
            Less - current maturities (2)                       36           39
                                                        ----------   ----------
                                                        $       95   $       45
                                                        ==========   ==========

            (1)   The weighted average interest rate for the year ended December
                  31, 2004 and 2003 is 6.375%.

            (2)   Included in other accounts receivable.

      b.    As  of  December  31,  2004,  the  aggregate  annual  maturities  of
            long-term loans are as follows:

                                                                    December 31,
                                                                    -----------

            2005 (current maturities)                               $        39
            2006                                                             36
            2007                                                              9
                                                                    -----------
                                                                    $        84
                                                                    ===========


                                      F-24
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 8:- OTHER INVESTMENTS

                                                              December 31,
                                                        -----------------------
                                                           2003          2004
                                                        ----------   ----------

            Long-term leasing deposits (1)              $       21   $       26
            Investment in other companies                      347          347
                                                        ----------   ----------
                                                        $      368   $      373
                                                        ==========   ==========

            (1)   Linked to the Israeli CPI.

NOTE 9:- PROPERTY AND EQUIPMENT, NET

            Cost:
              Computers and peripheral equipment       $    2,528   $    2,838
              Office furniture and equipment                  536          558
              Motor vehicles                                   96           62
              Leasehold improvements                          100          112
                                                       ----------   ----------
                                                            3,260        3,570
                                                       ----------   ----------
            Accumulated depreciation:
              Computers and peripheral equipment            2,300        2,454
              Office furniture and equipment                  358          407
              Motor vehicles                                   64           55
              Leasehold improvements                           56           73
                                                       ----------   ----------
                                                            2,778        2,989
                                                       ----------   ----------
            Depreciated cost                           $      482   $      581
                                                       ==========   ==========

            The depreciation expense for the years ended December 31, 2002, 2003
            and 2004 was $ 347, $ 247 and $ 211, respectively.


                                      F-25
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 10:- GOODWILL AND OTHER ASSETS

      a.    Goodwill:

            The changes in the  carrying  amount of goodwill  for the year ended
            December 31, 2004 are as follows:

            Balance as of December 31, 2003                          $    2,024
            Goodwill acquired during year (see Note 1c)                   1,391
            Impairment losses                                                --
                                                                     ----------
            Balance as of December 31, 2004                          $    3,415
                                                                     ==========

      b.    Other intangibles consist of the following:

                                                              December 31,
                                                        -----------------------
                                                            2003        2004
                                                        ----------   ----------

              Cost:
              Development technology                    $      750   $    1,440
              Capitalized software developed costs              --          386
              Customer relationship                             --          300
                                                        ----------   ----------
                                                               750        2,126
                                                        ----------   ----------
            Accumulated amortization:
              Development technology                           544          700
              Capitalized software developed costs              --           32
              Customer relationship                             --           --
                                                        ----------   ----------
                                                               544          732
                                                        ----------   ----------
                                                        $      206   $    1,394
                                                        ==========   ==========

      c.    Amortization expenses amounted to $ 154, $ 154 and $ 188 for each of
            the years ended December 31, 2002, 2003 and 2004.

      d.    Estimated amortization expenses for the years ended:

            December 31,
            ------------

            2005                                    273
            2006                                    223
            2007                                    222
            2008                                    222
            2009 and further                        100


                                      F-26
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 11:- ACCRUED EXPENSES AND OTHER LIABILITIES

                                                              December 31,
                                                        -----------------------
                                                            2003         2004
                                                        ----------   ----------

            Employees and payroll accruals              $      473   $      799
            Income tax payable                                 242          330
            Accrued expenses                                   456          646
            Customer advances                                  203          204
            Related parties                                     47           63
                                                        ----------   ----------
                                                        $    1,421   $    2,042
                                                        ==========   ==========

NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES

      a.    Lease commitments:

            The facilities of the Company are rented under operating  leases for
            periods ending in 2006.

            Future  minimum lease  commitments  under  non-cancelable  operating
            leases as of December 31 are as follows:

            2005                    $   399
            2006                        130
                                    -------
                                    $   529
                                    =======

            Lease expenses for the years ended December 31, 2002, 2003 and 2004,
            were approximately $ 446, $ 372 and $ 334, respectively.

      b.    Royalty commitments:

            1.    The Company is committed to pay royalties to the Office of the
                  Chief  Scientist  of the  Ministry  of  Trade  ("OCS")  of the
                  Government  of  Israel  on  proceeds  from  sales of  products
                  resulting from the research and development  projects in which
                  the Government participated.  In the event that development of
                  a  specific   product  in  which  the  OCS   participated   is
                  successful,  the Company will be obligated to repay the grants
                  through royalty  payments at the rate of 3% to 5% based on the
                  sales of the Company,  up to 100%-150% of the grants  received
                  linked to the dollar. As of December 31, 2004, the Company has
                  a  contingent  liability  to pay  royalties in the amount of $
                  7,429.  The  obligation  to pay these  royalties is contingent
                  upon actual sales of the products  and, in the absence of such
                  sales, no payment is required.

                  The  Company  has  paid or  accrued  royalties  in its cost of
                  revenues  relating  to the  repayment  of such  grants  in the
                  amount of $ 132, $ 146 and $ 181 for the years ended  December
                  31, 2002, 2003 and 2004, respectively.


                                      F-27
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 12:- COMMITMENTS AND CONTINGENT LIABILITIES (Cont.)

            2.    The Israeli Government,  through the Fund for Encouragement of
                  Marketing   Activities,   awarded  the   Company   grants  for
                  participation in foreign  marketing  expenses.  The Company is
                  committed  to pay  royalties at the rate of 3% of the increase
                  in  export  sales,  up to the  amount of the  grants  received
                  linked  to the U.S.  dollar.  As of  December  31,  2004,  the
                  Company has a contingent  obligation  to pay  royalties in the
                  amount of $ 259. During the three years ending on December 31,
                  2004, the Company accrued royalties in the amount of $129.

      c.    Claim and demand:

            In April 2000, the tax authorities in Israel issued to the Company a
            demand for a tax payment, for the period of 1997-1999, in the amount
            of approximately NIS 6 million ($ 1,350).

            The Company has appealed to the Israeli district court in respect of
            the  abovementioned  tax  demand.  Based on the opinion of its legal
            counsel,  the Company  believes that certain  defenses can be raised
            against the demand of the tax authorities. The Company believes that
            the outcome of this matter will not have a material  adverse  effect
            on its financial  position or results of operations and, the Company
            provided a  provision  in the amount of $464 , based on the  current
            evidence and on the basis of the said  opinion of its legal  counsel
            that, in the opinion of Company, is an adequate provision.

NOTE 13:- TAXES ON INCOME

      a.    Tax  benefits  under  the  Law  for  the  Encouragement  of  Capital
            Investments, 1959 ("the Law"):

            MTS was granted the status of an "Approved Enterprise" under the Law
            in respect of expansion projects. According to the provisions of the
            Law, MTS elected to enjoy the  "alternative  benefits " - the waiver
            of grants in return for a tax  exemption  and,  accordingly,  income
            derived from the "Approved Enterprise" is tax-exempt for a period of
            two years,  commencing  with the year it first earns taxable income,
            and subject to corporate tax at the rate of 10%- 25%, for additional
            periods of five to eight years.

            The expansion programs which are assigned to MTS are as follows:

            1.    One  program  entitled  MTS to  tax-exemption  for a  two-year
                  period ended  December  31, 1999,  and is subject to a reduced
                  tax rate of 10%-25%  for a five to eight years  period  ending
                  December 31, 2004.

            2.    The current  program  entitles MTS to tax  exemption for a two
                  year  period and it is subject to a tax rate of 10%-25% for an
                  additional  period of five to eight  years . The  benefits  in
                  respect of this program have not yet commenced.

            3.    During  2004 the  Company  received  an  additional  expansion
                  program  which  entitles MTS to tax  exemption  for a two year
                  period and to a reduced  tax rate of  10%-25%  for a five year
                  period.  The  benefits in respect of this program have not yet
                  commenced.


                                      F-28
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 13:- TAXES ON INCOME (Cont.)

            The period of tax benefits  detailed  above is subject to a limit of
            the earlier of 12 years from the  commencement  of  production or 14
            years from receiving the approval.

            The  entitlement  to the above  benefits is  conditional  upon MTS's
            fulfilling the conditions  stipulated by the above Law,  regulations
            published  thereunder  and the letters of approval  for the specific
            investment  in  "Approved  Enterprises".  In the event of failure to
            comply with these  conditions,  the benefits may be canceled and MTS
            may be required to refund the amount of the benefits, in whole or in
            part,  including  interest.  As of  December  31,  2004,  management
            believes that MTS is meeting all of the aforementioned conditions.

            The tax-exempt  income  attributable  to the "Approved  Enterprise",
            amounting to $2,250 as of December 31, 2004,  can be  distributed to
            shareholders  without subjecting MTS to taxes only upon the complete
            liquidation of MTS. MTS has determined that such  tax-exempt  income
            will not be  distributed  as dividends and  permanently  re-invested
            these profits.  Accordingly, no deferred taxes have been nor will be
            provided on income attributable to MTS's "Approved Enterprise".

            Should the retained  tax-exempt  income be  distributed  in a manner
            other than in the complete  liquidation of MTS, it would be taxed at
            the corporate tax rate  applicable to such profits as if MTS had not
            elected the  alternative  tax  benefits  (currently - 10%-25% for an
            "Approved Enterprise").

            Should MTS and its Israeli  subsidiary  derive  income from  sources
            other than an "Approved Enterprise",  they will be subject to tax at
            the regular rate of 35%.

            Since MTS is operating more than one "Approved Enterprise" and since
            part of its taxable income is not entitled to tax benefits under the
            abovementioned  law and is taxed at the regular  corporate tax rate,
            its  effective tax rate is the result of a weighted  combination  of
            the various applicable rate and tax exemptions,  and the computation
            is made  for  income  derived  from  each  program  on the  basis of
            formulas specified in the law and in the approvals.

      b.    Measurement  of results  for tax  purposes  under the Income Tax Law
            (Inflationary Adjustments), 1985:

            Results for tax  purposes  are  measured in terms of earnings in NIS
            after  certain  adjustments  for  increases in the Israeli  Consumer
            Price  Index  ("CPI").  As  explained  in  Note  2b,  the  financial
            statements  are  presented in dollars.  The  difference  between the
            annual change in the CPI and in the NIS/dollar  exchange rate causes
            a further  difference  between  taxable income and the income before
            taxes  presented in the financial  statements.  In  accordance  with
            paragraph 9(f) of SFAS 109, MTS and its Israeli  subsidiary have not
            provided for deferred  income  taxes on the  difference  between the
            functional currency and the tax bases of assets and liabilities.


                                      F-29
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 13:- TAXES ON INCOME (Cont.)

      c.    Tax  benefits  under  the  Law  for the  Encouragement  of  Industry
            (Taxation), 1969:

            MTS is currently  qualified  as an  "industrial  company"  under the
            above law and, as such, is entitled to certain tax benefits,  mainly
            accelerated  depreciation of machinery and equipment,  as prescribed
            by regulations published under the Inflationary Adjustments Law, the
            right  to  claim  public  issuance   expenses  and  amortization  of
            intangible property rights as a deduction for tax purposes.

      d.    Net operating losses carryforwards:

            As of December 31, 2004, the Company and its subsidiaries in Israel,
            Asia,  U.S. and Holland have an estimated  total amount of available
            carryforward tax losses of $5,717, $ 290, $210 and $ 0, respectively
            to offset against future taxable profits.

            The tax loss  carryforward  in  Israel  may be  offset  indefinitely
            against  operating income.  The operating loss  carryforwards of MTS
            and its Israeli subsidiary, which can be used indefinitely, amounted
            to approximately $5,717.

      e.    Tax assessments:

            Regarding  the claim from the tax  authorities  in Israel,  see Note
            12c. The Company has received final tax  assessments  until the 1996
            tax year.

      f.    Deferred income taxes:

            Deferred taxes reflect the net tax effects of temporary  differences
            between the carrying amounts of assets and liabilities for financial
            reporting  purposes  and the amounts  used for income tax  purposes.
            Significant components of the Company's deferred tax liabilities and
            assets are as follows:

<TABLE>
<CAPTION>
                                                                                December 31,
                                                                         ------------------------
                                                                             2003          2004
                                                                         ----------    ----------

<S>                                                                      <C>           <C>
            Tax loss carryforwards of the Company                        $      845    $    1,291

            Allowances for doubtful accounts and accruals for employee
              benefits                                                          121           122
            In respect of marketable securities                                  84            76
            Capitalized software and other intangible assets                    134            93
            Other                                                                 5           190
                                                                         ----------    ----------

            Net deferred tax asset before valuation allowance                 1,189         1,772
            Valuation allowance                                              (1,017)       (1,633)
                                                                         ----------    ----------

            Net deferred income taxes                                    $      172    $      139
                                                                         ==========    ==========
            Presented as follows:
              Current assets - foreign                                   $       66    $       66
                                                                         ==========    ==========

              Other assets - foreign                                     $       73    $       73
                                                                         ==========    ==========

              Other assets - domestic                                    $       33    $       --
                                                                         ==========    ==========
</TABLE>


                                      F-30
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 13:- TAXES ON INCOME (Cont.)

            MTS  and  certain  of  its  subsidiaries  have  provided   valuation
            allowances in respect of deferred tax assets resulting from tax loss
            carryforward  and other  temporary  differences,  since  they have a
            history of losses over the past years. Management currently believes
            that it is more  likely  than  not  that  part of the  deferred  tax
            regarding the loss  carryforward  in the Company and other temporary
            differences will not be realized in the foreseeable future.

      g.    A reconciliation  between the theoretical tax expense,  assuming all
            income is taxed at the  statutory  tax rate  applicable to income of
            the Company and the actual tax expense as reported in the statements
            of operations, is as follows:

<TABLE>
<CAPTION>
                                                                       Year ended December 31,
                                                               ----------------------------------------
                                                                   2002          2003           2004
                                                               ----------     ----------     ----------
<S>                                                            <C>            <C>            <C>
             Loss before taxes as reported in the statements
               of operations                                   $      (54)    $      (60)    $   (4,086)
                                                               ==========     ==========     ==========

             Tax rates                                                 36%            36%            35%
                                                               ==========     ==========     ==========

             Theoretical tax benefit                           $      (19)    $      (22)    $   (1,430)
             Increase in taxes resulting from:
               Effect of different tax rates and "Approved
                Enterprise" benefit                                   200             --              2
               Tax adjustment in respect of inflation in
                Israel and others                                     (61)           (22)            12
               Utilization of carryforward tax losses for
                which valuation allowance was provided               (246)           (86)           (21)
               Non-deductible expenses and tax exempt income          (24)             9             --
               Taxes in respect of previous years                      --            175            223
               Deferred taxes for which valuation allowance
                was  provided                                         202            144          1,480
                                                               ----------     ----------     ----------
               Taxes on income as reported in the
               statements of operations                        $       52     $      198     $      266
                                                               ==========     ==========     ==========

      h.    Loss before income taxes is comprised as follows:

            Domestic                                           $     (841)    $     (312)    $   (3,918)
            Foreign                                                   787            252           (168)
                                                               ----------     ----------     ----------
                                                               $      (54)    $      (60)    $   (4,086)
                                                               ==========     ==========     ==========
</TABLE>


                                      F-31
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 13:- TAXES ON INCOME (Cont.)

      i.    Taxes on income are comprised as follows:

<TABLE>
<CAPTION>
                                                        Year ended December 31,
                                                 -------------------------------------
                                                     2002         2003         2004
                                                 ----------   ----------    ----------
<S>                                              <C>          <C>           <C>
            Current taxes                        $       23   $       --    $       10
            Deferred taxes                               29           23            33
            Taxes in respect of previous years           --          175           223
                                                 ----------   ----------    ----------
                                                 $       52   $      198    $      266
                                                 ==========   ==========    ==========

            Domestic                             $       29   $      322    $      256
            Foreign                                      23         (124)           10
                                                 ----------   ----------    ----------
                                                 $       52   $      198    $      266
                                                 ==========   ==========    ==========
</TABLE>

NOTE 14:- RELATED PARTIES TRANSACTIONS

      a.    On November 8, 1999, the board of directors and the audit  committee
            approved,  subject to  shareholders'  approval,  an  increase in the
            monthly salary of the Chairman of the Board of Directors from $ 5 to
            $ 7 per month and the grant of options to purchase  98,824  ordinary
            shares.  The options  were  granted to him at his request in lieu of
            salary for the twelve month  period  ending  December 31, 2000.  The
            exercise  price of the options is $ 6 per share,  expected  dividend
            yield is 0%, and the risk free interest rate is 6%. The options will
            vest ratably over an eight-month  period  beginning  January 1, 2000
            and will  terminate  five years from the date of grant.  The options
            were forfeited by the end of the year 2004.

            The wife of the Chairman of the Board of Directors  provides ongoing
            legal  services to the Company and receives a monthly  retainer of $
            5. The  conditions  for  retaining her services were approved by the
            Company's Board of Directors and audit committee.

            MTS's subsidiaries, MTS Asia Ltd. and MTS IntegraTRAK,  entered into
            an  agreement  with C. Mer,  pursuant to which they  distribute  and
            support certain of C. Mer's (company under common control)  products
            and provide certain services on behalf of C. Mer. Generally,  C. Mer
            compensates MTS Asia Ltd. for these  activities at cost plus 10% and
            compensates MTS IntegraTRAK at cost plus 5%.


                                      F-32
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 14:- RELATED PARTIES TRANSACTIONS (Cont.)

      b.    In 2003 and 2004, the balance with C. Mer reflects  short-term  debt
            and other receivable.  Due to the short-term nature, no interest was
            charged by or paid to C. Mer through December 31, 2003 and 2004.

      c.    Transactions with related parties were as follows:

<TABLE>
<CAPTION>
                                                                  Year ended December 31,
                                                           --------------------------------------
                                                              2002           2003         2004
                                                           ----------    ----------    ----------
<S>                                                        <C>           <C>           <C>
            Sales through related parties                  $       65    $       28    $       15
                                                           ==========    ==========    ==========

            Amounts charged by related parties:
               Cost of revenues                            $      239    $       34    $       32
               Research and development                             8            --            --
               Selling and marketing                                2            --            --
               General and administrative                           4             5             7
                                                           ----------    ----------    ----------

                                                           $      253    $       39    $       39
                                                           ==========    ==========    ==========
            Amounts charged by MTS Integra TRAK
               and MTS Asia to related parties:
               Selling and marketing                       $        2    $       --    $       18
                                                           ==========    ==========    ==========
               Payments from (repayments to) the related
                 parties, net                              $     (172)   $      (48)   $       20
                                                           ==========    ==========    ==========
</TABLE>

      d.    Amounts due from an affiliate:

                                                            December 31,
                                                      ------------------------
                                                          2003         2004
                                                      ----------    ----------

            Jusan S.A                                 $       (2)   $      (21)
                                                      ==========    ==========

NOTE 15:- SHAREHOLDERS' EQUITY

      a.    Share capital:

            The  Ordinary  shares  entitle  their  holders  the right to receive
            notice to  participate  and vote in general  meetings of MTS and the
            right to receive cash dividends, if declared.

      b.    Share Option Plan:

            MTS has  authorized,  through its 1996 Incentive  Share Option plan,
            the  grant  of  options  to  officers,  management,   employees  and
            directors  of MTS or any  subsidiary  of up to  1,900,000  of  MTS's
            Ordinary shares.  Up to 1,500,000 options shall be granted under the
            option  plan  pursuant  to  section  102 of the  Israel  Income  Tax
            Ordinance.  Any  option,  which  is  canceled  or  forfeited  before
            expiration, will become available for future grants.


                                      F-33
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 15:- SHAREHOLDERS' EQUITY (Cont.)

            Each option granted under the Plan is exercisable  until the earlier
            of four  years  from the  date of the  grant  of the  option  or the
            expiration  dates of the  option  plan.  The  exercise  price of the
            options  granted  under the  plans may not be less than the  nominal
            value of the shares  into which such  options  were  exercised.  The
            options  vest  primarily  gradually  over  three  or four  years  of
            employment.

            In 2003, Section 102 of the Israeli Income Tax Ordinance was amended
            effective as of January 1, 2003.  Therefore MTS has  rolled-over the
            remaining options available,  at that time for grant into a new plan
            that conforms  with the newly  amended  provisions of Section 102 of
            the Israel Income Tax  Ordinance.  The  Incentive  Share Option Plan
            will terminate in 2013,  unless cancelled  earlier by MTS's board of
            directors.

            As of December 31, 2004,  672,025  options are  available for future
            grant.

            Summary of MTS's stock options activity and related  information for
            the three years ended December 31 is as follows:

<TABLE>
<CAPTION>
                                                        Options         Number                         Weighted
                                                       available      of options       Options         average
                                                       for grant     outstanding     exercisable    exercise price
                                                     --------------  -------------  --------------  ---------------
<S>                                                    <C>             <C>          <C>             <C>
            Options exercisable at January 1, 2002                                      800,887     $      4.48
                                                                                    ===========
              Balance on January 1, 2002                 531,609       1,227,141                    $      3.74
              Options granted                            (35,000)         35,000                    $      1.2
              Options forfeited                          504,561        (504,561)                   $      4.19
                                                     -----------     -----------

            Options exercisable at December 31, 2002                                    502,644     $      3.76
                                                                                    ===========
              Balance on December 31, 2002             1,001,170         757,580                    $      3.32
              Options granted                           (434,500)        434,500                    $      1.85
              Options exercised                               --        (133,333)                   $        --
              Options forfeited                          260,106        (260,106)                   $      2.91
                                                     -----------     -----------

            Options exercisable at December 31, 2003                                    355,413     $      3.68
                                                                                    ===========     ===========

            Balance on December 31, 2003                 826,776         798,641                    $      2.85
              Options granted                           (226,000)        226,000                    $      2.29
              Options exercised                               --         (17,333)                   $      0.08
              Options forfeited                          251,708        (251,708)                   $      4.62
              Options forfeited from old plan           (180,459)             --                    $        --
                                                     -----------     -----------                    -----------

            Options exercisable at December 31, 2004                                    301,812     $      2.01
                                                                                    ===========     ===========

            Balance on December 31, 2004                 672,025         755,600                    $      2.11
                                                     ===========     ===========                    ===========
</TABLE>


                                      F-34
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 15:- SHAREHOLDERS' EQUITY (Cont.)

            The options  outstanding as of December 31, 2004 have been separated
            into ranges of exercise prices, as follows:

<TABLE>
<CAPTION>
                                   Options          Weighted                                           Weighted
                                 outstanding        average          Weighted                          average
                                    as of          remaining         average                        exercise price
                Exercise         December 31,     contractual        exercise         Options       of exercisable
                 price               2004        life (in years)      price         exercisable        options
            -----------------  ----------------- ---------------  ---------------  ---------------  ---------------
<S>                                <C>                <C>         <C>                  <C>          <C>
               $ 0.93-1.3            31,500           1.08        $     1.18             20,998     $     1.18
                $ 1.844             250,000           3.92        $     1.844            62,500     $     1.844
               $ 1.9-2.05           186,300           0.39        $     1.95            186,300     $     1.95
               $ 2.2-2.35           184,000           4.71        $     2.27                  -     $     -
               $ 2.9-2.95            98,800           3.92        $     2.9              27,014     $     2.9
                 $ 4.5                2,000           0.08        $     4.5               2,000     $     4.5
                $ 5.9375              3,000           0.75        $     5.9375            3,000     $     5.9375
                               ------------                                        ------------
                                    755,600                       $     2.11            301,812     $     2.01
                               ============                       ============     ============     ============
</TABLE>

      c.    The weighted  average fair value of options  granted during 2003 and
            2004, whose exercise price equals the fair value of the stock on the
            date of grant, was $ 1.20 and $ 0.781 per option, respectively.

            During  2004,  the  Company  granted  226,000  options at a weighted
            average exercise price of $ 2.29 per share (the fair market value of
            the shares on the date of grant).

            The Company has recorded  deferred  stock  compensation  expense for
            options  issued in 2003 with an exercise price below the fair market
            value of the shares;  the deferred  stock  compensation  expense has
            been amortized and recorded as compensation expense ratably over the
            vesting period of the options. Compensation expense of approximately
            $ 60 and $ 66 was recognized during 2003 and 2004, respectively.

            During 2003 the Company reduced the exercise price of 83,000 options
            to zero resulting in a compensation expense of approximately $ 153.

      d.    In January  2000,  MTS  granted  98,824  options  to Mr.  Chaim Mer,
            chairman  of the  Company,  having an  exercise  price of $ 6.00 per
            share.  These  options were granted in lieu of Mr. Mer's salary ($ 7
            per month) in 2000.  The  options  were  exercisable  for five years
            commencing  January  1, 2000 and  forfeited  by the end of year 2004
            (see Note 14a).

      e.    On  February  7, 2001,  MTS issued  five-year  warrants  to purchase
            25,000 Ordinary shares of MTS to Investec Bank  (Mauritius)  Ltd. in
            connection  with  certain  financial  services  performed  on  MTS's
            behalf.  The warrants have an exercise price of $ 4.95 per share for
            warrants  exercised  until  February  2004 and $ 5.625 per share for
            warrants  exercised  until  February  2006.  The  fair  value of the
            warrants,  at the date of the grant,  using a  Black-Scholes  option
            pricing model was immaterial and therefore no compensation  expenses
            were recorded.


                                      F-35
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 15:- SHAREHOLDERS' EQUITY (Cont.)

      f.    Treasury shares:

            During 2002, 2003 and 2004, the Company purchased  195,183,  130,510
            and 3,800 treasury shares in  consideration  of $ 172, $ 147 $ 9 and
            respectively,  according  to the  stock  repurchase  program,  which
            authorized  the  Company's  officers  to  repurchase  up to  600,000
            Ordinary  shares of MTS and was approved by the  Company's  Board of
            Directors.

            During  2003,  MTS  cancelled  $457 of its  treasury  shares,  which
            represent 384,610 Ordinary shares.

      g.    Dividends:

            Dividends,   if  any,  will  be  paid  in  NIS.  Dividends  paid  to
            shareholders  outside Israel will be converted into dollars,  on the
            basis of the exchange rate prevailing at the date of payment.

NOTE 16:- GEOGAPHIC INFORMATION AND CLASSES OF PRODUCTS

      The Company adopted  Statement of Financial  Accounting  Standard No. 131,
      "Disclosures  About  Segments of an  Enterprise  and Related  Information"
      ("SFAS No. 131"). The Company operates in one reportable segment (see Note
      1 for a brief description of the Company's  business).  The total revenues
      are attributed to geographic areas based on the location of the customer.

      The following is a summary of revenues  within  geographic  areas based on
      end customer location and long-lived assets:

<TABLE>
<CAPTION>
                                                               Year ended December 31,
                                                        ------------------------------------
                                                            2002         2003        2004
                                                        ----------   ----------   ----------
<S>                                                     <C>          <C>          <C>
            Revenues from sales:
               Israel                                   $      217   $      186   $      256
               United States                                 6,449        4,917        4,967
               Germany                                       1,130        1,826        1,724
               Holland                                         756          924          798
               Europe (excluding Germany and Holland)          296          516          471
               Asia                                            469          364          635
               South America                                   328          368          423
               Others                                          142          129          139
                                                        ----------   ----------   ----------
                                                        $    9,787   $    9,230   $    9,413
                                                        ==========   ==========   ==========
</TABLE>


                                      F-36
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 16:- GEOGAPHIC INFORMATION AND CLASSES OF PRODUCTS(Cont.)

                                                       December 31,
                                           ------------------------------------
                                               2002         2003        2004
                                           ----------   ----------   ----------
            Long-lived assets:
               Israel                      $      624   $      394   $    3,103
               United States                    2,302        2,268        2,244
               Holland                             10            8            7
               Asia                                29           16            9
               South America                       22           27           27
                                           ----------   ----------   ----------
                                           $    2,987   $    2,713   $    5,390
                                           ==========   ==========   ==========

      Total  revenues  from  external  customers  divided  on the  basis  of the
      Company's product lines are as follows:

                                                   Year ended December 31,
                                           ------------------------------------
                                               2002         2003         2004
                                           ----------   ----------   ----------

            TABS                           $    9,787   $    9,230   $    9,327
            Application suite                      --           --           86
                                           ----------   ----------   ----------
                                           $    9,787   $    9,230   $    9,413
                                           ==========   ==========   ==========

NOTE 17:- SELECTED STATEMENTS OF OPERATIONS DATA

      a.    Financial income, net

<TABLE>
<CAPTION>
                                                                Year ended December 31,
                                                        --------------------------------------
                                                           2002           2003         2004
                                                        ----------    ----------    ----------
<S>                                                     <C>           <C>           <C>
            Financial expenses:

            Interest expenses                           $     (205)   $      (64)   $       --
            Other expenses                                      (7)           --           (24)
            Foreign currency translation differences            --           (11)           --
                                                        ----------    ----------    ----------
                                                              (212)          (75)          (24)
                                                        ----------    ----------    ----------
            Financial income:

            Interest income                                    310           186            83
            Other income                                         1            13            --
            Foreign currency translation differences            35            --            19
                                                        ----------    ----------    ----------
                                                               346           199           102
                                                        ----------    ----------    ----------
                                                        $      134    $      124    $       78
                                                        ==========    ==========    ==========

            Other income (expenses):

            Gain (loss) on marketable securities, net   $     (140)   $        6    $       --
                                                        ==========    ==========    ==========
</TABLE>


                                      F-37
<PAGE>

                                               MER TELEMANAGEMENT SOLUTIONS LTD.
                                                            AND ITS SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
U.S. dollars in thousands (except share data)

NOTE 18:- SUBSIDIARIES AND AFFILIATES

<TABLE>
<CAPTION>
                                                                       Percentage of        Jurisdiction of
                                                                         ownership           incorporation
                                                                       -------------        ---------------
            Subsidiaries:
            -------------
<S>                                                                       <C>                <C>
            MTS IntegraTRAK Inc.                                          100%                  Delaware

            MER Fifth Avenue Realty Inc. (a subsidiary of
               MTS IntegraTRAK Inc.)                                      100%                  New York

            MTS Asia Ltd.                                                 100%                  Hong Kong

            Telegent Ltd.                                                 100%                   Israel

            Jaraga B.V.                                                   100%               The Netherlands
            Verdura B.V. (a subsidiary of Jaraga B.V.)                    100%               The Netherlands
            Voltera  Technologies  V.O.F. (a partnership held
               99% by Jaraga B.V. and 1% by Verdura B.V.)                 100%               The Netherlands
            Bohera B.V. (a subsidiary of Jaraga B.V.)                     100%               The Netherlands
            Tabs Brazil Ltd. (a subsidiary of Jaraga B.V.)                100%                   Brazil

            Affiliate:
            ----------

            Jusan S.A. (a subsidiary of Jaraga B.V.)                      50%                     Spain
</TABLE>

NOTE 19:- SUBSEQUENT EVENTS

            On April 18,  2005,  Amdocs  (Israel)  Ltd.  and  Amdocs  Ltd.  (the
            "Plaintiffs")  filed a complaint  with the Tel Aviv  District  Court
            against the  Company,  its Chief  Executive  Officer and others (the
            "Defendants")  alleging,  among other things,  that professional and
            commercial  information  belonging to the Plaintiffs was transferred
            to the Defendants for use in the Company's activity.  The Plaintiffs
            are seeking an injunction prohibiting the Defendants from making any
            use of  the  information  and  trade  secrets  that  were  allegedly
            transferred,  injunctions  requiring the return of such  information
            and estimated damages of NIS 14,775  (approximately  $3,360). Due to
            the preliminary  stage of the litigation,  the Company and its legal
            advisors cannot  currently  advise as to its outcome or its possible
            adverse  effect on the  Company's  financial  position or results of
            operations. The company intends to vigorously defend this action.

                              - - - - - - - - - - -


                                      F-38
<PAGE>

                         [Letterhead of BDO Audiberia]


             REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
             -------------------------------------------------------

Board of Directors and Stockholders of Jusan, S.A.:

1.    We have  audited  the  accompanying  balance  sheet of Jusan,  S.A.  as of
      December  31, 2004 and the  related  statements  of income,  stockholders'
      equity  and cash  flows  for the  year  ended  December  31,  2004.  These
      financial  statements are the responsibility of the Company's  management.
      Our responsibility is to express an opinion on these financial  statements
      based on our audit. The consolidated  financial  statements of the Company
      as of December 31, 2003 were audited by other  auditors whose report dated
      January 14, 2004, expressed an unqualified opinion on those statements.

2.    We  conducted  our audit in  accordance  with the  standards of the Public
      Company  Accounting  Oversight  Board  (United  States).  Those  standards
      require that we plan and perform the audit to obtain reasonable  assurance
      about whether the financial statements are free of material  misstatement.
      Our audit  included  consideration  of  internal  control  over  financial
      reporting as a basis for designing  audit  procedures that are appropriate
      in the circumstances,  but not for the purpose of expressing an opinion on
      the  effectiveness  of  the  Company's  internal  control  over  financial
      reporting. Accordingly, we express no such opinion. An audit also includes
      examining,   on  a  test  basis,   evidence  supporting  the  amounts  and
      disclosures  in  the  financial   statements,   assessing  the  accounting
      principles used and significant  estimates made by management,  as well as
      evaluating the overall financial statement  presentation.  We believe that
      our audit provide a reasonable  basis for our opinion.

3.    In our opinion, the financial statements referred to above present fairly,
      in all material  respects,  the  financial  position of Jusan,  S.A. as of
      December 31, 2004 and the results of its operations and its cash flows for
      the year then ended in conformity  with  accounting  principles  generally
      accepted in the United States of America.

BDO Audiberia

/s/ Peter D. Cook
----------------------
Peter D. Cook

Madrid, March 3, 2005

                                      F-39
<PAGE>

                               SIGNATURES

      The registrant  hereby certifies that it meets all of the requirements for
filing on Form 20-F and that it has duly caused and authorized  the  undersigned
to sign this annual report on its behalf.


                                       MER TELEMANAGEMENT SOLUTIONS LTD.


                                       By: /s/Eytan Bar
                                           -------------------------------------
                                           Eytan Bar
                                           Chief Executive Officer


                                       By: /s/Shlomi Hagai
                                           -------------------------------------
                                           Shlomi Hagai
                                           Chief Financial Officer

Dated: June 28, 2005


                                       88