<PAGE>
 
                    U.S. SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
 
                                  FORM 10-QSB
 
(Mark One)
 [X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934
      For the quarterly period ended August 31, 1996
 
 [ ]  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: 0-08718


                     CITADEL COMPUTER SYSTEMS INCORPORATED
                     (Exact name of small business issuer
                         as specified in its charter)


                  DELAWARE                     75-2432011
       (State or other jurisdiction of        (I.R.S. Employer
       incorporation or organization)         Identification No.)

       3811 TURTLE CREEK BLVD., SUITE 330, DALLAS, TX 75219
       (Address of principal executive offices)

       (214) 520-9292
       (Issuer's telephone number)

                  -------------------------------------------
                (Former name, former address and former fiscal
                      year, if changed since last report)

     Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period 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
    -----     -----

     State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date.

Common Stock, par value $.01                            14,363,101
                                          -----------------------------------
                                            Outstanding at October 10, 1996
 

     Transitional Small Business Disclosure Format Yes [ ] No [X]
<PAGE>
 
     Unless otherwise indicated, share and per share information contained in
this Report reflect the Company's one-for-five reverse stock split, effective as
of December 11, 1995, the one-for-two stock dividend paid on February 2, 1996
and the one-for-two reverse stock split, effective as of May 1, 1996. The
Company changed its fiscal year end to the last day in February from March 31,
commencing February 29, 1996.


                    PART I.  FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

     The Financial Statements of the Company are found after the signature page.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS

RESULTS OF OPERATIONS

     During the three months ended August 31, 1996, the Company had net sales of
$1,762,000, an increase of $1,369,000, or 348% over net sales of $394,000 during
the three months ended August 31, 1995.  During the six months ended August 31,
1996, the Company had net sales of $2,889,000, an increase of $2,256,000, or
356% over net sales of $632,000 during the six months ended August 31, 1995.
The increases occurred primarily as a result of an increase in the Company's
marketing and sales efforts.  The Company realized additional sales as a result
of increased market awareness of its NetOFF, Server Sentry and Phantom of the
Console products, as well as the addition of new vertical marketing channels and
the increase in its sales and marketing efforts through the expansion of the
Company's sales and marketing department and approximately $200,000 of net sales
resulting from acquisitions.

     During the quarter ended August 31, 1996, the Company set aside a reserve
of $500,000 in connection with possible bad debts associated with accounts
receivable which is included in the financial statements under selling, general
and administrative expenses.  During the six month period ended August 31, 1996,
the Company set aside reserves of $900,000 in connection with possible bad debts
associated with accounts receivable, which is included in the financial
statements under selling, general and administrative expenses.  Management is
continuing its efforts to implement procedures that they believe will result in
a decrease in the percentage of reserves in future periods.

     The costs and expenses incurred in connection with producing the Company's
products were $108,000 during the three months ended August 31, 1996, an
increase of $59,000, or approximately 120%, from costs of sales of $49,000
incurred in the previous period.  As a percentage of gross sales, costs of sales
decreased in the three months ended August 31, 1996, to 6.2% from 12.5% in the
prior period.  The costs and expenses incurred in connection with producing the
Company's products were $155,000 during the six months ended August 31, 1996, an
increase of $77,000, or approximately 98%, from costs of sales of $78,000
incurred in the previous period.  As a percentage of gross sales, costs of sales
decreased in the six months ended 

                                       1
<PAGE>
 
August 31, 1996, to 5.4% from 12.4% in the prior period. The decreases in cost
of sales on a percentage basis were primarily the result of greater efficiencies
from the higher level of sales.

     Selling, general and administrative expenses for the three months ended
August 31, 1996, were $1,749,000, an increase of $1,471,000, or 528%, over
selling, general and administrative expenses during the three months ended
August 31, 1995.  Such expenses increased primarily due to the Company's growth
which included the addition of key management and implementation of corporate
infrastructure, the hiring of sales and marketing, development, and
administrative personnel, trade show and marketing expenses, expenses related to
its status as a publicly traded company, its continued efforts to expand its
product offerings and the opening of its Dallas office and expansion of its
Houston office, and as a result of a $500,000 reserve relating to possible bad
debts associated with accounts receivable, and $140,000 relating to promotional
product marketing expenses.  Selling, general and administrative expenses for
the six months ended August 31, 1996, were $3,202,000, an increase of
$2,368,000, or 284%, over selling, general and administrative expenses during
the six months ended August 31, 1995.  Such expenses increased as a result of
the factors discussed above relating to the Company's growth, including reserves
relating to possible bad debts associated with accounts receivable, and
promotional product marketing expenses.  The Company's priority during the early
stage of its development was to devote its primary efforts to increasing the
awareness of its products in the marketplace, to refine existing products
through feedback from customers, and to establish a market for upgrades of its
existing products and for new products.  The Company may continue this strategy
in connection with new technologies it developes or acquires.  The Company
expects to continue increases in selling, general and administrative expenses in
future periods as a result of expansion of its core business and acquired
technologies.

     In addition to the research and development costs of $3,959,000 reflected
in the Company's statement of operations for the three months ended August 31,
1996 (which reflected research and development costs written-off by the Company
in connection with the acquisitions of the ADI Group and MicroVault and the
purchase of technology from Xerox discussed in Item 5 and footnotes D and E to
the Consolidated Financial Statements), the Company has also capitalized $90,000
of development costs, which increase was due to increased development staff and
new product development activities and which are being amortized over the
expected lives of the products.  Depreciation and amortization expense increased
to $176,000 in the three months ended August 31, 1996, from $38,000, or an
increase of 362% over the prior period, due to the acquisition of certain
companies and products.  In addition to the research and development costs of
$4,008,000 reflected in the Company's statement of operations for the six months
ended August 31, 1996 (which reflected research and development costs of
$3,959,000 written-off by the Company as discused above), the Company has also
capitalized $160,000 of development costs, which increase was due to increased
development staff and new product development activities and which are being
amortized over the expected lives of the products.  Depreciation and
amortization expense increased to $341,000 in the six months ended August 31,
1996, from $102,000, or 233% during the prior period, due to the acquisition of
certain companies and products.  The Company expects to continue to increase
development staff and to enhance its product line through internal development
and possible acquisitions.

                                       2
<PAGE>
 
     Interest expense for the three months ended August 31, 1996 increased to
$144,000, an increase of $18,000, or 14%, over interest expense during the same
period in the prior year.  Interest expense for the six months ended August 31,
1996 increased to $179,000, an increase of $33,000, or 22%, over interest
expense during the same period in the prior year.  Such increases were primarily
due to increased indebtedness associated with the recent financing activities
described under "Liquidity and Capital Resources" below.

     The statements contained in this Report that are not historical facts,
including, but not limited to, statements found in this Item 2  - "Management's
Discussion and Analysis," are forward looking statements and as such involve a
number of risks and uncertainties.  The actual results of the future events
described in such forward-looking statements in this Report could differ
materially from those stated in such forward looking statements.  Among the
factors that could cause actual results to differ materially are:  general
economic conditions, competition, the market for network software products,
seasonality of product sales, costs and risks related to integration of
acquisitions, software development costs and possible future litigation, as well
as the risks and uncertainties discussed in this Report, including, without
limitation, the portions referenced above, and the uncertainties set forth from
time to time in the Company's other public reports and filings and public
statements.

LIQUIDITY AND CAPITAL RESOURCES

     The Company's cash and cash equivalents at August 31, 1996 were $594,000.

     Cash flows from operations were a negative $2,834,000 for the six months
ended August 31, 1996, compared to negative $626,000 for the six months ended
August 31, 1995.  The increase was due principally to the increased expenses
relating to the Company's expansion and development, selling and marketing
efforts, decreases in accounts payable and accrued expenses, and increases in
receivables.

     Cash used in investing activities was $3,614,000 in the six months ended
August 31, 1996, compared to $176,000 in the same period of the prior year.
This increase was due to an increase in net purchases of securities and
businesses and an increase in capital expenditures.

     In addition, on August 27, 1996, the Company announced a share
repurchase program whereby the Company is authorized to repurchase up to 500,000
shares of its outstanding common stock in the open market through February 1998.
During the quarter ended August 31, 1996, the Company had not repurchased any
shares.

     Cash flows provided by financing activities were $6,917,000 in the six
months ended August 31, 1996, compared to $802,000 in the six months ended
August 31, 1995.  This increase was due primarily to the proceeds of issuances
of shares of the Company's common stock, preferred stock and notes payable, net
of payments against debt.

     As a result of the aforementioned factors, cash and cash equivalents
increased by $469,000 in the six months ended August 31, 1996.

                                       3
<PAGE>
 
     During the three months ended August 31, 1996, the Company has realized an
aggregate total of $216,000 from  the exercise of outstanding options and
warrants.

     In June and July 1996, the Company conducted private placements of notes
and preferred stock that are mandatorily convertible into common stock.   The
Company raised net proceeds of $5,970,000 in these offerings.

     The Company has signed a nonbinding letter of intent with respect to a line
of credit with a bank under which the Company may refinance approximately
$1,250,000 of outstanding indebtedness and will be able to draw up to $500,000
for working capital.

     In March 1996, the Company consummated the sale of certain restaurant
assets and related development rights to Miami Subs Corporation  ("Miami Subs").
The Company received 1,325,000 shares of Miami Subs common stock, which are held
in escrow by Miami Subs and are subject to restrictions on transfer.  Miami Subs
has the right to acquire the stock for $2.50 per share.  The Company will be
able to sell the stock in private transactions, or in open market transactions
not to exceed 240,000 shares per calendar quarter or 20,000 shares per week,
with sales subject to a right of first refusal by Miami Subs.  The Company
issued a nonrecourse non-interest bearing promissory note to Miami Subs with a
remaining principal amount of $1,250,000, secured by a pledge of the stock.  The
maturity date has been extended to October 31, 1996 and the Company is in
negotiations with Miami Subs with respect to the Note and the stock.  The
Company determined that it could not recover its investment in the
Miami Subs stock and wrote down the investment during the quarter ended
May 31, 1996, to its market value as of July 19, 1996.

     The Company believes the funds available from the sources described above
will be sufficient to fund its current operations through the end of its 1997
fiscal year, but that it may need additional funds to expand its operations and
to pursue acquisitions that will permit it to expand its line of products and to
complement its internal software development efforts.  The Company expects to
engage in additional capital raising efforts during fiscal 1997 and is engaged
in discussions with investment banking from time to time firms about such
efforts, but has not entered into any letter of intent with an investment
banking firm or determined the structure or amount of any such efforts.  There
is no assurance that the Company will be successful in identifying or engaging
an investment banking firm or that, if it does so, it will be successful in
raising capital in any such offering.


                          PART II.  OTHER INFORMATION

     Except as listed below, all information required by Part II is omitted
because the items are inapplicable or the answer is negative.

ITEM 1. LEGAL PROCEEDINGS

     A former employee of Old LoneStar filed a lawsuit against the Company and
one of its 

                                       4
<PAGE>
 
officers and directors alleging that the Company and/or the individual owe the
plaintiff additional stock options and seeking damages in excess of $2,600,000.
The Company and the individual believe such claims are without merit and intends
to vigorously defend against the claim and is considering filing counterclaims.
The Company has filed an answer in the case, styled Heredia v. Citadel, et al.,
                                                    --------------------------
in the 298th Court of Dallas County, Texas.

     The Company is also involved in routine litigation from time to time.  Such
litigation, including other litigation in which the Company is currently
involved, is not material to the Company's consolidated financial condition or
results of operations.


ITEM 5.  OTHER INFORMATION

ACQUISITIONS

     In August 1996, the Company completed the acquisition of two affiliated
companies, Astonishing Developments Inc. and KentMarsh Ltd., Inc. (the
"ADI Group"), which develop security software for stand alone personal
computers, for a total consideration of approximately $2,200,000, consisting of
$1,200,000 in common stock (subject to sales limitations for two years) and
$1,000,000 in cash over six months ($600,000 of which has already been paid).

     In August 1996, the Company completed the acquisition of DanaSoft, Inc.,
which develops and markets software for internet and intranet applications, for
100,000 shares of Citadel common stock.  In August 1996, the Company also
completed the acquisition of MicroVault Corporation, a data security software
provider, for 150,000 shares of Citadel common stock and $75,000.

     In August 1996, the Company completed the purchase of the TabWorks and
Cougar technology and product lines from the XSoft Division of Xerox
Corporation, headquartered at the Xerox Palo Alto Research Center (PARC).  Total
consideration consists of $750,000 in cash, a non-interest bearing $1,350,000
senior note ($1,206,560 after discount for inputed interest) payable over two
years, and royalty payments of up to $1,250,000 over four years.  The Company
has the right to pay an aggregate of $2,500,000 during the first year following
the purchase in exchange for the release of its obligations under the note and
royalty terms.  In August 1996, the Company and XSoft announced their strategic
partnership pursuant to which XSoft's Summarizer Technology was licensed to the
Company.

     See Notes D and E to the Notes to Consolidated Financial Statements for a
discussion of the accounting treatment of such acquisitions and purchases.


EXPANSION OF BOARD OF DIRECTORS

     During the quarter ended August 31, 1996, the Company expanded the number
of 

                                       5
<PAGE>
 
directors comprising the board of directors from six to eight.  The board
appointed Victor K. Kiam II, chairman of Remington Products LLC, a leading
consumer products firm, and Mark Rogers, managing director of NFT Ventures, a
venture capital fund controlled by Ray Noorda, founder of Novell, Inc.  Each new
director was granted options to purchase 400,000 shares of the Company's common
stock.


ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

     (a) EXHIBITS
 
          4.1  Certificate of Designations of Series A Convertible Preferred
     Stock (incorporated by reference from Exhibit 4 to the Company's Form 10-
     QSB for the fiscal quarter ended May 31, 1996).

          4.2  Certificate of Designations of Series B Convertible Preferred
     Stock.

          27.  Financial Data Schedule

     (b) REPORTS ON FORM 8-K.

          On June 11, 1996, the Company filed a Form 8-K/A amending the March
          13, 1996 Form 8-K to include audited financial statements of Citadel
          Computer Systems Incorporated and Circuit Masters Software Inc.

          On September 5, 1996, the Company filed a Form 8-K relating to the
          acquisition of KentMarsh Ltd., Inc. and Astonishing Developments, Inc.

                                       6
<PAGE>
 
                                   SIGNATURES


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

                              CITADEL COMPUTER SYSTEMS INCORPORATED
                              (REGISTRANT)
                              
                              
Date: October 15, 1996        By:      /s/  Steven B. Solomon
                                   ----------------------------------------
                                 Steven B. Solomon, Chief Operating Officer and
                                 Secretary (Principal Financial and Accounting 
                                 Officer and Duly Authorized Signatory)

<PAGE>
 
                     CITADEL COMPUTER SYSTEMS INCORPORATED
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                          AUGUST 31, 1996   FEBRUARY 29, 1996
                                          ---------------   -----------------
                                            (UNAUDITED)
<S>                                       <C>               <C>
 
                 ASSETS
 
Current assets
 
 Cash                                         $   594,493         $   125,565
 
 Accounts receivable - net                      2,083,999             484,336
 
 Marketable securities - trading                2,000,000                 -
 
 Marketable securities - available for                                      
  sale                                          1,462,500                 - 
 
 Assets under contract of sale                        -             2,605,772
 
 Prepaid expenses and other current                                           
  assets                                          313,264              82,405 
                                              -----------         ----------- 
 
  Total current assets                          6,454,256           3,298,078
 
Property and equipment - net                      307,374             110,327
 
Software - net                                  4,374,886           2,757,412
 
Other assets                                      340,966             249,046
                                              -----------         -----------
 
                                              $11,477,482         $ 6,414,863
                                              ===========         ===========
 
 
                LIABILITIES AND STOCKHOLDERS' EQUITY
 
Current liabilities
 
 Notes payable                                $ 2,564,438         $ 4,034,214
 
 Debentures                                       515,100                 -
 
 Current portion of long-term notes                                         
  payable                                         420,000                 - 
 
 Accounts payable and accrued expenses          1,543,296           2,030,800
 
 Other current liabilities                      1,180,000                 -
                                              -----------         -----------
 
  Total current liabilities                   $ 6,222,834         $ 6,065,014
 

Notes payable                                     981,560                 -
 
Other long-term liabilities                       227,770              34,360
 
Stockholders' equity
 
 Common stock                                     131,782             115,091
 
 Preferred stock                                1,870,000                 -
 
 Mandatorily convertible debt                   3,223,700                 -
 
 Unrealized loss on securities                                              
  available for sale                             (104,687)                - 
 
 Additional paid-in capital                     7,105,397           2,405,144
 
 Accumulated deficit                           (8,180,874)         (2,204,746)
                                              -----------         -----------
 
                                                4,045,318             315,489
                                              -----------         -----------
 
                                              $11,477,482         $ 6,414,863
                                              ===========         =========== 
</TABLE>


                THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF
                          THESE FINANCIAL STATEMENTS.

<PAGE>
 
                     CITADEL COMPUTER SYSTEMS INCORPORATED
                     CONSOLIDATED STATEMENT OF OPERATIONS
                                  (UNAUDITED)
 
<TABLE>
<CAPTION>
 
                                                   THREE MONTHS ENDED                SIX MONTHS ENDED
                                                        AUGUST 31,                       AUGUST 31,
 
                                                     1996         1995               1996         1995
                                                 -----------   ----------        -----------   ----------
<S>                                       <C>                  <C>          <C>                <C>

Net sales                                        $ 1,762,407   $  393,586        $ 2,888,938   $  632,968
 
Cost of sales                                        108,318       49,244            155,190       78,413
                                                 -----------   ----------        -----------   ----------
    Gross profit                                   1,654,089      344,342          2,733,748      554,555
 
Operating expenses
 Selling, general and administrative                                                                       
  expenses                                         1,748,967      278,420          3,201,698      833,221  
 Depreciation and amortization                       175,856       38,087            340,505      102,212  
 Research and development costs                    3,959,069       27,271          4,007,792       27,271  
                                                 -----------   ----------        -----------   ----------  
                                                   5,883,892      343,778          7,549,995      962,704  
                                                 -----------   ----------        -----------   ----------  
  Operating income (loss)                         (4,229,803)         564         (4,816,247)    (408,149) 
 
Other income (expense)
 Interest expense                                   (144,256)    (126,480)          (178,909)    (146,405)
 Other                                                   -        (15,587)               -        (18,499)
 Loss on marketable securities                      (238,175)         -           (1,238,175)         -
                                                 -----------   ----------        -----------   ----------
                                                    (382,431)    (142,067)        (1,417,084)    (164,904)
                                                 -----------   ----------        -----------   ----------
    Net loss before extraordinary items           (4,612,234)    (141,503)        (6,233,331)    (573,053)
 
Extraordinary item - gain on debt                                                                         
 settlement                                          259,422          -              257,303          -   
                                                 -----------   ----------        -----------   ---------- 

    Net loss                                     $(4,352,812)  $ (141,503)       $(5,976,028)  $ (573,053)
                                                 ===========   ==========        ===========   ==========
 
Per share data
 Net loss before extraordinary item              $      (.38)       $(.02)       $      (.52)       $(.09)
 Extraordinary item                                      .02          -                  .02          -
                                                 -----------   ----------        -----------   ----------
 Net loss                                        $      (.36)       $(.02)       $      (.50)       $(.09)
                                                 ===========   ==========        ===========   ==========
Weighted average shares outstanding               12,030,060    6,514,000         11,888,385    6,514,000
                                                 ===========   ==========        ===========   ==========
</TABLE>


                THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF
                          THESE FINANCIAL STATEMENTS.

<PAGE>
 
                     CITADEL COMPUTER SYSTEMS INCORPORATED
                     CONSOLIDATED STATEMENT OF CASH FLOWS
                      FOR THE SIX MONTHS ENDED AUGUST 31,
                                  (UNAUDITED)
<TABLE>
<CAPTION>
 
                                              1996          1995
                                          -------------  -----------
<S>                                       <C>            <C>
 
Cash flows from operating activities
   Net loss                                $(5,976,028)   $(573,053)
   Adjustments to reconcile net loss to
    net cash (used in) operating activities                         
      Depreciation and amortization            338,681      102,212 
      Net loss on marketable securities      1,238,414          -   
      Research and development expenses                              
       acquired with stock                   3,959,069          -    
 
Change in operating assets and
 liabilities                                                         
   Accounts receivable                      (1,367,237)    (253,589) 
   Prepaid expenses and other current                                 
    assets                                    (172,140)     (13,594)  
   Other assets                                132,492         (875)  
   Other liabiliites                           (34,460)         -
   Accounts payable and accrued expenses      (952,686)     112,858   
                                           -----------    ---------   
   Net cash (used in) operations            (2,833,895)    (626,041)  
 
Cash flows from investing activities
   Purchase of equipment and software         (804,487)    (175,877)
   Purchase of trading securities           (4,818,841)         -
   Sales of trading securities               2,580,427          -
   Purchase of businesses                     (571,043)         -
                                           -----------   ----------
      Net cash used in investing                                     
       activities                           (3,613,944)    (175,877) 
 
Cash flows from financing activities
   Proceeds from sale of stock and                                  
    convertible debt                         7,157,443          -   
   Net change in notes payable                (755,776)     643,434 
   Proceeds from sale of debentures            515,100          -   
   Other                                           -        158,245 
                                          ------------    --------- 
      Net cash provided by financing                                 
       activities                            6,916,767      801,679  
 
      Net increase (decrease) in cash          468,928         (239)
 
Cash at beginning of period                    125,565       24,037
                                           -----------    ---------
 
Cash at end of period                      $   594,493    $  23,798
                                           ===========    =========
 
</TABLE>


                THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF
                          THESE FINANCIAL STATEMENTS.

<PAGE>
 
                     CITADEL COMPUTER SYSTEMS INCORPORATED
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Note A - Basis of Presentation

The financial information presented herein should be read in conjunction with
the financial statements and footnotes included in the Company's Annual Report
on Form 10-KSB for the period ended February 29, 1996.  The balance sheet as of
February 29, 1996, has been derived from the audited financial statement at that
date.

The accompanying unaudited financial statements have been prepared in accordance
with generally accepted accounting principles for interim financial information.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments considered necessary for a fair
presentation, consisting of those of a normal recurring nature, are reflected in
the accompanying financial statements.

Note B - Marketable Securities

The Company received 1,325,000 shares of Miami Subs U.S.A., Inc. (Miami Subs)
common stock as consideration for the sale of its restaurants on March 1, 1996.
The carrying value of the stock at the date of sale of $2,567,186 has been
reduced by $1,000,000 and has been charged to income for the quarter ended May
31, 1996.  Based on events occurring after the sale of the restaurants, the
Company concluded that it could no longer recover its investment in the Miami
Subs stock and wrote down the investment to its market value as of July 19,
1996.

Note C - Stockholders' Equity

During the period from March 1, 1996, through August 31, 1996, the Company's
stockholders' equity reflects the following changes.

<TABLE>
<CAPTION>
 
<S>                                       <C>
 
Stockholders' equity at February 29,      $   315,489
 1996
 
Exercise of stock options                     425,000
Securities issued pursuant to private                 
 placement                                    679,046 
Conversion of debt to equity                  714,000 
Net loss                                   (1,611,557)
                                          ----------- 
 
Stockholders' equity at May 31, 1996          521,978
 
Exercise of stock options and warrants        216,000
Securities issued pursuant to private                 
 placement                                  5,845,261 
Equity issued in acquisitions               1,919,578 
Unrealized loss on securities                (104,687)
Net loss                                   (4,352,812)
                                          ----------- 
 
Stockholders' equity at August 31, 1996     4,045,318
 
Securities issued pursuant to private                 
 placement                                  1,440,000 
                                          ----------- 
 
Stockholders' equity at October 14, 1996  $ 5,485,318
                                          ===========
</TABLE>

<PAGE>
 
Note D - Acquisitions

     In August 1996, the Company completed the acquisition of the ADI Group,
which develops security software for stand alone personal computers, for a total
consideration of approximately $2,200,000, consisting of $1,200,000 in common
stock (subject to sales limitations for two years) and $1,000,000 in cash over
six months ($600,000 of which has already been paid).

     In August 1996, the Company completed the acquisition of DanaSoft, Inc.,
which develops and markets software for internet and intranet applications, for
$264,000 in Citadel common stock and $30,000 in cash.  In August 1996, the
Company also completed the acquisition of MicroVault Corporation, a data
security software provider, for $475,200 in Citadel common stock and $75,000 in
cash.

     All of such acquisitions have been accounted for by the purchase method.
In connection with the acquisition of the ADI Group and MicroVault Corporation,
the Company wrote off $2,402,000 of purchased research and development
technology that had not reached the working model stage and for which there is
not alternate use. The following pro forma operating data has been prepared as
though the acquisitions had been made as of the beginning of the previous fiscal
year (March 1, 1995):

<TABLE>
<CAPTION>
                             Three months ended August 31,    Six months ended August 31,
                                 1996             1995               1996             1995       
                             -----------       -----------       -----------       -----------
<S>                          <C>               <C>               <C>               <C>
                                                              
Revenues                     $ 2,052,976       $   779,527       $  3,549,319      $ 1,364,076          
Net loss before                                               
 extraordinary item           (2,550,293)           N/A            (4,246,688)          N/A
Net loss                     $(2,290,871)      $(2,603,731)      $ (4,005,752)     $(3,120,951)  
Net loss per share                                            
before extraordinary item    $      (.20)           N/A          $       (.34)          N/A
Net loss per share           $      (.18)      $      (.36)      $       (.32)     $      (.44)

</TABLE>

The write-off of purchased research and development costs of $2,402,000 is
reflected in the pro form net loss only for the 1995 periods.

The pro forma operating results are not necessarily indicative of the actual
results that would have occurred had the acquisitions been made on March 1, 1995
or of the future operations of the combined companies.


Note E - Purchase and License of Technology

     In August 1996, the Company purchased the TabWorks and Cougar technology
and product lines from the XSoft Division of Xerox Corporation, headquartered at
the Xerox Palo Alto Research Center (PARC).  Total consideration consists of
$750,000 in cash, a non-interest bearing $1,350,000 senior note ($1,206,560
after discount for imputed interest) payable over two years, and royalty
payments of up to $1,250,000 over four years.  The Company has the right to pay
an aggregate of $2,500,000 during the first year following the acquisition in
exchange for the release of its obligations under the note and royalty terms.
In August 1996, the Company and XSoft announced their strategic partnership
pursuant to which XSoft's Summarizer Technology was licensed to the Company.

     In connection with this purchase of technology, the Company wrote off
approximately $1,557,000 of purchased research and development technology that
had not reached the working model stage and for which there is not alternate
use.