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                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549
                            ------------------------
 
                                   FORM 10-K
 
                       FOR ANNUAL AND TRANSITION REPORTS
                    PURSUANT TO SECTIONS 13 OR 15(D) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
 
(MARK ONE)
[ X ]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934 [FEE REQUIRED]
 
For the fiscal year ended December 31, 1996.
                                       OR
 
[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
 
For the transition period from ____________ to ____________
 
                         COMMISSION FILE NUMBER 0-26964
 
                              CARNEGIE GROUP, INC.
             (Exact name of registrant as specified in its charter)
 
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<S>                                              <C>
                  DELAWARE                                        25-1435252
        (State or other jurisdiction                           (I.R.S. Employer
     of incorporation or organization)                       Identification No.)
  FIVE PPG PLACE, PITTSBURGH, PENNSYLVANIA                          15222
  (Address of principal executive offices)                        (Zip Code)
</TABLE>
 
       Registrant's telephone number, including area code: (412) 642-6900
 
          Securities registered pursuant to Section 12(b) of the Act:
 
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<S>                                              <C>
            Title of each class                   Name of each exchange on which registered
--------------------------------------------     --------------------------------------------
                    NONE                                        NOT APPLICABLE
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          Securities registered pursuant to Section 12(g) of the Act:
 
                     COMMON STOCK, PAR VALUE $.01 PER SHARE
                                (Title of class)
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]     No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [X]
 
     As of March 21, 1997, the aggregate market value of voting common stock
held by non-affiliates of the registrant, based upon the last reported sale
price for the registrant's Common Stock on the Nasdaq National Market on such
date, as reported in The Wall Street Journal, was $29,891,912 (calculated by
excluding shares owned beneficially by directors and executive officers as a
group from total outstanding shares solely for the purpose of this response).
 
     The number of shares of the registrant's Common Stock outstanding as of the
close of business on March 21, 1997 was 6,283,091.
 
                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Certain portions of the definitive Proxy Statement of Carnegie Group, Inc.
to be used in connection with the 1997 Annual Meeting of Stockholders (the
"Proxy Statement") are incorporated by reference into Part III of this Annual
Report on Form 10-K to the extent provided herein. Except as specifically
incorporated by reference herein, the Proxy Statement is not to be deemed filed
as part of this Annual Report on Form 10-K.
 
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                                     PART I
 
ITEM 1. BUSINESS.
 
     Carnegie Group, Inc. ("Carnegie Group" or the "Company") provides
client/server software development services that integrate advanced
user-centered, intelligent software technologies with clients' existing
computing infrastructures to automate and enhance complex business processes.
The Company performs business and technical consulting, custom software
development, and systems integration services to improve clients' productivity
and market position in two business areas: customer interaction; and logistics,
planning, and scheduling. Within these areas, the Company targets its services
to clients in the financial services, government, manufacturing and
telecommunications industries.
 
     The Company's expertise encompasses a wide range of advanced software
technologies, including knowledge-based systems, object-oriented technology,
advanced graphical user interfaces, constraint-directed search and distributed
computing. The Company captures certain aspects of its business area experience
and advanced technology expertise in a portfolio of reusable software templates
that can be used as building blocks to create software solutions quickly and
effectively. In addition, Carnegie Group employs an iterative or "spiral"
approach to software design that begins with the construction of a prototype and
continues through testing of successive versions of the software against project
requirements. This iterative design approach facilitates rapid software
development, encourages client feedback and leads to greater congruence with
client needs and expectations.
 
     Since inception, Carnegie Group has emphasized relationships with leading
corporations in its targeted industries. These relationships have provided the
Company with opportunities for growth through the provision of additional
services to existing clients and through references to other companies within
the Company's targeted industries. Carnegie Group's clients include U S WEST
Communications, Inc., the United States Transportation Command, U.S. Army,
Caterpillar Inc., BellSouth Telecommunications, Inc., First USA Bank, Highmark
Blue Cross Blue Shield and Philips Medical Systems.
 
INDUSTRY BACKGROUND
 
     Corporations increasingly seek to gain competitive advantages by
reengineering business processes in order to increase productivity, improve
responsiveness to market demands and facilitate comprehensive planning. The
knowledge and experience of workers involved in complex business processes can
be captured and disseminated through business process reengineering in order to
support and improve enterprise-wide decision-making.
 
     As computer speed and capacity have increased and computer hardware and
software costs have declined, corporations have decentralized their computing
infrastructures by distributing computing power to end-users. While centralized
computing infrastructures have historically collected, stored and manipulated
large volumes of information, the widespread installation of client/server
architectures has enabled multiple personal computers and workstations to be
linked together in various locations within an enterprise and has permitted
information to be disseminated to end-users.
 
     The use of advanced software technologies within client/server
architectures has facilitated the creation of sophisticated software solutions
that capture, analyze and disseminate enterprise-wide knowledge. These solutions
allow end-users to access business rules and accumulated corporate knowledge,
and to use that information to make decisions more quickly and exploit business
opportunities more effectively.
 
     Successful implementation of sophisticated software solutions within
client/server architectures requires specialized expertise in advanced software
technologies. Generally, such expertise is not found in corporations' internal
information systems departments, because maintaining specialized expertise in
advanced software technologies is not believed to be cost-effective. As a
result, corporations are increasingly retaining information technology service
providers to develop the sophisticated software solutions they require.
 
     The demand for sophisticated software solutions that automate and enhance
business processes has created significant opportunities for information
technology service providers. However, not all information technology service
providers have the expertise to provide sophisticated solutions within
client/server architectures. Some of these providers focus on general business
consulting or on the methodologies through
 
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which business processes can be reengineered, while others focus on consulting
for specific industries or on specific systems integration services.
 
CARNEGIE GROUP'S STRATEGY
 
     Carnegie Group has recognized the demand for information technology
services from providers who combine expertise in a wide range of advanced
software technologies with experience in developing sophisticated software
solutions for specific industries. Carnegie Group's goal is to be a leading
provider of knowledge-based, user-centered client/server software development
services that integrate advanced technologies with clients' existing computing
infrastructures to automate and enhance business processes in two business
areas: customer interaction; and logistics, planning and scheduling. To attain
that goal, the Company employs the following strategies:
 
     Apply Advanced Software Technologies to Develop High-Value Solutions.
 Carnegie Group focuses on performing software development, systems integration
and technical consulting services that apply advanced software technologies to
develop high-value software solutions that improve its clients' productivity and
competitive market position. The Company's expertise encompasses a wide range of
advanced software technologies, including: knowledge-based systems;
object-oriented technology; advanced graphical user interfaces;
constraint-directed search; and distributed computing. Carnegie Group intends to
continue to focus on applying advanced software technologies as new technologies
are developed that can be used to build high-value solutions for its clients.
 
     Employ Reusable Software Templates to Leverage Business Area Experience.
 Carnegie Group captures certain aspects of its business area experience and
advanced technology expertise, developed principally in the course of
engagements for clients, in a portfolio of reusable software templates. The
Company selects templates for use in new engagements where appropriate, and then
modifies and enhances these templates to serve as the building blocks of
complete knowledge-intensive software solutions. Carnegie Group believes that
its portfolio of reusable software templates reduces development time and
project costs and enhances project quality, allowing it to quickly provide
sophisticated software solutions to its clients. The Company plans to continue
to employ reusable software templates within appropriate application niches and
to develop new templates as it performs engagements for its clients.
 
     Continue to Grow Significant Client Relationships.  Carnegie Group has
emphasized relationships with leading organizations in its targeted industries.
These organizations are characterized by business areas (such as customer
interaction, and logistics, planning and scheduling) to which the Company's
services and technology are particularly well-suited, and by participants who
possess the financial resources and scale of operations necessary to support the
engagement of service providers such as the Company. In each relationship, the
Company seeks to capitalize on its success in completing an initial engagement
by offering additional services that automate and enhance other business
processes for that client. Carnegie Group expects that its focus on providing
additional software solutions for existing clients will continue to be an
important component of its marketing efforts.
 
     Expand Client Base in Targeted Industries.  Carnegie Group is focused upon
expanding its client base in the financial services, government, manufacturing
and telecommunications industries. The Company believes that successful
engagements for existing clients create opportunities for client references that
enhance the Company's reputation and enable it to attract additional clients in
its targeted industries. Carnegie Group also intends to target additional
industries in which its business area experience and advanced software
technology expertise can be applied.
 
     Apply Iterative Design Approach to Facilitate Rapid Development.  In the
course of performing its engagements, the Company applies an iterative or
"spiral" approach to software design that begins with the construction of a
prototype and continues through testing of successive versions of the software
against project requirements. This iterative design approach encourages client
feedback and leads to greater congruence with client needs and expectations. The
Company believes that this approach enables the rapid deployment of
knowledge-intensive software solutions for its clients.
 
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SERVICES AND SOLUTIONS
 
     Carnegie Group's project teams provide software development, systems
integration and technical consulting services to create knowledge-intensive
software solutions that improve clients' productivity and competitive market
position.
 
  Services
 
     Carnegie Group provides its services through project teams comprised of
engineers, project managers and sales and marketing personnel that are assigned
to client engagements. These professionals apply industry, advanced technology
and business area expertise to create a solution that is intended to meet the
client's needs. The Company's project teams generally perform services in three
phases (which are usually the subjects of separate contracts but which may be
governed by one contract covering all phases):
 
     Phase I  typically consists of a "proof of concept" or feasibility
assessment for the client which identifies the specific problem and proposes the
solution to be created by Carnegie Group, including the technology likely to be
employed during the engagement and the engagement milestones for each phase. The
first phase is generally completed in one to three months and is usually
performed on a fixed-price basis. Successful completion of phase one may lead to
the continuation of the project into phase two, although there is no obligation
for the client to engage Carnegie Group to continue the project following the
completion of the first phase.
 
     Phase II  generally lasts three to nine months and involves completing a
solution for the client. The solution may include a licensed software component
such as a reusable software template. In designing software solutions, the
Company applies an iterative or "spiral" approach that starts with the client's
identification of its requirements during Phase I, from which Carnegie Group
proceeds to construct a prototype that is then tested with the client against,
and used to refine, the original requirements. Carnegie Group then produces
successive new versions of the software, each of which is again tested with the
client against project requirements.
 
     Phase III  generally consists of deploying the solution at additional
client sites or throughout the client's business enterprise. The project
specification may be further customized during this phase to incorporate
changing client needs. The third phase may take from six months to more than a
year. The majority of the Company's engagement contracts in the second and third
phases are performed on a time-and-materials basis.
 
  Solutions
 
     Carnegie Group creates software solutions for two business areas: customer
interaction; and logistics, planning and scheduling.
 
     Customer Interaction.  Carnegie Group develops knowledge-based agent
software that enables business managers to consistently deliver corporate
knowledge and business strategy to all points of customer contact across an
enterprise. Knowledge-based agents deliver corporate knowledge and strategy to
human decision makers in the form of recommendations that can help solve
problems and sell products and services. This technology enables organizations
to affect the quality of customer encounters and optimize all interactions to
generate greater revenue, improve customer satisfaction and achieve other
critical business goals.
 
     A solution designed for Philips Medical Systems helps customer support
engineers make a repair at the customer's site, where time and performance are
critical. Using Carnegie Group's TestBench(TM)diagnostic software, engineers are
able to service the customer immediately. TestBench automates the process of
accessing information and gives customer support engineers the instantaneous
access to knowledge bases, consisting of technical expertise and legacy data,
that they need to perform their job more efficiently and effectively. At
Philips, TestBench enables engineers to repair the company's medical equipment
efficiently and on the first call whenever possible. The engineer determines a
machine's symptoms, queries the knowledge base, and plays out scenarios to reach
a solution. Repair cycles are shortened, unnecessary service calls are
eliminated, spare parts inventory is reduced, and solutions are shared among
engineers' peers.
 
     A solution designed for U S WEST Communications, Inc. ("U S WEST"), a
subsidiary of a regional Bell operating company, helps make U S WEST's call
center more responsive and efficient and improves customer service and
satisfaction. To help U S WEST maximize its share of their Mass Market
environment,
 
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Carnegie Group developed a Front End Screen & Route (FES&R) system as the
central component of U S WEST's Call Handling program. The FES&R system shortens
call routing time to call centers and improves the match between the caller
(customer) and the call handler (customer service/collection teams) so that each
call gets to the call handler best equipped to help with the customer's
particular needs. The FES&R system handles any call, any time, anywhere and
supports a seven-day/24-hour call center operation covering multiple voice
response units (VRU's) and automatic call distributors in the 14-state U S WEST
Mass Market territory. The system provides a front end for VRU's to enable
customer self-help. Flexible business rules, combined with customer, network,
and market intelligence information, are used to provide advanced call control
capabilities and load balancing for intelligent call routing and screening.
 
     Logistics, Planning and Scheduling.  Carnegie Group's knowledge-based
logistics, planning and scheduling solutions are intended to optimize the
allocation of available resources, thereby increasing efficiency and reducing
costs. These solutions provide advanced decision-support to planners by modeling
and manipulating complex information, and by simulating and analyzing multiple
scenarios. The Company's logistics, planning and scheduling solutions help to
reduce lead times and to match resources with requirements.
 
     A solution designed for the U.S. Transportation Command (TRANSCOM) is
helping U.S. military patient movement planners synchronize operations with
evacuation processes. The TRANSCOM Regulatory And Command & Control Evacuation
System (TRAC(2)ES) is the result of a Department of Defense directive that
tasked TRANSCOM with establishing a global system for patient movement,
integrating medical regulating and evacuation. Prior to TRAC(2)ES, medical
regulation and evacuation were two separate processes. With little or no
correlation between a patient's needs and the capabilities at hand to transport
patients to proper care, TRAC(2)ES consolidates medical regulation and
evacuation through an advanced decision-support system. This system determines
the appropriate time-and-resource-sensitive information and how it should be
presented to support planners in getting patients where they need to go for the
best treatment.
 
     Another solution, developed for a steel producer, provides mill operators
with advanced decision-support for planning and scheduling continuous slab
caster and melt shop facilities. This solution arranges slab requirements into
possible production sequences and helps the operator evaluate alternative
sequences before scheduling actual production. This solution assists the client
in reducing costs by improving yield and cutting inventory, while simultaneously
improving customer service by creating more reliable production schedules. The
solution is based on the Company's Caster Planning and Scheduling System (CaPSS)
software template.
 
TECHNOLOGY
 
  Advanced Software Technologies
 
     Carnegie Group's engineering staff is experienced in applying advanced
software technologies to create solutions within enterprise-wide client/server
architectures. The architecture of the Company's software solutions typically
contains three tiers or layers: a "presentation layer" which contains the user
interface; a "functionality layer" which embodies the business logic, knowledge
base and application logic of the system; and a "data layer" which is comprised
of both data created with existing systems and new data created with the
solution.
 
     To create its solutions within three-tiered client/server environments,
Carnegie Group's engineers are skilled at employing advanced software
technologies, including: knowledge-based systems; object-oriented technology;
advanced graphical user interfaces; constraint-directed search; and distributed
computing.
 
     Knowledge-based systems are software systems that can make reasoned
decisions about complicated processes and that enable those processes to be
completed with little or no human intervention. Knowledge-based systems access
detailed information about the process, apply underlying reasoning and recommend
decisions.
 
     Object-oriented technology is a methodology for designing a software system
using an object-oriented programming language, which represents concepts, things
and actions by describing their attributes. Once a concept, thing, or action has
been described, that description and its accompanying software code can be
reused broadly.
 
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     Advanced graphical user interfaces combine screen icons, text and pointing
devices to allow computer users to direct a computer's activities by
manipulating images. Well-designed interfaces distill powerful and complex
functions into simple and intuitive graphic representations.
 
     Constraint-directed search is a software system that searches for desired
data or decisions across a large range of alternatives, with limiting factors
attached to the search. Such a search may, for example, be constrained by dates
or by certain characteristics of available resources. In a knowledge-based
system, the sets of constraints imposed on the search may be many, complex and
interdependent.
 
     Distributed computing refers to computer transactions, such as information
transfer, that may take place between different types of computers, which may or
may not be at the same location. Distributed computing and transaction
processing software automates and enables enterprise-wide information exchanges
that might not otherwise be available.
 
     Other advanced software technologies employed by the Company include
case-based reasoning and relational and object-oriented database management
systems.
 
  Reusable Software Templates
 
     Carnegie Group captures certain aspects of its business area experience and
advanced technology expertise in a portfolio of reusable software templates.
Generally, these templates are developed and refined in the course of performing
services for clients. The Company selects templates for use as building blocks
in new engagements where appropriate, and then modifies and enhances these
templates to form complete, customized, knowledge-intensive solutions. The
Company believes that its reusable software templates reduce development time
and project costs and enhance project quality, allowing it to quickly provide
sophisticated software solutions to its clients. The Company's reusable software
templates include the following:
 
     Customer Xpress is a customer contact software template that consolidates
valuable knowledge from sales, marketing and network personnel, and disseminates
it to sales consultants and customer service representatives. Customer Xpress
helps the user navigate through the process of defining customer needs and
exploring options among available products. It is intended to enable the
end-user to increase revenue from each customer contact, improve the quality of
service and reduce service representative training time and costs.
 
     Complex Order Engine (COE) is a customer contact software template designed
to support sales and order processing applications for complex products. COE
simplifies the ordering process by guiding the user through a series of options
in a pre-determined sequence. The template facilitates correct ordering under
circumstances in which the customer has a variety of options from which to
choose, but only a relatively small number of all the possible combinations of
options is realizable. COE applies an accumulated knowledge base that includes
the details and implications of each option and the restrictions among options,
to increase order accuracy and customer satisfaction.
 
     TestBench is a customer service software template that is designed to
increase the accuracy and efficiency of help desk, technical assistance center
and stand-alone field support. TestBench enables organizations to capture human
troubleshooting expertise and deploy that expertise rapidly and inexpensively to
end-users. This template can be integrated with or embedded in other
conventional computing environments. TestBench is also available from the
Company as a stand-alone software product.
 
     Field Service WorkBench is a reusable customer service software template
developed from a user-centric perspective. It provides a consistent, graphical
interface into service applications while allowing data to be shared between
these applications. Service representatives can access the information they need
quickly and easily, and share information through the system.
 
     Caster Planning and Scheduling System (CaPSS) is an advanced
decision-support software template that uses a knowledge-based system to plan
and schedule continuous slab caster and melt shop facilities in steelmaking
enterprises. CaPSS supports steelmaking and primary mill operations by arranging
slab requirements into production sequences called "caster strings." Graphic
interfaces support the user in evaluating potential caster strings before
selecting the caster strings to be scheduled for production. CaPSS is typically
accompanied by the Company's Rolling Mill Scheduling System (RMSS) template,
which provides steel mill operations planners with visibility into upcoming
rolling mill schedules.
 
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     ROCK is a C++ library of user-callable functions that lets developers
construct, access, manipulate and store complex data across a range of software
applications. ROCK incorporates key features of several data management and
programming disciplines, including object-oriented technology, relational
databases and knowledge representation, and enhances the software developer's
ability to model problems and represent and manipulate data. ROCK can be
seamlessly integrated with a variety of graphical user interfaces, reasoning
tools and relational databases.
 
MARKETING, SALES AND CLIENTS
 
     Carnegie Group markets its services directly to clients in its targeted
industries of financial services, government, manufacturing and
telecommunications. These industries are characterized by business areas (such
as customer interaction, and logistics, planning and scheduling) to which the
Company's services and technology are particularly well-suited, and by
participants who possess the financial resources and scale of operations
necessary to support the engagement of service providers such as the Company.
 
     The Company identifies leading organizations in each industry and seeks to
provide an initial solution that builds on one of the Company's reusable
software templates. Once an initial project has been successfully completed,
Carnegie Group seeks to offer additional services that automate and enhance
other business processes for the client. Carnegie Group intends to target
additional industries in which its business area experience and advanced
software technology expertise can be applied.
 
     The Company markets its services to clients throughout the United States
from its headquarters in Pittsburgh, Pennsylvania. In addition, the Company
maintains offices in Denver, Colorado and Atlanta, Georgia focusing upon clients
in the telecommunications industry, and an office in Fairview Heights, Illinois
serving government industry clients. Of the 238 people employed or engaged by
the Company as of December 31, 1996, 21 were involved directly in sales and
marketing and were supported by 36 project managers and 138 project engineers
focused upon the industries that the Company serves.
 
     The Company employs a variety of business development and marketing
techniques to communicate directly with current and prospective clients. These
techniques include exhibiting at trade shows, authoring articles and presenting
papers regarding the Company's solutions and technology, holding seminars for
clients and prospective clients on technology and industry issues and marketing
through direct mail initiatives. In accordance with government contracting
requirements, the Company's marketing and sales efforts toward government
industry clients that are governmental agencies or instrumentalities are limited
to responding to requests for proposals and participating in competitive
bidding. Periodically, the Company responds to requests by these clients for
bids on projects in which the technology to be employed or services to be
rendered are available from only one or a limited number of sources.
 
     In 1996, total revenue from billings to each of the United States
Transportation Command, the U S Army, Caterpillar, Inc. and BellSouth
Telecommunications accounted for more than 10% of the Company's total revenue.
In 1995, total revenue from billings to each of such customers and U S WEST
Communications, Inc. accounted for more than 10% of the Company's total revenue.
The Company expects to continue to derive a significant portion of its revenue
from a relatively limited number of major clients.
 
BACKLOG
 
     The Company only includes in backlog signed contracts that either have
milestones yet to be attained or for which the Company can make a reasonable
estimate of work yet to be performed. The Company's backlog totaled $9.6 million
at December 31, 1996, compared to $18.7 million at December 31, 1995.
 
     Contracts included in backlog are generally performed within 12 months. In
accordance with industry practice, most of the Company's contracts are
terminable by the Company or the client upon short or no notice. There can be no
assurance that contracts reflected in backlog will not be canceled or delayed.
Accordingly, the Company believes that backlog is not a reliable measure of
future revenue.
 
COMPETITION
 
     The information technology services market, which includes the market for
the Company's services and solutions, is comprised of a large number of
participants, is subject to rapid change and is highly competitive. Primary
competitors include: the consulting practices of the "Big Six" accounting firms;
systems consulting
 
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and integration firms such as American Management Systems, Inc. and Cambridge
Technology Partners Inc.; and the professional services groups of large
companies, such as International Business Machines Corporation, Digital
Equipment Corporation and AT&T Corporation. Many participants in the information
technology services market have significantly greater financial, technical and
marketing resources and greater name recognition than does Carnegie Group.
Moreover, clients may elect to use their internal information systems resources
to satisfy their needs for the software development, systems integration and
technical consulting services that the Company offers. The Company also faces
competition from organizations providing outsourcing services to the information
systems departments of existing and potential clients. In addition, the
information technology services market is highly fragmented and is served by
numerous firms; some of these firms compete nationally and internationally,
while others serve only their respective local markets. While the Company has
not experienced competition from foreign providers of information technology
services, there can be no assurance that the Company will not experience such
competition in the future. Carnegie Group has targeted, and expects to continue
to target, industries that are characterized by business areas (such as customer
interaction, and logistics, planning and scheduling) to which the Company's
services and technology are particularly well-suited, and by participants who
possess the financial resources and scale of operations necessary to support the
engagement of service providers such as the Company. A growing number of
professional services firms are seeking engagements from that same client group.
 
     The Company believes that the principal competitive factors in the
information technology services market include the nature of the service
offering, quality of service, timeliness, responsiveness to client needs,
experience with the client's industry and competitive environment, technical
expertise, access to replicable technology such as software templates and price.
The Company believes that it competes favorably with respect to these factors.
The Company believes that its ability to compete also depends in part upon a
number of competitive factors outside its control, including: the ability of its
competitors to hire, retain and motivate project managers, engineers and sales
and marketing personnel; competitors' ownership of or access to software and
technology used by potential clients; the development by others of software that
is competitive with the Company's solutions and services; the price at which
others offer comparable services; and the extent of competitors' responsiveness
to customer needs.
 
EMPLOYEES
 
     As of December 31, 1996, the Company had a total staff of 238 employees and
independent contractors, comprised of 174 technical personnel (of whom 36 were
project managers and 138 were project engineers), 21 sales and marketing
personnel and 43 corporate services and administrative personnel. The Company's
professional personnel have a variety of educational backgrounds, including
degrees in software engineering, electrical engineering, computer science,
mechanical engineering, linguistics and business administration; over 88 of the
Company's employees at December 31, 1996 have advanced degrees. The Company has
historically filled a portion of its engineering staffing needs through the
retention of independent contractors at a cost not materially greater than the
cost of retaining its own employees. The Company believes that its practice of
retaining independent contractors on a per engagement basis provides it with
access to specialized knowledge when needed, as well as greater flexibility in
adjusting staffing levels in response to changes in the demand for its services.
 
     The Company believes that its future success will depend in large part upon
its ability to attract, retain and motivate highly skilled managerial,
technical, marketing and support personnel. None of the Company's employees is
subject to a collective bargaining agreement. The Company believes that its
relations with its employees are excellent.
 
INTELLECTUAL PROPERTY
 
     The Company relies upon a combination of patent, trade secret,
non-disclosure and other contractual arrangements, and patent, copyright and
trademark laws, to protect its proprietary rights and the proprietary rights of
third parties from whom the Company licenses intellectual property. The Company
enters into confidentiality agreements with its employees, consultants, clients
and potential clients and limits access to and distribution of proprietary
information. There can be no assurance that the steps taken by the Company in
this regard will be adequate to deter misappropriation of proprietary
information or that the Company will be able to detect unauthorized use and take
appropriate steps to enforce its intellectual property rights.
 
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     The Company's business includes the development of custom software
solutions in connection with specific client engagements. Ownership of certain
custom components of such software is generally assigned to the client. The
Company has licensed through December 1997 certain custom software components
developed in the course of an engagement for a client. In addition, the Company
also develops core software technology and reusable software templates, often in
the course of engagements for clients, as well as object-oriented software
components and certain software "tools," which can be reused in software
application development and which generally remain the property of the Company.
 
     Although the Company believes that its services and solutions, including
its reusable software templates, do not infringe on the intellectual property
rights of others and that it has all rights necessary to utilize the
intellectual property employed in its business, the Company is subject to the
risk of litigation alleging infringement of third party intellectual property
rights. There can be no assurance that third parties, including the parties for
whom the Company has been engaged to develop solutions, from which its reusable
software templates have been derived, will not assert infringement claims
against the Company in the future with respect to intellectual property utilized
by the Company now or in the future. Any such claims could require the Company
to expend significant sums in litigation, pay damages, develop noninfringing
intellectual property or acquire licenses to the intellectual property which is
the subject of asserted infringement.
 
ITEM 2. PROPERTIES.
 
     The Company's headquarters and principal administrative, sales and
marketing and software solutions development operations are located in
approximately 55,000 square feet of leased space in Pittsburgh, Pennsylvania.
The Company occupies these premises under a lease expiring in December 1999. The
Company also leases an additional 20,000 square feet of space under this lease;
this additional space is currently subleased to other tenants for terms expiring
in September 1997 and March 1998. In addition, the Company leases office space
in Denver, Colorado, Atlanta, Georgia and Fairview Heights, Illinois. The
Company anticipates that additional space will be required as business expands
and believes that it will be able to obtain suitable space as needed.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company is not a party to any material litigation.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
     Not applicable
 
                      EXECUTIVE OFFICERS OF THE REGISTRANT
 
     The following table sets forth certain information regarding the executive
officers of the Company.
 
<TABLE>
<CAPTION>
       NAME            AGE                                 POSITION
------------------     ----     --------------------------------------------------------------
<S>                    <C>      <C>
Dennis Yablonsky        44      President, Chief Executive Officer and Director
Bruce D. Russell        51      Executive Vice President, Chief Operating Officer and Director
John W. Manzetti        49      Executive Vice President, Chief Financial Officer, Treasurer,
                                Secretary and Director
</TABLE>
 
     Mr. Yablonsky has served as President and Chief Executive Officer and as a
director of the Company since August 1987. Before joining the Company, Mr.
Yablonsky was President and Chief Operating Officer of Cincom Systems of
Cincinnati, Ohio, a privately-held company that markets software products to the
manufacturing, government and academic markets.
 
     Dr. Russell has served as Executive Vice President and Chief Operating
Officer and as a director of the Company since February 1995. Prior to becoming
an Executive Vice President, Dr. Russell served as Vice President and Division
Manager from January 1989 through January 1995.
 
     Mr. Manzetti has served as Executive Vice President, Chief Financial
Officer and Treasurer and as a director of the Company since February 1995.
Prior to becoming an Executive Vice President, Mr. Manzetti served as Vice
President, Finance and Administrative Services and Chief Financial Officer from
October 1988
 
                                        9
<PAGE>   10
 
to February 1993, and as Vice President and Division Manager and Chief Financial
Officer from February 1993 to February 1995. Mr. Manzetti has been Secretary
since February 1989.
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
 
     The Common Stock of the Company is traded on the Nasdaq National Market
under the symbol "CGIX." The following table sets forth the range of high and
low sale prices of the Common Stock as reported on the Nasdaq National Market
for the periods indicated.
 
<TABLE>
<CAPTION>
        1995                                                         HIGH        LOW
                                                                    -------     ------
        <S>                                                         <C>         <C>
        Fourth Quarter (ended 12/31/95)..........................   $11.000     $8.750
        1996:
        First Quarter (ended 3/31/96)............................   $10.250     $6.625
        Second Quarter (ended 6/30/96)...........................   $10.750     $8.250
        Third Quarter (ended 9/30/96)............................   $ 8.750     $5.000
        Fourth Quarter (ended 12/31/96)..........................   $ 8.500     $5.250
        1997:
        First Quarter (through 3/21/97)..........................   $ 7.750     $5.375
</TABLE>
 
     On March 21, 1997, the last reported sale price of the Common Stock on the
Nasdaq National Market was $5.50 per share. As of such date there were
approximately 4,100 holders of record of the Company's Common Stock.
 
     The Company has never declared or paid cash dividends on its capital stock.
The Company currently anticipates that it will retain future earnings, if any,
to fund the development and growth of its business and does not anticipate
paying any cash dividends in the foreseeable future.
 
ITEM 6. SELECTED FINANCIAL DATA.
 
<TABLE>
<CAPTION>
                                                            YEAR ENDED DECEMBER 31,
                                            -------------------------------------------------------
                                             1992        1993        1994        1995        1996
                                            -------     -------     -------     -------     -------
<S>                                         <C>         <C>         <C>         <C>         <C>
Statement of Operations Data:
Total Revenue............................   $16,239     $12,817     $17,875     $25,650     $28,409
Income (loss) from operations............      (844)     (2,065)      1,159       2,847       2,301
Income (loss) before income taxes........      (779)     (2,021)      1,162       2,849       2,928
Income tax benefit (provision)...........       (64)         --         277       1,827         432
Cumulative effect of change in accounting
  principle..............................       755          --          --          --          --
Net Income (loss)........................       (88)     (2,021)      1,439       4,676       3,360
Earnings (loss) per share of common
  stock..................................   ($ 0.02)    ($ 0.42)    $  0.25     $  0.82     $  0.47
Weighted average number of common shares
  outstanding............................     4,828       4,829       5,717       5,686       7,101
</TABLE>
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31
                                            -------------------------------------------------------
                                             1992        1993        1994        1995        1996
                                            -------     -------     -------     -------     -------
<S>                                         <C>         <C>         <C>         <C>         <C>
Balance Sheet Data:
Working Capital..........................   $ 3,104     $ 1,196     $ 2,055     $16,139     $19,793
Total assets.............................     7,416       6,025       8,943      24,989      28,489
Obligations under capital
  leases-noncurrent portion..............         4          --          90          40          --
Total stockholders' equity...............     5,301       2,761       4,200      19,729      23,638
</TABLE>
 
                                       10
<PAGE>   11
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
 
OVERVIEW
 
     Carnegie Group, founded in 1983, derives its revenue primarily from the
performance of software services, and to a lesser extent from the sale of
software licenses. Carnegie Group, Inc. provides client/server software
development services that integrate advanced user-centered, intelligent software
technologies with clients' existing computing infrastructures to automate and
enhance complex business processes. The Company performs business and technical
consulting, custom software development and systems integration services to
improve clients' productivity and market position in two business areas:
customer interaction; and logistics, planning and scheduling. Within these
areas, the Company targets its services to clients in the financial services,
government, manufacturing and telecommunications industries.
 
     The market for the Company's services and solutions is highly fragmented
and is served by numerous firms. In providing services to clients in its
targeted industries, the Company competes with, among others, the consulting
practices of the "Big Six" accounting firms, systems consulting and integration
firms and the professional services groups of large companies. In addition,
clients may elect to use their internal information systems resources to satisfy
their needs for the software development, systems integration and technical
consulting services that the Company offers.
 
     Revenue from software services represented 94.9% of the Company's total
revenue in 1996. Fees for software services provided by the Company typically
are based on Carnegie Group staffing requirements and the overall scope and
timing of the project as agreed upon with the client. The Company has
historically filled a portion of its engineering staffing needs through the
retention of independent contractors at a cost not materially greater than the
cost of retaining its own employees. The Company believes that its practice of
retaining independent contractors on a per engagement basis provides it with
access to specialized knowledge when needed, as well as greater flexibility in
adjusting staffing levels in response to changes in the demand for its services.
The Company's software services are generally performed on a time-and-materials
basis, although the Company also provides certain software services on a
fixed-price or cost-plus-fixed-fee basis, depending on the overall project
scope, risks and client requirements. The Company records software services
revenue at estimated realizable rates as labor hours are recorded, or as project
milestones or deliverables are met, whichever most accurately reflects project
completion status. Adjustments are made to software services revenue as required
using the percentage-of-completion method of accounting. In recent years, the
Company has realized higher cost of revenue on unrelated party software services
contracts due to differences in contract values, contractual periods and
relative productivity when compared to related party software services
contracts.
 
     Revenue from software licenses, which represented 5.1% of the Company's
total revenue in 1996, includes fees for licenses, education and training,
maintenance revenue and miscellaneous revenue. Revenue from software licenses
includes fees for reusable software templates as well as fees for templates sold
on a stand-alone basis. The Company records revenue on licenses of reusable
software templates when the license agreement is executed, the client purchase
order is received and the software has been shipped to the client. Because
development costs of these templates have been fully amortized in previous
periods (as described below), current costs of software licenses revenue are
insignificant. The Company does not believe that the effects of costs of
software licenses revenue on the Company's aggregate gross margins or software
licenses gross margins are material. Maintenance revenue with respect to
software licenses is recorded ratably over the term of the maintenance
agreement. Miscellaneous revenue includes fees received from various joint
marketing arrangements with other companies.
 
     Historically, a significant portion of the Company's total revenue has been
attributable to sales to a limited number of clients. In 1996, total revenue
from billings to each of the United States Transportation Command, Caterpillar
Inc., and BellSouth Telecommunications, Inc. accounted for more than 10% of the
Company's total revenue. In 1995, total revenue from billings to each of such
customers and U S WEST Communications, Inc. accounted for more than 10% of the
Company's total revenue. The Company expects to continue to derive a significant
portion of its revenue from a relatively limited number of major clients.
 
     In accordance with applicable accounting principles, the Company presents
revenue from related parties and cost of revenue from related parties as
separate line items in its statements of operations. Software license
 
                                       11
<PAGE>   12
 
revenue from related parties is not presented because it is not significant.
Related parties for these purposes include: U S West Communications, Inc., the
ultimate parent corporation of which has a representative on the Company's Board
of Directors, and Ford Motor Company, which holds approximately 8.9% of the
Company's Common Stock outstanding as of March 21, 1997. Because the Company's
business is characterized by significant customer concentration and relatively
large projects, the timing of performance for each client engagement can result
in significant variability in the Company's total revenue and total cost of
revenue from period to period; both revenue and cost of revenue from software
services from related parties have varied accordingly.
 
     Research and development expenses consist primarily of expenses for the
development of licensable software for sale as stand-alone products, rather than
development work performed in the course of client project engagements.
Development efforts with respect to TestBench represent investments in new or
updated functions or features. Research and development expenses have increased
as a percentage of total revenue and have remained a significant percentage of
software license revenue. Over the past five years, the Company has also
benefitted from the development of reusable software templates in the course of
performing engagements for clients. No software development costs were
capitalized in 1994, 1995 or 1996. Based on the Company's product development
process, technological feasibility is not established until completion of a
working model. Costs incurred by the Company between completion of the working
model and the point at which the product is ready for general release have been
insignificant in recent years.
 
RESULTS OF OPERATIONS
 
     The following table sets forth, for the periods indicated, the percentage
relationship to total revenue of certain items in the Company's consolidated
statement of operations.
 
<TABLE>
<CAPTION>
                                                                    YEAR ENDED DECEMBER 31
                                                                 -----------------------------
                                                                 1994        1995        1996
                                                                 -----       -----       -----
<S>                                                              <C>         <C>         <C>
Revenue:
  Software services-Unrelated parties.........................    53.0%       81.8%       84.6%
  Software services-Related parties...........................    37.2        12.6        10.3
                                                                 -----       -----       -----
     Total Software services..................................    90.2        94.4        94.9
  Software licenses...........................................     9.8         5.6         5.1
                                                                 -----       -----       -----
     Total revenue............................................   100.0       100.0       100.0
Costs and expenses:
  Cost of revenue-Unrelated parties...........................    38.4        53.1        56.1
  Cost of revenue-Related parties.............................    20.6         6.9         6.4
                                                                 -----       -----       -----
     Total cost of revenue....................................    59.0        60.0        62.5
  Research and development....................................     3.1         2.2         3.2
  Selling, general and administrative.........................    31.4        26.7        26.2
                                                                 -----       -----       -----
     Total costs and expense..................................    93.5        88.9        91.9
Income from operations........................................     6.5        11.1         8.1
Other income, net.............................................      --          --         2.2
                                                                 -----       -----       -----
Income before income taxes....................................     6.5        11.1        10.3
Income tax benefit............................................     1.6         7.1         1.5
Net income....................................................     8.1%       18.2%       11.8%
                                                                 -----       -----       -----
</TABLE>
 
  COMPARISON OF YEARS ENDED DECEMBER 31, 1996 AND DECEMBER 31, 1995.
 
     Revenue.  Total revenue was $28.4 million in 1996 compared to $25.7 million
in 1995, an increase of $2.7 million or 10.8%. This growth resulted principally
from volume increases in sales of software services.
 
     Total software services revenue was $27.0 million in 1996 compared to $24.2
million in 1995, an increase of $2.8 million or 11.4%. This increase was
primarily attributable to an extension of a logistics, planning and scheduling
engagement for a government industry client and the continuation of a customer
contact engagement for a client in the telecommunications industry. Revenue from
software services-unrelated parties was $24.0 million in 1996 compared to $21.0
million in 1995, an increase of $3.0 million or 14.6%. This
 
                                       12
<PAGE>   13
 
increase was primarily attributable to the extension of a logistics, planning
and scheduling engagement and of a customer interaction engagement, both of
which are described above. Revenue from software services-related parties was
$2.9 million in 1996 compared to $3.2 million in 1995, a decrease of $.3 million
or 9.7%. This decrease was primarily attributable to the completion of customer
interaction engagements for a telecommunications industry client. Also, results
for 1996 were affected by the renegotiation of a fixed-price contract, which
resulted in engineers related to that contract being underutilized for a portion
of the year.
 
     Revenue from software licenses was unchanged at $1.4 million in 1996
compared to $1.4 million in 1995.
 
     Cost of Revenue.  Cost of revenue consists primarily of salaries and
related benefits for personnel, and also includes an allocated portion of rent,
building services and computer equipment services and expenses. Total cost of
revenue was $17.8 million in 1996 compared to $15.4 million in 1995, an increase
of $2.4 million or 15.5 %. This increase was primarily attributable to
additional professional staff hired to perform the increased volume of software
services. Total cost of revenue was 62.5% of total revenue in 1996, compared to
60.0% of total revenue in 1995. This percentage increase was primarily
attributable to increased costs associated with the renegotiation of a
fixed-price contract for a telecommunications industry client. Cost of
revenue-unrelated parties was $15.9 million in 1996 compared to $13.6 million in
1995, an increase of $2.3 million or 17.1 %. This increase was primarily
attributable to additional professional staff hired or reassigned to perform the
increased volume of software services following the completion of customer
contact engagements for a telecommunications client. Also, as mentioned earlier,
the increased revenue from software services-unrelated parties for the extension
of a logistics, planning and scheduling engagement for a government industry
client required an increase in associated costs. Cost of revenue from software
services-related parties was $1.8 million in 1996 compared to $1.8 million in
1995.
 
     Research and Development.  Research and development expenses were $908,000
in 1996 compared to $568,000 in 1995, an increase of $340,000 or 59.9%. This
increase was primarily due to product development of various templates for the
services areas of the business.
 
     Selling, General and Administrative.  Selling, general and administrative
expenses include costs of proposal development and proposal writing, marketing
communications and advertising, sales and management staff and corporate
services functions, including accounting, human resources and legal services,
along with corporate executive staff. Selling, general and administrative
expenses were $7.4 million in 1996 compared to $6.9 million in 1995, an increase
of $.5 million or 8.5%. This dollar increase resulted primarily from increases
in sales and marketing expenses needed to support the Company's total revenue
growth along with increased insurance and professional services expenses related
to being a newly public company. These expenses decreased as a percentage of
total revenue from 26.7% in 1995 to 26.2% in 1996 as a result of lower Company
fixed costs as a percentage of total revenue.
 
     Other Income.  Total other income for 1996 was $627,000 compared to total
other income of $2,000 in 1995, an increase of $625,000. This increase was due
primarily to interest income earned on the net proceeds received in December
1995 from the Company's initial public offering, which were invested in an
interest-bearing account.
 
     Income Tax Benefit.  An income tax benefit of $432,000 was recorded in
1996. The effective income tax rate in 1996 was higher than the effective income
tax rate in 1995 due to changes in the amount of benefit recognized as a result
of the Company's current estimate of the deferred tax asset believed more likely
than not to be realized. See "Income Tax Considerations."
 
  COMPARISON OF YEARS ENDED DECEMBER 31, 1995 AND DECEMBER 31, 1994
 
     Revenue.  Total revenue was $25.7 million in 1995 compared to $17.9 million
in 1994, an increase of $7.8 million or 43.5%. This growth resulted principally
from volume increases in sales of software services.
 
     Total software services revenue was $24.2 million in 1995 compared to $16.1
million in 1994, an increase of $8.1 million or 50.3%. This increase was
primarily attributable to an extension of a logistics, planning and scheduling
engagement for a government industry client and the commencement of a customer
contact engagement for a new client in the telecommunications industry. Revenue
from software services-unrelated parties was $21.0 million in 1995 compared to
$9.5 million in 1994, an increase of $11.5 million or 121.5%. This increase was
primarily attributable to the extension of a logistics, planning and scheduling
engagement
 
                                       13
<PAGE>   14
 
and the commencement of a customer contact engagement, both of which are
described above. A portion of the increase was also attributable to the
enlargement of the scope of a customer services engagement for a manufacturing
industry client. Revenue from software services-related parties was $3.2 million
in 1995 compared to $6.6 million in 1994, a decrease of $3.4 million or 51.2%.
This decrease was primarily attributable to the completion of customer contact
engagements for a telecommunications industry client.
 
     Revenue from software licenses was $1.4 million in 1995 compared to $1.8
million in 1994, a decrease of $400,000 or 18.6%. This decrease was attributable
to a decrease in revenue from licenses of the Company's TestBench template.
 
     Cost of Revenue.  Cost of revenue consists primarily of salaries and
related benefits for personnel, and also includes an allocated portion of rent,
building services and computer equipment services and expenses. Total cost of
revenue was $15.4 million in 1995 compared to $10.5 million in 1994, an increase
of $4.9 million or 45.9%. This increase was primarily attributable to additional
professional staff hired to perform the increased volume of software services.
Total cost of revenue was 60.0% of total revenue in 1995, compared to 59.0% of
total revenue in 1994. This percentage increase was primarily attributable to
lower levels of higher margin software license revenue and increased costs
associated with the commencement of an engagement for a new client. Cost of
revenue-unrelated parties was $13.6 million in 1995 compared to $6.9 million in
1994, an increase of $6.7 million or 98.3%. This increase was primarily
attributable to additional professional staff hired or reassigned to perform the
increased volume of software services. Cost of revenue-related parties was $1.8
million in 1995 compared to $3.7 million in 1994, a decrease of $1.9 million or
52.1%. This decrease was primarily attributable to the reallocation of
professional staff to provide additional software services to unrelated parties
following the completion of customer contact engagements for a
telecommunications industry client.
 
     Research and Development.  Research and development expenses were $568,000
in 1995 compared to $548,000 in 1994, an increase of $20,000 or 3.6%. This
increase was primarily due to product development related to the TestBench
template.
 
     Selling, General and Administrative.  Selling, general and administrative
expenses include costs of proposal development and proposal writing, marketing
communications and advertising, sales and management staff and corporate
services functions, including accounting, human resources and legal services,
along with corporate executive staff. Selling, general and administrative
expenses were $6.9 million in 1995 compared to $5.6 million in 1994, an increase
of $1.3 million or 21.9%. This dollar increase resulted primarily from increases
in sales and marketing expenses to support growth in the Company's total
revenue. These expenses decreased as a percentage of total revenue from 31.4% in
1994 to 26.7% in 1995 as a result of lower Company fixed costs as a percentage
of total revenue.
 
     Income Tax Benefit.  An income tax benefit of $1,827,000 was recorded in
1995. The effective income tax rate in 1995 was lower than the effective income
tax rate in 1994 as a result of the Company's current estimate of the deferred
tax asset believed more likely than not to be realized. See "Income Tax
Considerations."
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The Company has funded its operations in recent years primarily through
cash generated from operations and the use of cash reserves. In 1995 the Company
also funded its operations in part through borrowing under available lines of
credit and through the net proceeds of the initial public offering of its Common
Stock. There were no borrowings in 1996.
 
     During 1996, the Company had net income of $3.4 million and had a net
generation of cash of $2.3 million. The net generation of cash was primarily
attributable to $3.2 million from operations.
 
     The Company has experienced growth in revenue earned but not yet billed
when comparing the year ended December 31, 1996 to the year ended December 31,
1995. Invoicing of amounts to clients generally occurs within 45 days of time
and materials cost occurrence, unless a specific schedule is agreed upon, and
payment follows invoicing in accordance with customary terms. The Company has
not experienced any significant write-downs of receivables, nor does the Company
expect that the payments are doubtful; accordingly, the Company has not made an
allowance for doubtful accounts.
 
                                       14
<PAGE>   15
 
     Advanced billings and deferred revenue increased at December 31, 1996 when
compared to the year ended December 31, 1995. Advanced billings and deferred
revenue balances normally will change from period to period. Any increase would
reflect billings in advance of revenue earned, but which were billed in
accordance with established or agreed billings schedules. These amounts are
recorded as deferred revenue until earned. The timing and magnitude of such
advance billings vary from contract to contract and from client to client.
 
     The Company has a committed line of credit agreement in the amount of $3.5
million in place with PNC Bank, N.A. (the "Bank"). No borrowings were
outstanding against the committed line of credit at December 31, 1996 and
December 31, 1995. Borrowings under this agreement are collateralized by
accounts receivable. This line of credit bears interest at the Bank's prime
interest rate and the Bank charges a 0.15% fee per annum on the unused portion
of that line of credit. The Bank's prime interest rate at December 31, 1996 was
8 1/4% compared to 8 1/2% at December 31, 1995.
 
     The Company believes that current cash balances, together with cash
generated from operations and borrowing available under its lines of credit,
will satisfy the Company's working capital and capital expenditure requirements
during fiscal year 1997 and the foreseeable period thereafter. In the longer
term, the Company may require additional sources of liquidity to fund future
growth. Such sources of liquidity may include additional equity offerings or
debt financings. Capital expenditures are typically made for computing
equipment, software, physical plant and furniture and fixtures in order to seek
enhancements in the productivity of the Company's employees and to support
growth.
 
     In the normal course of business, the Company evaluates acquisitions of
businesses, products and technologies that complement the Company's business.
The Company has no present plans, intentions, understandings, commitments or
agreements, nor is it currently engaged in any negotiations, with respect to any
such transaction. However, the Company may acquire businesses, products or
technologies in the future.
 
INCOME TAX CONSIDERATIONS
 
     At December 31, 1996, the Company had net operating loss carryforwards of
approximately $8.2 million available to reduce federal taxable income through
2008. If an "ownership change" were to occur, within the meaning of the Internal
Revenue Code of 1986, as amended, the utilization of net operating loss
carryforwards would be subject to an annual limitation. Generally, an "ownership
change" occurs with respect to a corporation if shareholders who own, directly
or indirectly, 5% or more of the capital stock of the corporation increase their
aggregate percentage ownership of such stock by more than 50 percentage points
over the lowest percentage of such stock owned by such shareholders at any time
during a prescribed testing period. If the annual limitation were to apply, the
amount of the limitation would equal the product of (i) the fair market value of
the Company's equity on the date of the ownership change, with certain
adjustments, including an adjustment to exclude capital contributions made in
the two years preceding the date of the ownership change and (ii) a long-term
tax exempt bond rate of return published monthly by the Internal Revenue
Service. Should the annual limitation apply, the Company believes that it would
affect the timing of the use of, but not the ultimate ability of the Company to
use, the net operating loss carryforwards to reduce future income tax
liabilities. The applicability of the limitation is not expected to affect the
income tax provision (benefit) reported for financial accounting purposes.
 
     SFAS No. 109, "Accounting for Income Taxes," requires a valuation allowance
when it is "more likely than not that some portion or all of the deferred tax
assets will not be realized." It further states that "forming a conclusion that
a valuation allowance is not needed is difficult when there is negative evidence
such as cumulative losses in recent years." The ultimate realization of its
deferred income tax asset depends on the Company's ability to generate
sufficient taxable income in the future. The Company has weighed the positive
evidence of sustained profitability over the last three years and future income
expectations within the Company's three-year strategic planning horizon against
the negative evidence of dependence upon a limited number of customers and other
uncertainties and has concluded that retaining a valuation allowance related to
net operating losses is no longer necessary at December 31, 1996.
 
     In estimating the amount of its realizable deferred tax asset, the Company
gives substantial weight to recent historical results. Significant changes in
circumstances or in enacted tax laws which affect the valuation allowance are
recorded when they occur. The Company's annual strategic business planning
process takes
 
                                       15
<PAGE>   16
 
place in the fourth quarter of the year, and the valuation allowance is adjusted
for future years' income expectations resulting from that process. When
preparing subsequent interim and annual financial statements, the Company
reevaluates whether there has been any significant change in the assumptions
underlying its plan and adjusts the valuation allowance as necessary. For
example, in the fourth quarter of 1996, 1995 and 1994, as a result of its annual
strategic business planning process, the Company reevaluated its future years'
income expectations and recorded a discrete income tax benefit as an adjustment
to the valuation allowance in each of those quarters.
 
OTHER
 
     SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than
Pensions," and SFAS No. 112, "Employers' Accounting for Postemployment
Benefits," did not affect the Company's financial position or results of
operations because the Company has not offered such benefits.
 
     SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets to be
Disposed of," became effective in 1996. The adoption of this standard did not
have a material effect on the results of operations or the financial position of
the Company.
 
     SFAS No. 123, "Accounting for Stock-Based Compensation," defines a fair
value based method of accounting for an employee stock option but allows
companies to continue recording compensation cost using currently accepted
measurement principles. Beginning in 1996, companies electing to continue using
currently accepted recognition principles are required to make pro forma
disclosures of net income as if the fair value based method of accounting had
been applied. Carnegie Group continues accounting for its stock-based employee
compensation plans under currently accepted recognition principles and has
presented the pro forma disclosures required under this statement in 1996.
Accordingly, the adoption of this statement had no affect on the results of
operations or financial position of Carnegie Group.
 
     Inflation is not expected to have a significant effect upon the Company's
business in the near future.
 
                            ------------------------
 
     In December 1995, Congress enacted the Private Securities Litigation Reform
Act of 1995 (the "Act"). The Act provides a "safe harbor" from liability in any
private action that is based on an alleged untrue statement of a material fact
or alleged omission of a material fact necessary to make the statement not
misleading. The Company wishes to take advantage of the "safe harbor" provided
by the Act. To the extent that any of the statements made herein may be deemed
to be forward-looking statements or to the extent that the Company or its
representatives may in the future be deemed to make oral forward-looking
statements, the following is a list of important factors, among others, that
could cause actual results to differ materially from those expressed in any such
forward-looking statements:
 
     Dependence Upon Limited Number of Clients.  The Company has derived in the
past, and expects to derive in the future, a significant portion of its revenue
from a relatively limited number of major clients. For example, approximately
83%, 87% and 80% of total software services revenue in the years ended December
31, 1996, 1995 and 1994, respectively, was derived from the Company's five
largest clients in each such period. In 1996, revenue from billings to each of
the United States Transportation Command, BellSouth Telecommunications, Inc. and
Caterpillar Inc. accounted for more than 10% of the Company's total revenue. In
1995, revenue from billings to each of such customers and U S WEST
Communications, Inc. accounted for more than 10% of the Company's total revenue.
The Company's business depends in large part upon its ability to establish and
maintain relationships with a limited number of large clients. The loss of, or
any significant reduction in the services provided to, any existing major
clients, or the failure of the Company to establish and maintain relationships
with new major clients, would have a material adverse effect on the Company's
business, financial position and results of operations.
 
     Project Risks.  Many of the Company's engagements involve projects which
are critical to the operations of its clients' businesses and which provide
benefits that may be difficult to quantify. Moreover, many of these engagements
are significant to the Company, in that each may represent a significant portion
of the Company's total revenue. For example, the Company's ten largest
engagements accounted for approximately 76%, 68%, and 56% of total software
services revenue in the years ended December 31, 1996, 1995 and 1994,
respectively. The Company's failure or inability to meet a client's expectations
in the performance of an
 
                                       16
<PAGE>   17
 
engagement could have a material adverse effect on the Company's business,
financial position and results of operations, including damage to the Company's
reputation that could adversely affect its ability to attract new business. In
addition, the Company's engagements generally are terminable by clients on short
or no notice. An unanticipated termination of a major engagement could require
the Company either to maintain under-utilized employees, resulting in a higher
than expected number of unassigned persons and concomitant lower utilization
rate, or to terminate such employees, resulting in higher severance expenses.
The Company must maintain a sufficient number of senior professionals to oversee
existing client engagements and to participate with the Company's sales force in
securing new client engagements; thus, professional staff expenses are
relatively fixed. Although the majority of the Company's contracts are performed
on a time-and-materials basis, some contracts are performed on a fixed-price
basis, exposing the Company to the risks of cost overruns and inflation.
 
     Variability of Quarterly Operating Results; Future Operating Results
Uncertain.  The Company has experienced significant quarterly and other
variations in revenue and operating results. Because the Company's business is
characterized by significant client concentration and relatively large projects,
the timing of performance for each client engagement can result in significant
variability in the Company's revenue and cost of revenue from quarter to
quarter. In addition, variations in the Company's revenue and operating results
occur as a result of a number of other factors, such as employee hiring and
utilization rates and the number of working days in a quarter. The timing of
revenue is difficult to forecast because the Company's sales cycle is relatively
long and may depend on factors such as the size and scope of assignments and
general economic conditions. Because a high percentage of the Company's
expenses, particularly employee compensation, are relatively fixed, a variation
in the timing of the initiation or completion of client engagements, especially
at or near the end of any quarter, can cause significant variations in operating
results from quarter to quarter and could result in quarterly losses. Future
revenue and operating results may vary as a result of these and other factors,
including the demand for the Company's services and solutions and the
competitive conditions in the industry. Moreover, much of the Company's revenue
from software licenses is realized upon the licensing of individual copies of
software, rather than in the course of a specific services engagement.
Accordingly, the timing of software license revenue can be difficult to predict
and may vary significantly from quarter to quarter. Many of the factors that
could result in quarterly variations are not within the Company's control. The
Company believes that quarter-to-quarter comparisons of its financial results
are not necessarily meaningful and should not be relied upon as an indication of
future performance.
 
     In addition, quarterly variations, together with the Company's dependence
upon a limited number of clients and the Company's experience of adverse
operating results in years prior to 1994, make it difficult for management to
engage in strategic planning that contemplates a horizon of more than three
years. Thus, income expectations beyond three years are viewed by management as
very uncertain, and management's assessment of its ability to realize its
deferred tax asset through future taxable income reflects this. The Company's
interim and annual financial statements include a valuation allowance that is
intended to reflect management's estimation, in light of these and other risk
factors, of the realizability of its deferred tax asset. In determining the
amount of the valuation allowance and the possible need to adjust that amount,
the Company weighs the negative evidence of its dependence upon a limited number
of clients and the other risks described herein, on the one hand, against the
positive evidence of recent results and future expectations over its three-year
planning horizon, on the other hand. The Company then adjusts the valuation
allowance to reflect the portion of the deferred tax asset that the Company
believes it will, more likely than not, be unable to realize. The valuation
allowance reflects that the Company does not believe, that it is more likely
than not to realize certain deferred tax assets.
 
     Dependence on Key Management Personnel.  The Company's success depends in
significant part upon the retention of key senior management and technical
personnel. The Company does not have employment agreements with any of its
personnel other than Dennis Yablonsky, its President and Chief Executive
Officer, nor does it maintain key man life insurance on any of its personnel.
The loss of one or more of its key management employees or the inability to
attract and retain other qualified management employees could have a material
adverse effect on the Company's business, financial position and results of
operations.
 
     Attraction and Retention of Employees.  Carnegie Group's business involves
the delivery of software development services and is labor-intensive. The
Company's success depends in large part upon its ability to
 
                                       17
<PAGE>   18
 
attract, retain and motivate highly skilled employees, particularly project
managers, sales and marketing personnel, engineers and other senior personnel.
Qualified project managers and engineers are in particularly great demand and
are likely to remain a limited resource in the foreseeable future. Although the
Company expects to continue to attract sufficient numbers of highly skilled
employees and to retain existing project managers, sales and marketing
personnel, engineers and other senior personnel for the foreseeable future,
there can be no assurance that the Company will be able to do so. The Company,
like others in the information technology services industry, is subject to a
relatively high annual rate of turnover in personnel. The loss of project
managers, sales and marketing personnel, engineers and other senior personnel
could have a material adverse effect on the Company's business, financial
position and results of operations, including its ability to secure and complete
engagements. No project managers, sales and marketing personnel, engineers or
other senior personnel have entered into employment agreements, other than
Dennis Yablonsky, the Company's President and Chief Executive Officer.
 
     Management of Growth.  Carnegie Group is currently experiencing a period of
growth which has placed, and could continue to place, a strain on the Company's
financial and other resources. The Company was founded in 1983 by computer
scientists at Carnegie Mellon University in Pittsburgh, Pennsylvania. The
Company was initially funded through equity investments and technology alliances
with Digital Equipment Corporation, Generale de Service Informatique, The Boeing
Company, Texas Instruments Incorporated, Ford Motor Company and U S WEST, Inc.
From January 1, 1994 through December 31, 1996, the size of the Company's staff
increased from 124 to 238 employees and independent contractors. In addition,
the Company has opened offices in Atlanta, Georgia and Fairview Heights,
Illinois since January 1, 1995. In order to manage any further growth in its
staff and facilities, the Company must continue to improve its operational,
financial and other internal systems, and to attract, train, motivate and manage
its personnel. If the Company is unable to manage growth effectively and new
personnel are unable to achieve anticipated performance levels, the Company's
business, financial position and results of operations would be adversely
affected.
 
     Competition.  The information technology services market includes a large
number of participants, is subject to rapid change and is highly competitive.
The Company competes with and faces potential competition for client assignments
and experienced personnel from a number of companies that have significantly
greater financial, technical and marketing resources and greater name
recognition. Primary competitors include: the consulting practices of the "Big
Six" accounting firms; systems consulting and integration firms such as American
Management Systems, Inc. and Cambridge Technology Partners, Inc.; and the
professional services groups of large companies, such as International Business
Machines Corporation, Digital Equipment Corporation and AT&T Corporation. In
addition, clients may elect to use their internal information systems resources
to satisfy their needs for software development, systems integration and
technical consulting services, rather than using those services offered by the
Company. The Company also faces competition from organizations providing
outsourcing services to the information systems departments of existing and
potential clients. In addition, the information technology services market is
highly fragmented and is served by numerous firms; some of these firms compete
nationally and internationally, while others serve only their respective local
markets. While the Company has not experienced competition from foreign
providers of information technology services, there can be no assurance that the
Company will not experience such competition in the future. Carnegie Group has
targeted, and expects to continue to target, industries that are characterized
by business areas (such as customer interaction, and logistics, planning and
scheduling) to which the Company's services and technology are particularly
well-suited, and by participants who possess the financial resources and scale
of operations necessary to support the engagement of service providers such as
the Company. A growing number of professional services firms are seeking
engagements from that same client group. The Company believes that the principal
competitive factors in the information technology services industry include the
nature of the service offering, quality of service, timeliness, responsiveness
to client needs, experience with the client's industry and competitive
environment, technical expertise, access to replicable technology, such as
software templates, and price. The Company believes that its ability to compete
also depends in part upon a number of competitive factors outside its control,
including: the ability of its competitors to hire, retain and motivate project
managers, sales and marketing personnel and engineers; competitors' ownership of
or access to software and technology used by potential clients; the development
by others of software that is competitive with the Company's solutions and
services; the price at which others offer comparable services; and the extent of
competitors' responsiveness to customer needs.
 
                                       18
<PAGE>   19
 
     Developing Market; Technological Advances.  The market for client/server
software development services is continuing to develop. The Company's success is
dependent in part upon the acceptance of information processing systems
utilizing client/server architectures. While the Company believes that
corporations and government agencies will continue to accept the use of
client/server architectures, a decline in this trend could have a material
adverse effect on the Company's business, financial position and results of
operations. The Company's success will also depend in part on its ability to
develop software solutions that incorporate and keep pace with continuing
changes in advanced software technologies, evolving industry standards and
changing client preferences. There can be no assurance that the Company will be
successful in adequately addressing these developments on a timely basis or
that, if these developments are addressed, the Company will be successful in the
marketplace. The Company's failure to address these developments could have a
material adverse effect on the Company's business, financial position and
results of operations. In addition, there can be no assurance that products or
technologies developed by others will not render the Company's services
uncompetitive or obsolete.
 
     Intellectual Property Rights.  The Company's success is dependent in part
upon reusable software templates and other intellectual property. The Company's
business includes the development of custom software solutions in connection
with specific client engagements. Ownership of certain custom components of such
software is generally assigned to the client. The Company has licensed through
December 1997 certain custom software components developed in the course of an
engagement for a client. In addition, the Company also develops core software
technology and reusable software templates, often in the course of engagements
for clients, as well as object-oriented software components and certain software
"tools," which can be reused in software application development and which
generally remain the property of the Company.
 
     The Company relies upon a combination of patent, trade secret,
non-disclosure and other contractual arrangements, and patent, copyright and
trademark laws, to protect its proprietary rights and the proprietary rights of
third parties from whom the Company licenses intellectual property. The Company
enters into confidentiality agreements with its employees, consultants, clients
and potential clients and limits access to and distribution of proprietary
information. There can be no assurance that the steps taken by the Company in
this regard will be adequate to deter misappropriation of proprietary
information or that the Company will be able to detect unauthorized use and take
appropriate steps to enforce its intellectual property rights.
 
     Although the Company believes that its services and solutions (including
its reusable software templates) do not infringe on the intellectual property
rights of others and that it has all rights necessary to utilize the
intellectual property employed in its business, the Company is subject to the
risk of litigation alleging infringement of third party intellectual property
rights. There can be no assurance that third parties (including the parties for
whom the Company has been engaged to develop solutions, from which its reusable
software templates have been derived) will not assert infringement claims
against the Company in the future with respect to intellectual property utilized
by the Company now or in the future. Any such claims could require the Company
to expend significant sums in litigation, pay damages, develop non-infringing
intellectual property or acquire licenses to the intellectual property which is
the subject of asserted infringement.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
 
                                       19
<PAGE>   20
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To the Board of Directors
and Stockholders of Carnegie Group, Inc.
 
     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, of stockholders' equity and of
cash flows present fairly, in all material respects, the financial position of
Carnegie Group, Inc. and its subsidiaries (the Company) at December 31, 1994,
1995 and 1996, and the results of their operations and their cash flows for the
years then ended in conformity with generally accepted accounting principles.
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 conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.
 
Price Waterhouse LLP
 
Pittsburgh, Pennsylvania
February 3, 1997
 
                                       20
<PAGE>   21
 
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
 
                        DECEMBER 31, 1994, 1995 AND 1996
 
<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                   ----------------------------------------------
                                                       1994             1995             1996
                                                   ------------     ------------     ------------
<S>                                                <C>              <C>              <C>
                                             ASSETS
CURRENT ASSETS:
Cash and cash equivalents.......................   $    915,237     $ 12,394,588     $ 14,691,765
Accounts receivable (Note 3)....................      3,256,054        5,131,922        2,751,316
Accounts receivable from related parties (Notes
  3 and 10).....................................      1,137,149           76,296          769,223
Accounts receivable--unbilled (Note 3)..........        517,550        2,048,609        3,660,765
Accounts receivable related parties--unbilled
  (Notes 3 and 10)..............................        600,924           87,690          188,302
Deferred income taxes (Note 11).................         90,968        1,222,061        2,179,426
Other current assets............................        189,294          397,883          403,508
                                                   ------------     ------------     ------------
       Total current assets.....................      6,707,176       21,359,049       24,644,305
                                                   ------------     ------------     ------------
Property and equipment, net of accumulated
  depreciation and amortization (Note 4)........      1,252,050        1,812,894        2,046,415
Deferred income taxes (Note 11).................        922,524        1,779,792        1,775,480
Other assets....................................         61,040           36,900           23,055
                                                   ------------     ------------     ------------
       Total assets.............................   $  8,942,790     $ 24,988,635     $ 28,489,255
                                                   ============     ============     ============
 
                              LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Trade accounts payable..........................   $  1,158,088     $  1,107,592     $    614,458
Payables to related parties (Note 10)...........        571,212          967,673        1,034,608
Accrued compensation............................      1,085,504        1,130,479          706,965
Advance billings and deferred revenue...........        898,985          537,541        1,101,221
Accrued rent (Note 5)...........................        695,014          626,253          538,641
Other accrued liabilities.......................        194,727          801,544          821,752
Obligations under capital leases--current
  portion (Note 5)..............................         48,691           48,691           33,242
                                                   ------------     ------------     ------------
       Total current liabilities................      4,652,221        5,219,773        4,850,887
                                                   ------------     ------------     ------------
Obligations under capital leases--noncurrent
  portion (Note 5)..............................         90,193           39,671               --
                                                   ------------     ------------     ------------
       Total liabilities........................      4,742,414        5,259,444        4,850,887
                                                   ------------     ------------     ------------
STOCKHOLDERS' EQUITY (NOTES 7 AND 8):
Common stock, $.01 par value; 20,000,000 shares
  authorized, 4,755,870, 6,386,200, and
  6,512,038 shares issued at December 31, 1994,
  1995, and 1996, respectively..................         47,559           63,862           65,120
Capital in excess of par value..................     19,999,834       30,836,317       31,384,080
Accumulated deficit.............................    (15,372,017)     (10,695,988)      (7,335,832)
Treasury stock, 190,000 shares at December 31,
  1994, 1995, and 1996 (at cost)................       (475,000)        (475,000)        (475,000)
                                                   ------------     ------------     ------------
       Total stockholders' equity...............      4,200,376       19,729,191       23,638,368
                                                   ------------     ------------     ------------
Commitments (Note 5)............................             --               --               --
                                                   ------------     ------------     ------------
       Total liabilities and stockholders'
          equity................................   $  8,942,790     $ 24,988,635     $ 28,489,255
                                                   ============     ============     ============
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       21
<PAGE>   22
 
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
                 YEARS ENDED DECEMBER 31, 1994, 1995, AND 1996
 
<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                      -------------------------------------------
                                                         1994            1995            1996
                                                      -----------     -----------     -----------
<S>                                                   <C>             <C>             <C>
Revenue (Notes 9 and 10):
  Software services--Unrelated parties.............   $ 9,468,433     $20,972,461     $24,039,258
  Software services--Related parties...............     6,647,986       3,245,219       2,931,565
                                                      -----------     -----------     -----------
       Total software services.....................    16,116,419      24,217,680      26,970,823
  Software licenses................................     1,759,037       1,432,628       1,438,225
                                                      -----------     -----------     -----------
       Total revenue...............................    17,875,456      25,650,308      28,409,048
                                                      -----------     -----------     -----------
Costs and expenses:
  Cost of revenue--Unrelated parties...............     6,869,140      13,618,798      15,948,615
  Cost of revenue--Related parties.................     3,671,653       1,757,072       1,810,554
                                                      -----------     -----------     -----------
       Total cost of revenue.......................    10,540,793      15,375,870      17,759,169
  Research and development.........................       547,926         567,710         907,976
  Selling, general and administrative..............     5,627,878       6,859,608       7,441,487
                                                      -----------     -----------     -----------
       Total costs and expenses....................    16,716,597      22,803,188      26,108,632
                                                      -----------     -----------     -----------
Income from operations.............................     1,158,859       2,847,120       2,300,416
Other income (expense):
  Interest income..................................         8,768          58,660         617,764
  Other income.....................................        25,465          24,447          27,428
  Interest expense.................................       (31,590)        (81,124)        (17,665)
                                                      -----------     -----------     -----------
       Total other income..........................         2,643           1,983         627,527
                                                      -----------     -----------     -----------
Income before income taxes.........................     1,161,502       2,849,103       2,927,943
Income tax benefit (Note 11).......................       277,350       1,826,926         432,213
                                                      -----------     -----------     -----------
       Net income..................................   $ 1,438,852     $ 4,676,029     $ 3,360,156
                                                      ===========     ===========     ===========
Earnings per share of common stock.................   $       .25     $       .82     $       .47
                                                      ===========     ===========     ===========
Weighted average number of common shares
  outstanding......................................     5,717,494       5,686,456       7,101,389
                                                      ===========     ===========     ===========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       22
<PAGE>   23
 
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
 
<TABLE>
<CAPTION>
                                                CAPITAL
                                   COMMON      IN EXCESS       TREASURY     ACCUMULATED        NOTE
                                    STOCK     OF PAR VALUE      STOCK         DEFICIT       RECEIVABLE       TOTAL
                                   -------    ------------    ----------    ------------    ----------    -----------
<S>                                <C>        <C>             <C>           <C>             <C>           <C>
Balance at December 31, 1993....   $47,558    $ 19,999,789    $       --    $(16,810,869)   $ (475,000)   $ 2,761,478
1994:
  Exercise of stock options-- 40
    shares at $1.15 per share...        1               45            --              --            --             46
  Cancellation of note
    receivable in exchange for
    190,000 shares (Note 7).....       --               --      (475,000)             --       475,000             --
  Net income....................       --               --            --       1,438,852            --      1,438,852
                                   -------     -----------     ---------     -----------     ---------    -----------
Balance at December 31, 1994....   47,559       19,999,834      (475,000)    (15,372,017)           --      4,200,376
                                   -------     -----------     ---------     -----------     ---------    -----------
1995:
  Exercise of stock options--
    130,330 shares at
    $1.25-$5.625 per share......    1,303          463,974            --              --            --        465,277
  Initial Public Offering--
    1,500,000 shares at $8.00
    per share (less issuance
    costs)......................   15,000       10,372,509            --              --            --     10,387,509
  Net income....................       --               --            --       4,676,029            --      4,676,029
                                   -------     -----------     ---------     -----------     ---------    -----------
Balance at December 31, 1995....   63,862       30,836,317      (475,000)    (10,695,988)           --     19,729,191
                                   -------     -----------     ---------     -----------     ---------    -----------
1996:
  Exercise of stock options--
    123,847 shares at
    $1.15-$5.00 per share.......    1,238          359,593            --              --            --        360,831
  Issuance of common stock under
    employee stock purchase
    plan........................       20           15,887            --              --            --         15,907
  Income tax benefit from stock
    option plan activity........       --          196,863            --              --            --        196,863
  Initial Public Offering
    costs.......................       --          (24,580)           --              --            --        (24,580)
  Net Income....................       --               --            --       3,360,156            --      3,360,156
                                   -------     -----------     ---------     -----------     ---------    -----------
Balance at December 31, 1996....   $65,120    $ 31,384,080    $ (475,000)   $ (7,335,832)   $       --    $23,638,368
                                   =======     ===========     =========     ===========     =========    ===========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       23
<PAGE>   24
 
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
 
<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                      -------------------------------------------
                                                         1994            1995            1996
                                                      -----------     -----------     -----------
<S>                                                   <C>             <C>             <C>
Cash flows from operating activities:
  Net income.......................................   $ 1,438,852     $ 4,676,029     $ 3,360,156
  Adjustments to reconcile net income to net cash
     (used in) provided by operating activities:
       Depreciation and amortization...............       568,602         704,312         982,208
       (Gain) loss on the sale of fixed assets.....        (4,500)          2,176          (1,833)
       Deferred income taxes.......................      (311,350)     (1,988,361)       (953,053)
       Changes in working capital component:
          Accounts receivable......................    (1,133,958)     (3,406,927)        768,450
          Accounts receivable--Related parties.....    (1,214,480)      1,574,087        (793,539)
          Other assets.............................      (108,827)       (184,449)          8,220
          Trade accounts payable...................       707,510         (50,496)       (493,134)
          Payables to related parties..............       216,207         396,461          66,935
          Accrued compensation.....................       633,546          44,975        (423,514)
          Accrued rent.............................        64,420         (68,761)        (87,612)
          Accrued restructuring charge.............      (340,500)             --              --
          Other accrued liabilities................      (192,240)        606,817         217,071
          Advance billings and deferred revenue
            .......................................       261,799        (361,444)        563,680
                                                      -----------     -----------     -----------
            Net cash provided by operating
               activities..........................       585,081       1,944,419       3,214,035
                                                      -----------     -----------     -----------
Cash flows from investing activities:
  Proceeds from the sales of fixed assets, net.....         4,500          18,420           4,585
  Capital expenditures.............................      (963,759)     (1,285,752)     (1,218,481)
                                                      -----------     -----------     -----------
            Net cash used in investing
activities.........................................      (959,259)     (1,267,332)     (1,213,896)
                                                      -----------     -----------     -----------
Cash flows from financing activities:
  Borrowings on line of credit.....................     2,025,000       5,125,000              --
  Repayments on line of credit.....................    (2,025,000)     (5,125,000)             --
  Capital lease obligations incurred...............       159,802              --              --
  Principal payments under capital lease
     obligations...................................       (25,145)        (50,522)        (55,120)
  Proceeds from sales of common stock, net.........            46      10,852,786         352,158
                                                      -----------     -----------     -----------
            Net cash provided by financing
               activities..........................       134,703      10,802,264         297,038
                                                      -----------     -----------     -----------
Net change in cash.................................      (239,475)     11,479,351       2,297,177
Cash and cash equivalents:
  Beginning of period..............................     1,154,712         915,237      12,394,588
  End of period....................................   $   915,237     $12,394,588     $14,691,765
                                                      ===========     ===========     ===========
Supplementary information:
  Cash paid during the period for income taxes.....   $    32,800     $    32,474     $   157,250
  Cash paid during the period for interest.........   $    31,590     $    63,358     $     5,667
</TABLE>
 
                      See Note 7 for noncash transaction.
 
   The accompanying notes are an integral part of these financial statements.
 
                                       24
<PAGE>   25
 
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1994, 1995 AND 1996
 
1. DESCRIPTION OF THE BUSINESS
 
     Carnegie Group, Inc. ("Carnegie Group" or the "Company") provides
     client/server software development services that integrate advanced
     user-centered, intelligent software technologies with clients' existing
     computing infrastructures to automate and enhance complex business
     processes. The Company performs business and technical consulting, custom
     software development, and systems integration services to improve clients'
     productivity and market position in two business areas: customer
     interaction; and logistics, planning, and scheduling. Within these areas,
     the Company targets its services to clients in the financial services,
     government, manufacturing and telecommunications industries.
 
2. SIGNIFICANT ACCOUNTING POLICIES
 
  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 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.
 
  PRINCIPLES OF CONSOLIDATION
 
     The consolidated financial statements include Carnegie Group, Inc., and its
     wholly owned subsidiaries, Carnegie Group Investments, Inc., Carnegie
     Investment Services, Inc., Carnegie Services, Inc., and Carnegie Federal
     Systems Corporation. All significant intercompany balances and transactions
     have been eliminated.
 
  REVENUE RECOGNITION
 
     Software services.  Revenue from software services contracts is recognized
     as time and material costs are incurred, or as project milestones or
     deliverables are met, and is adjusted using the percentage-of-completion
     method of accounting, as required. When a loss is anticipated for a
     software services contract, a provision for such loss is recorded in the
     period in which the loss becomes evident. The difference between
     contractual amounts billed in advance to customers and amounts recorded as
     revenue is included in advance billings. Amounts earned but not billed to
     the customer are included in accounts receivable.
 
     Software licenses.  Revenue from software licenses is recognized when a
     license agreement is executed, the client purchase order is received and
     the software is shipped to the customer. No significant vendor and
     post-contract support obligations remain at the time revenue is recognized.
     Revenue applicable to insignificant post-contract support is deferred and
     recognized ratably as the obligations are fulfilled. Revenue from customer
     support and training is recognized over the period in which the services
     are rendered.
 
  SOFTWARE DEVELOPMENT COSTS
 
     Certain internal development costs, primarily coding and testing of new
     products and enhancements to existing products, are capitalized after
     technological feasibility has been established. Capitalized software costs
     are amortized on a straight-line basis over the estimated useful life of
     each product, not to exceed five years, or the ratio of current revenue to
     the total of current and anticipated future revenue, whichever is the
     greater annual charge. Based on the Company's product development process,
     technological feasibility is not established until completion of a working
     model. Costs incurred by the Company between completion of the working
     model and the point at which the product is ready for general release have
     been insignificant in recent years. Accordingly, no software development
     costs were capitalized in 1994, 1995 or 1996.
 
                                       25
<PAGE>   26
 
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
     Research and development expenses consist primarily of expenses for the
     development of licensable software for sale as stand-alone products.
     Research and development costs, including software costs incurred prior to
     establishing technological feasibility, are expensed as incurred.
 
  CASH AND CASH EQUIVALENTS
 
     Cash equivalents consist of short-term interest-bearing deposits with
     original maturities of less than 90 days.
 
  CREDIT RISKS
 
     Financial instruments that subject the Company to concentrations of credit
     risks consist primarily of billed and unbilled receivables. The Company's
     clients are primarily involved in the financial services, government,
     manufacturing and telecommunications industries (Notes 3 and 9).
     Concentrations of credit risk with respect to billed and unbilled accounts
     receivable are limited due to the Company's credit evaluation process.
     Historically, the Company has not incurred any significant credit-related
     losses.
 
  PROPERTY AND EQUIPMENT
 
     Properties are recorded at cost. Equipment under capital lease is recorded
     at the lower of fair market value or the present value of future minimum
     lease payments. For financial reporting purposes, depreciation and
     amortization are provided under the straight-line method over the estimated
     useful lives of the respective assets, which range up to 5 years but are
     primarily 3 years or less. The Company uses accelerated methods for income
     tax purposes.
 
  EMPLOYEE BENEFIT PLAN
 
     The Company has a Section 401(k) Savings Plan (the Plan). The Plan allows
     employees to contribute up to 20 percent of their annual compensation,
     subject to statutory limitations. Company contributions to the Plan are
     discretionary. No Company contributions have been made to the Plan through
     December 31, 1996.
 
  INCOME TAXES
 
     The Company accounts for income taxes in accordance with Statement of
     Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income
     Taxes," which requires an asset and liability approach in accounting for
     income taxes. The asset and liability approach requires the recognition of
     deferred tax assets and liabilities for the expected future tax
     consequences of temporary differences between carrying amounts and the tax
     bases of all assets and liabilities.
 
  PER SHARE AMOUNTS
 
     All share and per share data have been adjusted to give effect to the 2:5
     "reverse" stock split of the Company's common stock which became effective
     on September 18, 1995 (Note 7). An initial public offering of common stock
     was consummated on December 4, 1995. Pursuant to Securities and Exchange
     Commission staff accounting guidance, all common share equivalents issued
     subsequent to September 18, 1994 (using the initial public offering price
     of $8.00 per share for purposes of applying the treasury stock method)
     through September 30, 1995 (the interim period included in the initial
     public offering prospectus) have been included in the calculation of common
     shares outstanding as if they were outstanding for all periods for which
     net income or loss per share is presented.
 
     Earnings per share amounts are based on weighted average shares
     outstanding. Stock options are dilutive in the years 1994, 1995 and 1996
     and are included as share equivalents using the treasury stock method.
 
  STOCK-BASED COMPENSATION
 
     Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting
     for Stock-Based Compensation," encourages, but does not require companies
     to record compensation cost for stock-based
 
                                       26
<PAGE>   27
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
     employee compensation plans at fair value. The Company has chosen to
     continue to account for stock-based compensation using the intrinsic value
     method prescribed in Accounting Principles Board Opinion No. 25 (APBO 25) ,
     "Accounting for Stock Issued to Employees," and related Interpretations.
     Accordingly, compensation cost for stock options is measured as the excess,
     if any, of the quoted market price of the Company's stock at the date of
     the grant over the amount an employee must pay to acquire the stock. Refer
     to Note 8.
 
3. ACCOUNTS RECEIVABLE
 
     Accounts receivable are as follows:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                     ----------------------------------------
                                                        1994           1995           1996
                                                     ----------     ----------     ----------
    <S>                                              <C>            <C>            <C>
    U.S. government agencies:
         Billed...................................   $1,164,014     $  277,060     $  663,877
         Unbilled.................................      264,328        946,192      2,269,340
    Telecommunications companies, including
      $1,623,660, $64,932 and $852,122 from
      related parties
         Billed...................................    1,623,660      1,315,904      1,066,187
         Unbilled.................................      837,517        347,077        241,182
    Other trade receivables, including $114,413,
      $99,054 and $105,402 from related parties
         Billed...................................    1,605,529      3,615,254      1,790,475
         Unbilled.................................       16,629        843,030      1,338,545
    Allowance for doubtful accounts...............           --             --             --
                                                     ----------     ----------     ----------
                                                     $5,511,677     $7,344,517     $7,369,606
                                                     ==========     ==========     ==========
</TABLE>
 
     Revenue earned but not yet billed to customers is generally billed to
     customers within 45 days of time and material cost incurrence unless a
     specific billing schedule is agreed. Retainage and claims are not
     significant.
 
4. PROPERTY AND EQUIPMENT
 
     Property and equipment are as follows:
<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                 ----------------------------------------------------------------------------
     <S>                         <C>           <C>          <C>           <C>          <C>           <C>
                                          1994                       1995                       1996
                                 ----------------------     ----------------------     ----------------------
 
<CAPTION>
                                   OWNED        LEASED        OWNED        LEASED        OWNED        LEASED
                                 ----------    --------     ----------    --------     ----------    --------
     <S>                         <C>           <C>          <C>           <C>          <C>           <C>
     Equipment (primarily
       computer equipment)....   $5,950,055    $130,839     $7,055,000    $     --     $8,124,460    $     --
     Furniture and fixtures...    1,237,617     419,494      1,430,806     419,494      1,541,005     419,494
     Other....................      119,740          --        210,758          --        244,604          --
                                 ----------    --------     ----------    --------     ----------    --------
                                  7,307,412     550,333      8,696,564     419,494      9,910,069     419,494
     Less--Accumulated
       depreciation and
       amortization...........    6,204,774     400,921      6,975,381     327,783      7,897,505     385,643
                                 ----------    --------     ----------    --------     ----------    --------
                                 $1,102,638    $149,412     $1,721,183    $ 91,711     $2,012,564    $ 33,851
                                 ==========    ========     ==========    ========     ==========    ========
</TABLE>
 
     There were no significant operating leases other than leases for office
space (see Note 5).
 
     Depreciation expense for the years ended December 31, 1994, 1995 and 1996,
     was $527,244 $646,608, and $924,347 respectively.
 
                                       27
<PAGE>   28
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
     For the years ended December 31, 1994, 1995 and 1996, amortization expense
     was $41,358, $57,704, and $57,861 respectively.
 
5. COMMITMENTS
 
     The Company leases office space in Pittsburgh, Pennsylvania, under an
     agreement that provides for escalating rent. Rent expense is normalized
     over the term of the lease which expires in December 1999. The difference
     between cash payments and rent expense is carried as accrued rent.
 
     Future minimum lease payments under noncancelable operating leases and
     capital leases as of December 31, 1996, are as follows:
 
<TABLE>
<CAPTION>
                                                                 OPERATING      CAPITAL
                                                                 ----------     -------
        <S>                                                      <C>            <C>
        1997..................................................   $1,721,963     $34,346
        1998..................................................    1,603,158          --
        1999..................................................    1,345,853          --
                                                                 ----------     -------
        Total minimum lease payments..........................   $4,670,974      34,346
        Amount representing imputed interest..................                   (1,104)
                                                                                -------
        Present value of future minimum lease payments........                  $33,242
                                                                                =======
</TABLE>
 
     Minimum payments under operating leases have not been reduced by minimum
     sublease rentals of $292,242 due in the future under noncancelable
     subleases. The interest rate on the capitalized lease is 9.75%. Rent
     expense under operating leases was $1,239,602, $1,546,873, and $1,592,215,
     and receipts under subleases were $194,810, $288,821 and $286,105 during
     the periods ended December 31, 1994, 1995 and 1996, respectively.
 
6. BORROWINGS
 
     At December 31, 1994, the Company had a $2,500,000 line of credit
     agreement. At December 31, 1995, the line of credit increased to
     $3,000,000. Additionally, the Company had an agreement for a $500,000
     discretionary line of credit. The availability of those funds were subject
     to the lender's approval. Both the $3,000,000 committed line and the
     discretionary line expired on June 30, 1996.
 
     Effective July 1, 1996, the agreement was amended by extending the
     expiration date from June 30, 1996 to June 29, 1997 and increasing the
     committed line to $3,500,000, while eliminating the $500,000 discretionary
     amount. Borrowings under this agreement are collateralized by accounts
     receivable. The line of credit bears interest at the bank's prime interest
     rate and the bank charges a 0.15% fee per annum on the unused portion of
     the line of credit. The line of credit agreement in place at December 31,
     1994 and 1995 bore interest at the bank's prime interest rate plus 0.75%,
     and the bank charged a 0.25% fee per annum on the unused portion. The
     bank's prime interest rate was 8.50%, 8.50% and 8.25% at December 31, 1994,
     1995 and 1996 respectively. There were no borrowings outstanding at
     December 31, 1994, 1995 or 1996.
 
7. STOCKHOLDERS' EQUITY
 
     In 1994, the Company accepted 190,000 shares of the Company's common stock
     from a former officer in order to satisfy a note receivable of $475,000.
     The note, which was originally received for purchase of the stock by the
     former officer, was due in 1994. Because the note receivable had been
     recorded by the Company as a reduction of stockholders' equity and its
     recorded balance approximated the fair value of the treasury shares
     acquired, this acquisition of treasury stock had no impact on the Company's
     net assets.
 
     On September 1, 1995, the Board of Directors authorized 5,000,000 shares of
     preferred stock, par value $.01 per share. Terms of any series of such
     preferred stock will be established by the Board of Directors at the time
     of issue.
 
                                       28
<PAGE>   29
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
8. STOCK OPTIONS
 
  1989 STOCK OPTION PLAN
 
     Incentive stock options granted under the Carnegie Group, Inc., 1989 Stock
     Option Plan expire 10 years from the date of grant, generally become
     exercisable over a four-year period and are adjusted pro forma for stock
     splits or dividends. All grants of incentive stock options under the plan
     are exercisable at prices that were at least 100% of the fair market value
     of the Company's common stock at the date of grant as determined by the
     Board of Directors. The plan provides that the payment for the shares may
     be in cash or by exchange of common stock previously held.
 
     In May 1992, the Company issued 4,000 nonqualified stock options under this
     plan to a newly elected member of the Board of Directors at an exercise
     price of $1.65 per share. The options become exercisable over a four-year
     period and expire on May 11, 2002. In March 1995, the Company issued 2,000
     nonqualified stock options under the plan to the same member of the Board
     of Directors at an exercise price of $4.65 per share. The options become
     exercisable over a four-year period and expire on March 6, 2005.
 
     The following table summarizes activity under the plan:
 
<TABLE>
<CAPTION>
                                                                     OPTIONS
                                                    AVAILABLE       GRANTED &       WEIGHTED AVERAGE
                                                    FOR GRANT      OUTSTANDING       EXERCISE PRICE
                                                    ----------     ------------     ----------------
        <S>                                         <C>            <C>              <C>
        Balance, December 31, 1993...............     178,920         761,870            $ 4.09
        Granted..................................     (44,408)         44,408            $ 1.20
        Exercised................................          --             (40)           $ 1.25
        Forfeitures..............................      28,756         (28,756)           $ 3.13
                                                      -------         -------
        Balance, December 31, 1994...............     163,268         777,482            $ 3.96
        Granted..................................     (43,060)         43,060            $ 4.65
        Exercised................................          --         (56,170)           $ 3.53
        Forfeitures..............................      12,530         (12,530)           $ 3.53
                                                      -------         -------
        Balance, December 31, 1995...............           *         751,842            $ 4.04
        Granted..................................          --              --            $   --
        Exercised................................          --         (94,793)           $ 4.19
        Forfeitures..............................          --          (7,408)           $ 2.08
                                                      -------         -------
        Balance, December 31, 1996...............           *         649,641            $ 4.15
                                                                      =======
</TABLE>
 
        -----------------
 
        * See additional discussion below regarding the termination of the 1989
          stock option plan.
 
     At December 31, 1996, options to purchase 613,125 shares of the Company's
     common stock were exercisable under this plan.
 
     On February 7, 1995, the Board of Directors determined the estimated fair
     market value of the stock to be $4.65 per share. During 1995, options to
     acquire 43,060 shares were granted at this exercise price.
 
     NONQUALIFIED STOCK OPTIONS:  On September 30, 1985, in exchange for a
     six-month personal guarantee of a line of credit to the Company from a
     bank, an individual was granted an option to purchase 40,000 shares of
     common stock exercisable over a 10-year period at a price of $5.625 per
     share. The option was exercised on September 29, 1995.
 
     Not included in the table above are 108,000 nonqualified stock options
     (which do not qualify under Section 422A of the Internal Revenue Code),
     which were granted in August 1987, as part of the employment agreement with
     an officer, at an exercise price of $0.025 per share. These options became
     exercisable immediately upon grant, and all of these options are currently
     outstanding.
 
                                       29
<PAGE>   30
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
  LONG-TERM INCENTIVE STOCK OPTION PLAN
 
     In 1991, the Company implemented the Carnegie Group, Inc. Long-Term
     Incentive Stock Option Plan to provide an incentive for the Company's key
     management employees to achieve long-term corporate objectives.
 
     The options under the Long-Term Incentive Plan become exercisable on
     September 29, 2001, subject to an acceleration clause. Each year,
     acceleration can be awarded based on predetermined Company performance
     criteria and individual performance criteria set by the Compensation
     Committee of the Board of Directors. Within 90 days after the previous
     year, the Committee determines the number of shares (allotted shares) to be
     accelerated for exercise, if any. Options subject to acceleration will
     become exercisable over a two-year period, with one-third becoming
     exercisable immediately upon the determination date and the remaining
     two-thirds becoming exercisable on each anniversary of the determination
     date.
 
     In October 1991, under this plan, 662,000 shares were granted to 16 key
     management employees at an option price of $1.25, which was the
     Board-determined fair market value at the date of grant.
 
     The following table summarizes activity under the plan:
 
<TABLE>
<CAPTION>
                                                                     OPTIONS
                                                    AVAILABLE       GRANTED &       WEIGHTED AVERAGE
                                                    FOR GRANT      OUTSTANDING       EXERCISE PRICE
                                                    ----------     ------------     ----------------
        <S>                                         <C>            <C>              <C>
        Balance, December 31, 1993...............     149,840         512,160            $ 1.25
                                                      -------         -------
        Balance, December 31, 1994...............     149,840         512,160            $ 1.25
        Granted..................................     (24,000)         24,000            $ 4.65
        Exercised................................          --         (34,160)           $ 1.25
                                                      -------         -------
        Balance, December 31, 1995...............           *         502,000            $ 1.45
        Granted..................................          --              --            $   --
        Exercised................................          --         (29,054)           $ 1.25
        Forfeitures..............................          --         (19,706)           $ 1.25
                                                      -------         -------
        Balance, December 31, 1996...............           *         453,240            $ 1.43
                                                                      =======
</TABLE>
 
        -----------------
 
        * See additional discussion below regarding the termination of the long
          term incentive stock option plan.
 
     Of the total options outstanding as of December 31, 1996, the number of
     shares subject to accelerated exercise was 389,116 and 216,428 shares had
     become exercisable.
 
  1995 STOCK OPTION PLAN
 
     In 1995, the Company implemented the 1995 Stock Option Plan (1995 Stock
     Option Plan) under which stock option awards may be made to eligible
     employees of the Company. Awards to employees under the 1995 Stock Option
     Plan may take the form of incentive stock options or nonqualified stock
     options. The term of each option will be determined by the Board of
     Directors, but no option will be exercisable more than 10 years after the
     date of grant. The exercise price for incentive stock options must be at
     least equal to 100% of the fair market value of the common stock on the
     date of grant. The exercise price of nonqualified options will be
     determined by the Board of Directors at the time of grant. The maximum
     number of shares of common stock which may be issued or delivered and as to
     which awards may be granted under the 1995 Stock Option Plan is 800,000
     shares. In 1995, the Board of Directors terminated the 1989 Stock Option
     and Long-Term Incentive Plans and directed that options under the plans
     which thereafter become available for grant (because outstanding options
     expire or terminate unexercised) will become available for award under the
     1995 Stock Option Plan.
 
                                       30
<PAGE>   31
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
     The following table summarizes activity under the plan:
 
<TABLE>
<CAPTION>
                                                                     OPTIONS
                                                    AVAILABLE       GRANTED &       WEIGHTED AVERAGE
                                                    FOR GRANT      OUTSTANDING       EXERCISE PRICE
                                                    ----------     ------------     ----------------
        <S>                                         <C>            <C>              <C>
        Balance, September 8, 1995...............      800,000             --                --
                                                      --------        -------
        Granted..................................     (436,000)       436,000            $ 8.00
        Forfeitures 1989 Plan....................        3,710             --            $   --
                                                      --------        -------
        Balance, December 31, 1995...............      367,710        436,000            $ 8.00
        Granted..................................      (69,500)        69,500            $ 9.22
        Exercised................................           --             --            $   --
        Forfeitures..............................       86,114        (59,000)           $ 8.06
                                                      --------        -------
        Balance, December 31, 1996...............      384,324        446,500            $ 8.18
                                                      ========        =======
</TABLE>
 
     At December 31, 1995, options to purchase 103,000 shares of the Company's
     stock were exercisable under this plan.
 
SUMMARY STOCK OPTION INFORMATION
 
     The Company applies APBO 25 and related interpretations in accounting for
     its three stock-based compensation plans. No compensation cost has been
     recognized for its stock option plans and its stock purchase plan. The pro
     forma data below reflects the effect had compensation cost for the
     Company's three stock-based compensation plans been determined based on the
     fair value at the grant dates for awards under those plans consistent with
     SFAS 123.
 
<TABLE>
<CAPTION>
                                                                       1995           1996
                                                                    ----------     ----------
        <S>                      <C>                                <C>            <C>
        Net Income               As Reported....................    $4,676,029     $3,360,156
                                 Pro forma......................    $4,536,105     $2,411,481
        Earnings per share       As Reported....................    $      .82     $      .47
                                 Pro forma......................    $      .80     $      .34
</TABLE>
 
     The fair value of each option grant is estimated on the date of grant using
     the Black-Scholes option-pricing model with the following assumptions used
     for grants in 1995 and 1996: risk-free interest rates of 5.85 to 7.52
     percent and 5.68-6.97 percent; dividend yields of zero in both years;
     expected terms of 7.7-10.0 years and 9.7-10.0 years, and volatility (based
     on an analysis of "peer" companies) of 69.7 percent for both years.
 
     The following table summarizes information about stock options outstanding
     under all of the Company's stock option plans at December 31, 1996:
 
<TABLE>
<CAPTION>
                                              OPTIONS OUTSTANDING                              OPTIONS EXERCISABLE
                             ------------------------------------------------------     ---------------------------------
                                NUMBER        WEIGHTED-AVERAGE                             NUMBER
            RANGE OF         OUTSTANDING         REMAINING         WEIGHTED-AVERAGE     EXERCISABLE      WEIGHTED-AVERAGE
         EXERCISE PRICES     AT 12/31/96      CONTRACTUAL LIFE      EXERCISE PRICE      AT 12/31/96       EXERCISE PRICE
         ---------------     ------------     ----------------     ----------------     ------------     ----------------
         <S>                 <C>              <C>                  <C>                  <C>              <C>
           $1.15-$1.65           573,835            4.88                $ 1.25             342,901            $ 1.26
           $4.65-$5.00           529,046            2.64                $ 4.96             486,652            $ 4.99
           $7.13-$9.88           446,500            9.00                $ 8.18             103,000            $ 8.15
                               ---------                                                   -------
                               1,549,381                                                   932,553
                               =========                                                   =======
</TABLE>
 
     The weighted average fair values of options granted during 1995 under the
     1989 Stock Option Plan, the Long Term Incentive Stock Option Plan and the
     1995 Stock Option Plan were $3.65, $3.68 and $7.89, respectively. The
     weighted average fair value of options granted during 1996 under the 1995
     Stock Option Plan was $7.35.
 
                                       31
<PAGE>   32
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
  1995 EMPLOYEE STOCK PURCHASE PLAN
 
     In 1995, the Company implemented the 1995 Employee Stock Purchase Plan
     (1995 Stock Purchase Plan). Under the 1995 Stock Purchase Plan, eligible
     employees will have the opportunity to purchase up to an aggregate of
     200,000 shares of common stock. Shares of common stock purchased under the
     1995 Stock Purchase Plan will be paid for by payroll deductions. Each
     participant will be deemed to be granted purchase rights to acquire the
     whole number of shares of common stock that can be purchased with
     accumulated payroll deductions at an amount equal to 85% (or such higher
     amount as the Board of Directors may establish) of the fair market value of
     the common stock as of the offering commencement date (January 1, April 1,
     July 1 or October 1) or the offering termination date, whichever is less.
     Under the 1995 Stock Purchase Plan the Company sold 1,991 shares to
     employees during 1996 at 95% of the fair market value as of the offering
     commencement date. The 1995 Stock Purchase Plan is intended to be an
     "employee stock purchase plan" under section 423 of the Internal Revenue
     Code and noncompensatory under SFAS 123.
 
9. MAJOR CUSTOMERS
 
     For the years ended December 31, 1994, 1995, and 1996, clients who
     individually accounted for 10% or more of the Company's revenue were as
     follows:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                    -----------------------------------------
                                                       1994           1995           1996
                                                    ----------     ----------     -----------
        <S>                                         <C>            <C>            <C>
        Client A................................    $5,652,000     $2,769,000     $         *
        Client B................................     4,220,000      9,060,000      12,340,000
        Client C................................     2,339,000      3,787,000       3,340,000
        Client D................................             *      3,706,000       2,937,000
</TABLE>
 
        -----------------
 
       * Less than 10%
 
     Receivables from these clients were $3,481,244, $3,984,468 and $2,368,735
     at December 31, 1994, 1995 and 1996, respectively.
 
10. RELATED PARTIES
 
     The Company provides software services to four companies (Ford Motor
     Company, Digital Equipment Corporation, Texas Instruments Incorporated, and
     U S WEST Inc.) which have been significant stockholders of the Company; one
     of these companies has a representative on the Company's Board of
     Directors. Revenue from software services from these companies is reported
     as from related parties. U S WEST Inc. and Ford Motor Company are major
     customers (Note 9).
 
     The Company and Carnegie Mellon University, through its Center for Machine
     Translation, are parties to a License and Affiliate Agreement dated January
     31, 1991 (as amended, the License Agreement) and a Subcontract Agreement
     dated February 1, 1991 (as amended, the Subcontract Agreement). Carnegie
     Mellon University's Center for Machine Translation is headed by a director
     and stockholder of the Company. Under the License Agreement, Carnegie
     Mellon University granted to the Company several perpetual, non-exclusive,
     worldwide licenses, some of which are royalty-bearing, to use and
     distribute certain base software and to access Center personnel,
     computational resources and technical information. The term of each of the
     License Agreement and the Subcontract Agreement continues through December
     31, 1997, unless extended or terminated earlier. Pursuant to the
     Subcontract Agreement, the Company engages Carnegie Mellon University,
     through its Center for Machine Translation, to perform certain software
     development services and to furnish certain deliverable items. All of the
     deliverables developed under the Subcontract Agreement belong exclusively
     to the Company. Expenses incurred under the agreement were $1,428,442,
     $1,996,987 and $1,904,473 for the years ended December 31,
 
                                       32
<PAGE>   33
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
     1994, 1995 and 1996, respectively. Total payables at December 31, 1994,
     1995 and 1996 under these agreements amounted to $571,212, $967,673,and
     $959,608 respectively.
 
11. INCOME TAXES
 
     The Company accounts for income taxes in accordance with SFAS 109, which
     requires an asset and liability approach in accounting for income taxes.
 
     The Company and its subsidiaries file a consolidated federal income tax
     return. The income tax benefit consists of the following for the years
     ended December 31, 1994, 1995 and 1996:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                     ---------------------------------------
                                                       1994           1995           1996
                                                     ---------     -----------     ---------
        <S>                                          <C>           <C>             <C>
        Current:
          Federal.................................   $      --     $    54,659     $ 333,897
          State...................................      34,000         106,776        28,227
                                                      --------     -----------     ---------
                                                        34,000         161,435       362,124
                                                      --------     -----------     ---------
        Deferred:
          Federal.................................    (120,340)     (1,891,057)     (829,309)
          State...................................    (191,010)        (97,304)       34,972
                                                      --------     -----------     ---------
                                                      (311,350)     (1,988,361)     (794,337)
                                                      --------     -----------     ---------
        Net income tax benefit....................   $(277,350)    $(1,826,926)    $(432,213)
                                                      ========     ===========     =========
</TABLE>
 
     The income tax expense differs from the amount computed by applying the
     statutory rate of 34 percent to income (loss) before taxes as shown in the
     following table:
 
<TABLE>
<CAPTION>
                                                             YEAR ENDED DECEMBER 31,
                                                    -----------------------------------------
                                                      1994           1995            1996
                                                    ---------     -----------     -----------
        <S>                                         <C>           <C>             <C>
        Federal income tax provision (benefit),
          at statutory rate......................   $ 394,911     $   968,695     $ 1,002,875
        Effect of valuation allowance
          adjustments............................    (716,402)     (2,936,159)     (1,779,675)
        Prior year adjustments and other.........      21,701          26,906         302,876
        State income tax, net of federal
          benefit................................      22,440         113,632          41,711
                                                    ---------     -----------     -----------
        Net income tax (benefit).................   $(277,350)    $(1,826,926)    $  (432,213)
                                                    =========     ===========     ===========
</TABLE>
 
                                       33
<PAGE>   34
 
                     Carnegie Group, Inc. and Subsidiaries
 
            Notes to Consolidated Financial Statements--(Continued)
 
     Deferred tax assets and liabilities consist of the following as of December
     31, 1994, 1995 and 1996:
 
<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                   ------------------------------------------
                                                      1994            1995            1996
                                                   -----------     -----------     ----------
        <S>                                        <C>             <C>             <C>
        Deferred tax assets:
          Net operating losses..................   $ 4,734,270     $ 3,728,724     $2,838,951
          Tax credit carryforwards..............       589,629         644,299        693,585
          Executive compensation................       377,283         375,575        378,773
          Expense accruals......................       363,711         294,548        338,725
          Prior years write-off of investments
             in affiliates......................       253,988         252,833        254,991
          Depreciation..........................       121,988         107,789         61,014
          Deferred revenue......................        22,302          48,751         50,106
                                                   -----------     -----------     ----------
          Total deferred tax assets.............     6,463,171       5,452,519      4,616,145
             Less--Valuation allowance..........    (5,286,990)     (2,351,116)      (571,441)
                                                   -----------     -----------     ----------
          Net deferred tax assets...............   $ 1,176,181     $ 3,101,403     $4,044,704
                                                   ===========     ===========     ==========
        Deferred tax liabilities:
          Capital leases........................   $    94,568     $    94,139     $   77,953
          Expense accrual.......................        62,833              --             --
          Other.................................         5,288           5,411         11,845
                                                   -----------     -----------     ----------
          Total deferred tax liabilities........   $   162,689     $    99,550     $   89,798
                                                   ===========     ===========     ==========
</TABLE>
 
     Income tax benefits of $196,863 associated with the exercise of employee
     stock options were credited to equity in 1996.
 
     SFAS No. 109, "Accounting for Income Taxes," requires a valuation allowance
     when it is "more likely than not" that some portion or all of the deferred
     tax assets will not be realized. The ultimate realization of the deferred
     income tax asset depends on the Company's ability to generate sufficient
     taxable income in the future. The Company has weighed the positive evidence
     of sustained profitability over the last three years and future income
     expectations within the Company's three-year strategic planning horizon
     against the negative evidence of dependence upon a limited number of
     customers and other uncertainties and has concluded that retaining a
     valuation allowance related to net operating losses is no longer necessary
     at December 31, 1996. The remaining valuation allowance at December 31,
     1996 relates to general business credits which expire sooner than net
     operating loss carryforwards and realization is limited to years not
     subject to the alternative minimum tax.
 
     Significant changes in circumstances or in enacted tax laws which affect
     the valuation allowance are recorded when they occur. The Company's annual
     strategic business planning process takes place in the fourth quarter of
     the year, and the valuation allowance is adjusted for future years' income
     expectations resulting from that process. When preparing subsequent interim
     and annual financial statements, the Company reevaluates whether there has
     been any significant change in the assumptions underlying its plan and
     adjusts the valuation allowance as necessary. In the event the estimated
     results are not achieved, an adjustment to the recorded deferred tax asset
     could result and such adjustment could be material.
 
     The changes in the valuation allowance at December 31, 1994, 1995 and 1996
     resulted primarily from current year utilization of net operating loss
     carryforwards in excess of amounts estimated at the respective preceding
     year ends together with changes in the Company's estimate of the portion of
     the deferred tax asset more likely than not to be realized in the future in
     light of the factors described above.
 
                                       34
<PAGE>   35
 
                     CARNEGIE GROUP, INC. AND SUBSIDIARIES
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
     At December 31, 1996, the net operating loss carryforwards for federal tax
     purposes available to offset future income are as follows:
 
<TABLE>
<CAPTION>
              YEAR                                              FEDERAL          YEAR OF
            ORIGINATED                                           AMOUNT         EXPIRATION
            ---------                                          ----------       ----------
            <S>       <C>                                      <C>              <C>
              1987..........................................    1,122,800          2002
              1988..........................................    2,463,600          2003
              1989..........................................    2,898,300          2004
              1992..........................................      419,600          2007
              1993..........................................    1,329,200          2008
                                                               ----------
                                                               $8,233,500
</TABLE>
 
     Additionally, at December 31, 1996, the Company has net operating loss
     carryforwards for Pennsylvania income tax purposes of $500,000 available to
     offset taxable income in 1997.
 
     At December 31, 1996, Carnegie Group had investment, research and minimum
     tax credit carryforwards available totaling $96,162, $475,279 and $122,144,
     respectively. Investment credit carryforwards have been reduced 35 percent
     under the provisions of the Tax Reform Act of 1986. The investment tax
     credit carryforwards expire by the year 2000, the research tax credit
     carryforward expires by the year 2003 and the minimum tax credit has an
     indefinite carryforward.
 
     If certain substantial changes in the Company's ownership were to occur,
     there would be an annual limitation on the amount of carryforwards that
     could be utilized for federal income tax purposes.
 
12. QUARTERLY RESULTS (UNAUDITED)
 
<TABLE>
<CAPTION>
                                             FIRST      SECOND       THIRD      FOURTH
                                            QUARTER     QUARTER     QUARTER     QUARTER      TOTAL
                                            -------     -------     -------     -------     -------
                                            ($ IN THOUSANDS EXCEPT EARNINGS PER SHARE)
        <S>                                 <C>         <C>         <C>         <C>         <C>
        1996:
          Revenue........................   $ 8,323     $ 6,664     $ 6,509     $ 6,913     $28,409
          Revenue less cost of revenue...     3,258       2,344       2,547       2,501      10,650
          Income from operations.........       944          40         529         788       2,301
          Net Income.....................       683         121         410       2,146       3,360
          Earnings per share of common
             stock.......................      0.10        0.02        0.06        0.31        0.47
        1995:
          Revenue........................   $ 6,052     $ 6,621     $ 6,388     $ 6,589     $25,650
          Revenue less cost of revenue...     2,276       2,787       2,732       2,479      10,274
          Income from operations.........       572         812         677         786       2,847
          Net Income.....................       479         651         549       2,997       4,676
          Earnings per share of common
             stock.......................      0.09        0.12        0.10        0.49        0.82
</TABLE>
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE.
 
     Not applicable.
 
                                       35
<PAGE>   36
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
 
     The information set forth under the caption "Executive Officers of the
Registrant" in Part I of this Annual Report on Form 10-K and the information set
forth under the captions "Election of Directors" and "Section 16(a) Beneficial
Ownership Reporting Compliance" in the Proxy Statement is incorporated herein by
reference in response to this Item 10.
 
     In addition to Messrs. Yablonsky, Russell and Manzetti, the principal
occupations and employments of whom are set forth under the caption "Executive
Officers of the Registrant" in Part I of this Annual Report on Form 10-K, the
following persons are directors of the Company:
 
     Dr. Reddy is a co-founder of the Company and has served as a director since
the Company's inception. Dr. Reddy serves as a consultant in a scientific or
engineering capacity from time to time on projects for the Company. Dr. Reddy
has served as Chairman of the Board since February 1988. Dr. Reddy is Dean of
the School of Computer Science and the Herbert A. Simon University Professor of
Computer Science and Robotics at Carnegie Mellon University. Dr. Reddy joined
Carnegie Mellon's Department of Computer Science in September 1969 and served as
Director of the Robotics Institute from September 1979 to September 1992. Dr.
Reddy is a member of the Board of Directors of Telxon Corporation, Director and
Chairman of the Board of SEEC, Inc., and a member of the Technical Advisory
Board of Microsoft Corporation.
 
     Dr. Carbonell is a co-founder of the Company and has served as a director
since the Company's inception. Dr. Carbonell serves as a consultant in a
scientific or engineering capacity from time to time on projects for the
Company. Dr. Carbonell has been affiliated with Carnegie Mellon University since
January 1979. He has been a Professor of Computer Science since July 1983 and
the Director, Center for Machine Translation since July 1986 at Carnegie
Mellon's School of Computer Science. Dr. Carbonell is Director, Wisdom
Technologies Corporation.
 
     Mr. Chatfield has served as a director of the Company since May 1992. Mr.
Chatfield was President of Chatfield Enterprises from April 1990 to November
1992, and has been President of Optimum Power Technology, Inc. since December
1992, Chairman of Emprise Technologies, Inc. since December 1992, and General
Partner of CEO Venture Fund since January 1986. He was a founder of Duquesne
Systems, Inc., a predecessor of LEGENT Corporation.
 
     Dr. Fox is a co-founder of the Company and has served as a director since
the Company's inception. Dr. Fox serves as a consultant in a scientific or
engineering capacity from time to time on projects for the Company. Dr. Fox has
been Professor of Industrial Engineering with cross appointments in the
Department of Computer Science and Faculty of Management at the University of
Toronto since August 1991. Dr. Fox is founder, President and Chief Executive
Officer of Fox-Novator Systems Ltd., a provider of electronic commerce software
for the Internet/World Wide Web. Prior to August 1991, Dr. Fox was an Associate
Professor of Computer Science and Robotics and Director of the Center for
Integrated Manufacturing Systems at Carnegie Mellon University.
 
     Ms. Muesing has served as a director of the Company since August 1995. Ms.
Muesing has been Vice President of Network and Technology Services for U S WEST
Communications, Inc., a wholly owned subsidiary of U S WEST, Inc., since
September 1995. Prior to that time, Ms. Muesing was Vice President of
Transformation Systems for U S West Communications, Inc. from August 1994 to
September 1995, Vice President of Information Application Development for U S
WEST Technologies from June 1992 to August 1994 and Vice President of Quality, U
S WEST, Inc. from October 1990 to June 1992.
 
                                       36
<PAGE>   37
 
ITEM 11. EXECUTIVE COMPENSATION.
 
     The information set forth under the caption "Executive Compensation" in the
Proxy Statement is incorporated herein by reference in response to this Item 11.
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
 
     The information set forth under the caption "Security Ownership of Certain
Beneficial Owners and Management" in the Proxy Statement is incorporated herein
by reference in response to this Item 12.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
 
     The information set forth under the subcaption "Certain Transactions" in
the Proxy Statement is incorporated herein by reference to this Item 13.
 
                                       37
<PAGE>   38
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
 
     (a) Documents filed as part of this Report:
 
     1. FINANCIAL STATEMENTS.  The following consolidated financial statements
of the Company are filed as part of this Annual Report on Form 10-K:
 
<TABLE>
<CAPTION>
                                                                              PAGE NO.
                                                                              --------
        <S>                                                                   <C>
        Report of Independent Accountants..................................      20
        Consolidated Balance Sheets at December 31, 1994, 1995 and 1996....      21
        Consolidated Statements of Operations for the years ended December
          31, 1994, 1995 and 1996..........................................      22
        Consolidated Statements of Stockholders' Equity for the years ended
          December 31, 1994, 1995 and 1996.................................      23
        Consolidated Statements of Cash Flows for the years ended December
          31, 1994, 1995 and 1996..........................................      24
        Notes to Consolidated Financial Statements.........................      25
</TABLE>
 
     2. FINANCIAL STATEMENT SCHEDULES.
 
     Financial statement schedules have been omitted because they are
inapplicable, are not required under applicable provisions of Regulation S-X, or
the information that would otherwise be included in such schedules is contained
in the registrant's consolidated financial statements or accompanying notes.
 
     3. EXHIBITS.  The Exhibits listed below are filed or incorporated by
reference as part of this Annual Report on Form 10-K.
 
<TABLE>
<CAPTION>
EXHIBIT NO.                                       DESCRIPTION
-----------    ---------------------------------------------------------------------------------
<S>            <C>
 3.01          Restated Certificate of Incorporation of Carnegie Group, Inc. (1)
 3.02          Amended and Restated By-Laws of Carnegie Group, Inc. (1)
10.01          Carnegie Group, Inc. 1989 Stock Option Plan. (1)(2)
10.02          Carnegie Group, Inc. Long-Term Incentive Plan. (1)(2)
10.03          Carnegie Group, Inc. 1995 Stock Option Plan. (1)(2)
10.04          Carnegie Group, Inc. 1995 Employee Stock Purchase Plan. (1)(2)
10.05          Employment Agreement, dated August 11, 1987, between Carnegie Group, Inc. and
               Dennis Yablonsky. (1)(2)
10.06          Signing Bonus Stock Option Agreement, dated August 11, 1987, between Carnegie
               Group, Inc. and Dennis Yablonsky. (1)(2)
10.07(a)       Severance Agreement, dated May 28, 1993, between Carnegie Group, Inc. and Dennis
               Yablonsky. (1)(2)
10.07(b)       Severance Agreement, dated May 28, 1993, between Carnegie Group, Inc. and Bruce
               D. Russell. (1)(2)
10.07(c)       Severance Agreement, dated May 17, 1993, between Carnegie Group, Inc. and John W.
               Manzetti. (1)(2)
10.08(a)       General License Agreement, dated December 17, 1992, among U S WEST Advanced
               Technologies, Inc., U S WEST Communications, Inc. and Carnegie Group, Inc. (1)
10.08(b)       Development Agreement, dated as of January 2, 1996. (3)
10.08(c)       Development Agreement, dated as of March 1, 1996.(3)
10.08(d)       Development Agreement, dated as of July 1, 1996. (4)
</TABLE>
 
                                       38
<PAGE>   39
 
<TABLE>
<CAPTION>
EXHIBIT NO.                                       DESCRIPTION
-----------    ---------------------------------------------------------------------------------
<S>            <C>
10.08(e)       Development Agreement, dated as of October 15, 1996 (confidential treatment with
               respect to certain information contained in this exhibit has been requested of
               the Securities and Exchange Commission pursuant to Rule 24b-2 under the
               Securities Exchange Act of 1934, as amended).
10.09          CCA Marketing Agreement, dated January 19, 1995, between U S WEST Communica-
               tions, Inc. and Carnegie Group, Inc. (1)
10.10(a)       Lease, dated December 12, 1986, between Glass Plaza Associates and Carnegie
               Group, Inc. (1)
10.10(b)       Amendment, dated as of September 2, 1987. (1)
10.10(c)       Amendment, dated as of December 15, 1987. (1)
10.10(d)       Amendment, dated as of February 4, 1991. (1)
10.10(e)       Amendment, dated as of October 1, 1991. (1)
10.10(f)       Amendment, dated as of November 23, 1993. (1)
10.10(g)       Amendment, dated as of March 14, 1995. (1)
10.10(h)       Lease, dated as of October 18, 1995, between Glass Plaza Associates and Carnegie
               Group, Inc.(5)
21.01          Subsidiaries of the Registrant
23.01          Consent of Price Waterhouse LLP
27             Financial Data Schedule
</TABLE>
 
---------
 
(1) Incorporated by reference from the Company's Registration Statement on Form
    S-1, File No. 33-97118.
 
(2) Management contract or compensatory plan or arrangement.
 
(3) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the fiscal quarter ended March 31, 1996 as amended.
 
(4) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the fiscal quarter ended September 30, 1996, as amended.
 
(5) Incorporated by reference from the Company's Annual Report on Form 10-K for
    the fiscal year ended December 31, 1995.
 
     (b) Reports on Form 8-K:
 
     The Company did not file any Reports on Form 8-K during the year ended
December 31, 1996.
 
                                       39
<PAGE>   40
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities Act
of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
 
                                            CARNEGIE GROUP, INC.
 
March 27, 1996                                  /s/ DENNIS YABLONSKY
                                            By:
                                            ------------------------------------
 
                                              Dennis Yablonsky
                                              President and Chief
                                                Executive Officer
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
          SIGNATURE                                CAPACITY                          DATE
------------------------------     ----------------------------------------     ---------------
<S>                                <C>                                          <C>
 
/s/ DENNIS YABLONSKY               President and Chief Executive Officer         March 27, 1997
------------------------------     (Principal Executive Officer) and
Dennis Yablonsky                   Director
 
/s/ JOHN W. MANZETTI               Executive Vice President and Chief            March 27, 1997
------------------------------     Financial Officer (Principle Financial
John W. Manzetti                   and Accounting Officer) and Director
 
/s/ BRUCE D. RUSSELL               Executive Vice President, Chief               March 27, 1997
------------------------------     Operating Officer and Director
Bruce D. Russell
 
/s/ RAJ REDDY                      Chairman of the Board and Director            March 27, 1997
------------------------------
Raj Reddy
 
/s/ JAIME G. CARBONELL             Director                                      March 27, 1997
------------------------------
Jaime G. Carbonell
 
/s/ GLEN F. CHATFIELD              Director                                      March 27, 1997
------------------------------
Glen F. Chatfield
 
/s/ MARK S. FOX                    Director                                      March 27, 1997
------------------------------
Mark S. Fox
 
/s/ TRACIE A. MUESING              Director                                      March 27, 1997
------------------------------
Tracie A. Muesing
</TABLE>
 
                                       40
<PAGE>   41
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
                                                                                          SEQUENTIAL
EXHIBIT NO.                                  DESCRIPTION                                   PAGE NO.
-----------    ------------------------------------------------------------------------   ----------
<S>            <C>                                                                        <C>
 3.01          Restated Certificate of Incorporation of Carnegie Group, Inc. (1)
 3.02          Amended and Restated By-Laws of Carnegie Group, Inc. (1)
10.01          Carnegie Group, Inc. 1989 Stock Option Plan. (1)
10.02          Carnegie Group, Inc. Long-Term Incentive Plan. (1)
10.03          Carnegie Group, Inc. 1995 Stock Option Plan. (1)
10.04          Carnegie Group, Inc. 1995 Employee Stock Purchase Plan. (1)
10.05          Employment Agreement, dated August 11, 1987, between Carnegie Group,
               Inc. and Dennis Yablonsky. (1)
10.06          Signing Bonus Stock Option Agreement, dated August 11, 1987, between
               Carnegie Group, Inc. and Dennis Yablonsky. (1)
10.07(a)       Severance Agreement, dated May 28, 1993, between Carnegie Group, Inc.
               and Dennis Yablonsky. (1)
10.07(b)       Severance Agreement, dated May 28, 1993, between Carnegie Group, Inc.
               and Bruce D. Russell. (1)
10.07(c)       Severance Agreement, dated May 17, 1993, between Carnegie Group, Inc.
               and John W. Manzetti. (1)
10.08(a)       General License Agreement, dated December 17, 1992, among U S WEST
               Advanced Technologies, Inc., U S WEST Communications, Inc. and Carnegie
               Group, Inc. (1)
10.08(b)       Development Agreement, dated as of January 2, 1996. (2)
10.08(c)       Development Agreement, dated as of March 1, 1996. (2)
10.08(d)       Development Agreement, dated as of July 1, 1996. (3)
10.08(e)       Development Agreement, dated as of October 15, 1996 (confidential
               treatment with respect to certain information contained in this exhibit
               has been requested of the Securities and Exchange Commission pursuant to
               Rule 24b-2 under the Securities Exchange Act of 1934, as amended).
10.09          CCA Marketing Agreement, dated January 19, 1995, between US WEST
               Communications, Inc. and Carnegie Group, Inc. (1)
10.10(a)       Lease, dated December 12, 1986, between Glass Plaza Associates and
               Carnegie Group, Inc. (1)
10.10(b)       Amendment, dated as of September 2, 1987. (1)
10.10(c)       Amendment, dated as of December 15, 1987. (1)
10.10(d)       Amendment, dated as of February 4, 1991. (1)
10.10(e)       Amendment, dated as of October 1, 1991. (1)
10.10(f)       Amendment, dated as of November 23, 1993. (1)
10.10(g)       Amendment, dated as of March 14, 1995. (1)
10.10(h)       Lease, dated as of October 18, 1995, between Glass Plaza Associates and
               Carnegie Group, Inc.(4)
21.01          Subsidiaries of the Registrant.
23.01          Consent of Price Waterhouse LLP.
27             Financial Data Schedule.
</TABLE>
 
---------
 
(1) Incorporated by reference from the Company's Registration Statement on Form
    S-1, File No. 33-97118.
 
(2) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the fiscal quarter ended March 31, 1996, as amended.
 
(3) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
    for the fiscal quarter ended September 30, 1996, as amended.
 
(4) Incorporated by reference from the Company's Annual Report on Form 10-K for
    the fiscal year ended December 31, 1995.