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# SECURITIES AND
EXCHANGE COMMISSION WASHINGTON, D.C. 20549

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# FORM 20-F

ANNUAL REPORT PURSUANT
TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2002 Commission File Number 333-12076

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AREL COMMUNICATIONS AND
SOFTWARE LTD. (Exact name of Registrant as specified in its charter and translation of Registrants name
into English)

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Israel
(Jurisdiction of incorporation or organization)

3 Hayarden Street, Yavne 70600, Israel 
(Address of principal executive offices)

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

# None

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

Ordinary Shares, nominal value 0.001 New Israeli Shekels per share

(Title of Class)

Securities
for which there is a reporting obligation pursuant to Section 15(d) of the Act:

# None

(Title of Class)

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Indicate
the number of outstanding shares of each of the issuers classes of capital or common
stock as of the close of the period covered by the annual report: 
        13,128,466 Ordinary Shares

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
 Noo

Indicate by check mark which financial statements the registrant has elected to follow:        
Item 17 o
Item 18 x



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|PART I                                                              |                                                        
|------------------------------------------------------------------- | -------------------------------------------------------
|                                                                    |                                                        
|ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND
ADVISORS       | 4                                                      
|                                                                    |                                                        
|ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE                     | 4                                                      
|                                                                    |                                                        
|ITEM 3. KEY INFORMATION                                             | 4                                                      
|                                                                    | SELECTED FINANCIAL DATA                                
|                                                                    | RISK FACTORS                                           
|                                                                    | RISK FACTORS RELATED TO OUR BUSINESS                   
|                                                                    | RISK FACTORS RELATING TO OUR ORDINARY SHARES           
|                                                                    | RISK FACTORS RELATED TO OPERATIONS IN ISRAEL           
|                                                                    |                                                        
|ITEM 4. INFORMATION ON THE COMPANY                                  | 15                                                     
|                                                                    | HISTORY AND DEVELOPMENT OF THE COMPANY                 
|                                                                    | BUSINESS OVERVIEW                                      
|                                                                    | ORGANIZATIONAL STRUCTURE                               
|                                                                    | PROPERTY, PLANTS AND EQUIPMENT                         
|                                                                    | INTELLECTUAL PROPERTY RIGHTS AND SOFTWARE PROTECTION   
|                                                                    | GOVERNMENTAL REGULATIONS AFFECTING THE COMPANY         
|                                                                    |                                                        
|ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS                | 27                                                     
|                                                                    | CRITICAL ACCOUNTING POLICIES                           
|                                                                    | SELECTED FINANCIAL DATA                                
|                                                                    | OPERATING RESULTS                                      
|                                                                    | LIQUIDITY AND CAPITAL RESOURCES                        
|                                                                    | RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC    
|                                                                    | TREND INFORMATION                                      
|                                                                    |                                                        
|ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES                  | 44                                                     
|                                                                    | COMPENSATION OF OFFICERS AND DIRECTORS                 
|                                                                    | BOARD PRACTICES                                        
|                                                                    | EMPLOYEES                                              
|                                                                    | SHARE OWNERSHIP                                        
|                                                                    |                                                        
|ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY
TRANSACTIONS           | 53                                                     
|                                                                    | MAJOR SHAREHOLDERS                                     
|                                                                    | RELATED PARTY TRANSACTIONS                             
|                                                                    |                                                        
|ITEM 8. FINANCIAL INFORMATION                                       | 56                                                     
|                                                                    | CONSOLIDATED STATEMENTS AND OTHER FINANCIAL
INFORMATION
|                                                                    | LEGAL PROCEEDINGS                                      
|                                                                    | DIVIDEND DISTRIBUTIONS                                 
|                                                                    | SIGNIFICANT CHANGES                                    
|                                                                    |                                                        
|ITEM 9. THE OFFER AND LISTING                                       | 57                                                     
|                                                                    | MARKET AND SHARE PRICE HISTORY                         
|                                                                    |                                                        
|ITEM 10. ADDITIONAL INFORMATION                                     | 58                                                     
|                                                                    | MEMORANDUM AND ARTICLES OF ASSOCIATION                 
|                                                                    | EXCHANGE CONTROLS                                      
|                                                                    | TAXATION                                               
|                                                                    | DOCUMENTS ON DISPLAY                                   
|                                                                    |                                                        
|ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK | 70                                                     
|                                                                    | GENERAL                                                

1

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|                                                                                                    | EXCHANGE RATE RISK MANAGEMENT | 70
|--------------------------------------------------------------------------------------------------- | ----------------------------- | --
|                                                                                                    | INTEREST RATE RISK MANAGEMENT | 71
|                                                                                                    | EQUITY-PRICE RISK MANAGEMENT  | 71
|                                                                                                    |                              
|ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY
SECURITIES                                     | 71                           
|                                                                                                    |                              
|PART II                                                                                             |                              
|                                                                                                    |                              
|ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND
DELINQUENCIES                                            | 71                           
|                                                                                                    |                              
|ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF
SECURITY HOLDERS
              AND
USE OF PROCEEDS | 71                           
|                                                                                                    |                              
|ITEM 15. CONTROLS AND PROCEDURES                                                                    | 71                           
|                                                                                                    |                              
|ITEM 16. [RESERVED]                                                                                 | 72                           
|                                                                                                    |                              
|PART III                                                                                            |                              
|                                                                                                    |                              
|ITEM 17. FINANCIAL STATEMENTS                                                                       | 72                           
|                                                                                                    |                              
|ITEM 18. FINANCIAL STATEMENTS                                                                       | 72                           
|                                                                                                    |                              
|ITEM 19. EXHIBITS                                                                                   | 72                           

2

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This annual report on
Form 20-F includes certain forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934.  The use of the words project, expect, may, plan or
intend, or words of similar import, identifies a statement as
forward-looking.  There can be no
assurance, however, that actual results will not differ materially from our
expectations or projections.  Factors
that could cause actual results to differ from our expectations or projections
include the risks and uncertainties relating to our business described in this
annual report in Item 3 Risk Factors.

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

We have prepared our
consolidated financial statements in United States dollars and in accordance
with accounting principles generally accepted in Israel.  As applicable to our consolidated financial
statements for all fiscal periods for which financial data is presented herein,
such accounting principles vary in certain aspects from accounting principles
generally accepted in the United States, as indicated in Note 16 to our
consolidated financial statements included herein.  All references herein to dollars or $ are to United States
dollars, and all references to Shekels or NIS are to New Israeli
Shekels.

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

3

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PART I

|ITEM 1. | IDENTITY OF DIRECTORS, SENIOR
MANAGEMENT ANDADVISERS.
|------- | -----------------------------------------------------

Not applicable.

|ITEM 2. | OFFER STATISTICS AND EXPECTED
TIMETABLE.
|------- | ----------------------------------------

Not applicable.

|ITEM 3. | KEY INFORMATION.
|------- | ----------------

Selected
Financial Data

The selected financial
data is incorporated by reference to Item 5 of this annual report.

Risk
Factors

This annual report and
statements that we may make from time to time may contain forward-looking
information.  There can be no assurance
that actual results will not differ materially from our expectations,
statements or projections. Factors that could cause actual results to differ
from our expectations, statements or projections include the risks and
uncertainties relating to our business described below.

Risk
Factors Related to our Business

We experience significant fluctuations in
our results of operations.

We have experienced, and
expect to continue to experience, significant quarter-to-quarter fluctuations
in our results of operations as a result of a variety of factors, including:

| |  | long sales cycle ranging from 6 months to 2 years;                                                                                     
| | - | ---------------------------------------------------------------------------------------------------------------------------------------
|
| |  | the size and timing of individual orders, especially
with respect to our Arel Virtual Class and Arel SpotlightTM
e-learning solutions;
|
| |  | competition and pricing;                                                                                                               
|
| |  | customer order deferrals in anticipation of
introduction or enhancement of products by us or our competitors;                          
|
| |  | availability of bandwidth;                                                                                                             

4

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| |  | market acceptance of new products;                                                    
| | - | --------------------------------------------------------------------------------------
|
| |  | research and development costs;                                                       
|
| |  | technological changes;                                                                
|
| |  | changes in our operating expenses;                                                    
|
| |  | personnel changes;                                                                    
|
| |  | foreign currency exchange rates;                                                      
|
| |  | mix of products sold;                                                                 
|
| |  | quality control of products sold;                                                     
|
| |  | difficulties in complying with e-Learning,
video-conferencing and telephony standards;
|
| |  | risks related to entering the conferencing and
collaboration market;                  
|
| |  | political unrest in Israel; and                                                       
|
| |  | general economic conditions.                                                          

As a result, in reviewing
our results of operations, you should not place undue emphasis on
quarter-to-quarter comparisons.  Our
results in any quarter may not be indicative of the results we may achieve in
any subsequent quarter or for the full year. Quarterly fluctuations in
operating results may result in volatility in the market price of our ordinary
shares.  If our results of operations
for any quarter are less favorable than the results expected by the market, the
market prices of our ordinary shares would be adversely affected.

In order to compete effectively in the
markets for our products, we need to develop new and enhanced products, which
are acceptable to our customers.

Our industry is
characterized by rapid technological changes. The introduction of new products
or services or enhancements embodying new technologies and the emergence of new
industry standards and practices can rapidly render existing products obsolete
and unmarketable.  Accordingly, in order
for us to grow and remain competitive in the future, we will need to continue
to anticipate changes in technology and industry standards.  We will also have to successfully develop
and introduce new and enhanced products, which can gain market acceptance on a
timely basis.

If we do not develop
products that are technologically competitive, responsive to our customers
needs and competitively priced, our business will be negatively affected.  We cannot guarantee that we will timely or successfully
develop new or enhanced products or successfully manage transitions from one
product release to the next.  We may not
have the necessary resources to invest in such product development.

5

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We may not be able to successfully compete
in the extremely competitive markets for our products.

The conferencing and the
interactive distance learning markets are extremely competitive.  In the interactive distance learning market,
our primary direct competitor is One Touch Systems, Inc.  In addition, we face competition from
companies whose products are more geared towards web-based training and
e-learning. Our primary competitors in this area are Centra Software, Inc., and
InterWise Ltd. We have also encountered competition from IBM with its Lotus
Learning Space product and limited competition from companies such as Docent,
Inc., Saba Software, Inc. and SkillSoft, plc. which have business relationships
with our direct competitors. Since the expansion of our strategic positioning
toward the fully synchronized video, voice and data conferencing market, our
competitors landscape has grown to include companies such as Polycom, Inc,
Webex, Placeware (acquired by Microsoft in 2003), and First Virtual
Communications due to their efforts to introduce conference solutions through
IP-based networks. We expect that we will continue to be exposed to additional
competitors as result of our shift towards the video conferencing market.

Many of our competitors
have substantially greater capital resources, research and development staffs,
facilities, marketing and distribution networks, name recognition and more
extensive customer bases than we do. While we plan to continue to improve our
products, we cannot guarantee that we will successfully differentiate our
products from those of our competitors or that the marketplace will consider
our products superior to those of our competitors. Our competitors may also
merge, thus creating stronger vendors.

We have a history of losses and may not be
profitable in the future.

We
have not generated net income on an annual basis since 1999. We incurred net
losses of $228,000 (excluding amortization of goodwill of $878,000), $5.3
million (excluding amortization and impairment of goodwill, restructuring and
impairment of property and equipment, and impairment of investment of $20.22
million), and $6.22 million (excluding amortization and impairment of goodwill,
restructuring and impairment of property and equipment, and impairment of
investment of  $7.44 million) in 2000,
2001, and 2002, respectively. We may continue to operate at a loss for the
foreseeable future and we cannot estimate when or if we will achieve
profitability.

Some of our products may contain defects.

Computer software and
hardware products frequently contain errors or failures, especially when first
introduced or when new versions are released. 
Accordingly, some of our products could contain errors or defects,
software viruses, or otherwise fail to meet customer specifications, despite
our extensive product testing.  Any
product defects in our existing or new products may result in loss or deferral
of our revenues, diversion of our resources, damage to our reputation, or
increased service and other costs. Although our business has not been adversely
affected by product defects to date, we cannot guarantee that our business will
not be adversely affected by product defects in the future.

6

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We depend on single-source suppliers.

Most of the parts and
components which we use to manufacture and assemble our products are available
from several sources. However, we purchase certain components from
single-source suppliers. If we are forced to use alternative parts or
components, we may have to make certain changes in the design of our products
that use such components. This could result in delays and interruptions in
shipments.  A shortage of such
single-source components or our inability to timely develop or obtain
alternative sources, if required, would negatively affect our operations.

Our products employ proprietary technology
which is difficult to protect.

Our success and ability
to compete are dependent to a significant degree on our proprietary
technology.  We rely on a combination of
patent, trade secret, copyright and trademark laws, together with
non-disclosure agreements and technological measures to establish and protect
proprietary rights in our products.  We
cannot assure you that these efforts will provide meaningful protection for our
technology because:

| | some foreign countries may not protect our
proprietary rights as fully as do the laws of the United States;                                                                            
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                        
| | if a competitor were to infringe on our proprietary
rights, enforcing our rights may be time consuming and costly, diverting
managements attention and our resources;                 
|  |                                                                                                                                                                                        
| | measures like entering into non-disclosure and
non-competition agreements afford only limited protection;                                                                              
|  |                                                                                                                                                                                        
| | unauthorized and/or unidentifiable parties may
attempt to copy aspects of our products and develop similar software or to
obtain and use information that we regard as proprietary; and
|  |                                                                                                                                                                                        
| | our competitors may be able to design around our
intellectual property rights or independently develop products that are
substantially equivalent or superior to our products.         

7

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Potential intellectual property rights
disputes could make our operations more expensive.

Our ability to compete
successfully depends in part on our ability to operate without infringing on
the proprietary rights of others. 
Possible infringement claims could harm our business by requiring us to
pay royalties or to change our manufacturing processes. The cost of responding
to infringement claims could be significant, regardless of whether the claims
are valid. While there are no lawsuits or other claims currently pending
against us regarding the infringement of patents or intellectual property
rights of others, there can be no assurance that we will not become party to
such claims in the future.

Certain of our activities
make use of intellectual property owned by third parties.  We believe that we are in compliance with
the licensing agreements with the owners of these rights and that the licensing
agreements adequately protect our rights. 
Failure to maintain our licenses could harm our business.

The market for our Arel IDEAL suite of
e-learning solutions is still developing.

The market for our Arel
IDEAL suite of e-learning solutions, including Arel Spotlight and Arel
Spotlight On-Demand, has begun to develop significantly only in recent years
and is rapidly evolving.  As a result,
we are uncertain about market demand for, and acceptance of, our systems and
the future growth rate of these markets. 
We cannot assure you that the market for our IDEAL family, including the
Spotlight and Spotlight On-Demand solutions, will develop or that these systems
or products will be widely accepted. If the markets fail to develop, develop
more slowly than we expect or evolve differently than we anticipate, our
business, financial condition and results of operations could be negatively
affected.

The market for our corporate conferencing
solutions on converged networks is still developing.

During the course of
2002, we made a strategic decision to expand our served market by providing
integrated conferencing and training platforms over converged networks.
Converged networks are IP based networks capable of simultaneous and merged
transmission of all of the data, voice and video requirements of an
organization. This market is still in its first stages and may take a few years
to mature and stabilize. Companies may be reluctant, in the near future, to run
live video-related traffic as a corporate-wide solution and may only begin by
implementing monitored pilots. If the market for fully integrated video, voice
and data solutions over converged networks fails to develop, develops more
slowly than we expect or evolves differently than we anticipate, our business,
financial condition and results of operations could be negatively affected.

Our business relies on key customers.

There are a number of key
customers to which we sell a large portion of our products. In light of the
fact that the competition is intensive in our field of business, should any of
our target customers seek to purchase similar products from other companies, or
such key customers reduce or cancel expected orders, this could have a material
adverse affect on our profitability.

8

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We depend on a limited number of key
personnel who would be difficult to replace.

Our success depends to a
substantial degree upon our executive and research and development personnel
and upon our technical staff.  There is
considerable competition for the services of such personnel.  There can be no assurance that we will be
able to either retain our current personnel or acquire additional personnel.
The loss of certain key managers could diminish our ability to develop and
maintain relationships with customers and potential customers.

We may not be able to retain or attract
personnel.

We will need to attract
and retain qualified employees, particularly technical, managerial and research
and development personnel.  The
competition for such personnel is intense. 
We may not be able to retain our key employees or recruit additional
qualified personnel.  In addition, our
inability to recruit additional key technical personnel in a timely manner
would be detrimental to our research and development programs.

We are subject to several risks as a result
of our international sales.

To date, our products
have been sold primarily in North America, and we have increased our efforts to
develop business in Europe and the Far East. We are subject to all of the risks
inherent in international business activities including the following:

| | unexpected changes in regulatory requirements,
tariffs and other trade barriers;            
|- | --------------------------------------------------------------------------------------------
|  |                                                                                             
| | difficulties in staffing and managing foreign
operations;                                   
|  |                                                                                             
| | political instability;                                                                      
|  |                                                                                             
| | fluctuations in currency exchange rates or
restrictions on conversion of foreign currencies;
|  |                                                                                             
| | reduced protection for intellectual property rights
in some countries;                      
|  |                                                                                             
| | burdens with complying with a wide variety of
foreign laws and regulations; and             
|  |                                                                                             
| | potentially adverse tax consequences.                                                       

In addition, if we fail
to obtain approvals from foreign governmental bodies, our business, financial
condition and results of operations could be negatively affected.  To date, we generally have not experienced
any material difficulties in collecting accounts receivable as a result of our
international sales.

9

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The spread of the SARS epidemic could
seriously harm our profitability in Asia and other continents.

SARS is a flu-like virus
which first appeared in China in November 2002. To date, there have been
thousands of cases reported worldwide with hundreds of fatalities. Due to the
ease with which SARS can spread, medical experts recommend placing people who
have contracted SARS into quarantine. Although there have been cases of SARS
reported in various regions, SARS is most prominent in Asia and specifically
China and Hong Kong. The spread of SARS has resulted in a slowdown in our
business in China, Singapore, Thailand and Taiwan, where most of our operations
in the Far East are situated. In addition, the spread of such disease could
limit our ability to travel to selected areas, which may have an additional
impact on our business in these areas. 
There is no way of knowing when the global spread of SARS will be
brought under control. If the situation persists or worsens, it could seriously
damage our future sales and our ongoing projects in Asia.

Exchange rate fluctuations could increase
the cost of our operations.

Since the majority of our
revenues are denominated and paid in U.S. dollars, we believe that inflation in
Israel and fluctuations in the U.S. dollar/NIS exchange rate have no material
effect on our revenue. Inflation and U.S. dollar exchange rate fluctuations, however,
have some effect on our expenses and, as a result, on our net income/loss.  The cost of our Israel operations, as
expressed in U.S. dollars, is influenced by the extent to which any increase in
the rate of inflation in Israel is not offset, or is offset on a lagging basis,
by a devaluation of the NIS in relation to the U.S. dollar. We strive to limit our exposure to currency
fluctuations through natural hedging, but we do not presently engage
in any hedging or other transactions intended to manage the risks relating to
foreign currency exchange rate or interest rate fluctuations. However, we may
in the future undertake such transactions if management determines that it is
necessary to offset such risks.

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

We currently participate
in certain government programs and receive certain Israeli government grants
and tax benefits.  In order to maintain
our eligibility for these grants, programs and tax benefits, we must continue
to meet certain conditions, including making certain specified investments in
fixed assets.  In addition, some of
these programs may restrict our ability to manufacture products or transfer
technology outside of Israel.  If we
fail to comply with these conditions in the future, the benefits we receive
could be canceled or reduced. We could also be required to refund payments
previously received under these programs or pay certain taxes or
penalties.  We cannot guarantee that
these programs and tax benefits will be continued in the future, at their
current levels, or at all.  If these
programs and tax benefits are ended, our business, financial condition and
results of operations could be materially adversely affected.

10

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Corporate governance scandals and new
legislation could increase the cost of our operations.

As a result of recent
corporate governance scandals and the legislative and litigation environment
resulting from those scandals, the costs of being a public company in general
are expected to increase in the near future. New legislation, such as the
recently enacted Sarbanes-Oxley Act of 2002, will have the effect of increasing
the burdens and potential liabilities of being a public reporting company. This
and other proposed legislation may increase the fees of our professional
advisors and our insurance premiums.

Risk
Factors Relating to our Ordinary Shares

The market price of our ordinary shares has
been, and may continue to be, very volatile.

The market prices of our
ordinary shares since our initial public offering in December 1994, and of
other publicly traded software companies in general, have been subject to wide
fluctuations.  The following factors may
have a significant impact on the market price of our ordinary shares:

| | announcements of technological innovations or new
products by our competitors or us;                            
|- | ----------------------------------------------------------------------------------------------------------------
|  |                                                                                                                 
| | developments or disputes concerning patents or
proprietary rights;                                              
|  |                                                                                                                 
| | publicity regarding actual or potential results
relating to products under development by us or our competitors;
|  |                                                                                                                 
| | regulatory developments in the United States and
other foreign countries;                                       
|  |                                                                                                                 
| | delays in our testing and development schedules;                                                                
|  |                                                                                                                 
| | events or announcements relating to our
collaborative relationships with others;                                
|  |                                                                                                                 
| | economic and other external factors;                                                                            
|  |                                                                                                                 
| | period-to-period fluctuations in our financial
results;                                                         
|  |                                                                                                                 
| | low trading volume in our ordinary shares; and                                                                  
|  |                                                                                                                 
| | volatility in the securities markets.                                                                           

11

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Our results are affected by volatility in
the securities markets and low trading volume in our ordinary shares.

Due to the recent
downturn in the world economy, the securities markets in general have
experienced increased volatility which has particularly affected the market
prices of equity securities of many high-technology companies, including
companies that have a significant presence in Israel.  Although the volatility of these companies securities has often
been unrelated to the operating performance of these companies, they, and
particularly those in the fields of communications, software and Internet, may
experience difficulties in raising additional financing required to effectively
operate and grow their businesses.  Such
failure, the history of low trading volume in our ordinary shares, incidents of
unrest and terrorist activity in Israel and the volatility of the securities
market in general, and in particular in relation to our ordinary shares, may
affect our ability to raise additional financing in the future.

Market sales of large amounts of our shares
eligible for future sale may lower the price of our ordinary shares.

As of May 31, 2003, we
had 13,128,466 ordinary shares outstanding, of which, 8,461,410 ordinary shares
are freely tradable.  The remaining
4,677,056 ordinary shares outstanding are restricted securities, as that term
is defined under Rule 144 of the Securities Act of 1933, as amended.  Approximately 4,506,795 of the restricted
securities have been held for more than two years, therefore, they may be sold
under Rule 144 without regard to the volume limitations and other restrictions
of Rule 144, except by holders who are deemed to be our affiliates.  In addition, there are ordinary shares
issuable upon the exercise of warrants and options that we have previously
granted.

We are unable to predict
the effect that sales made under Rule 144 or other sales may have on the
then prevailing market price of our ordinary shares.  It is likely that market sales of large amounts of our ordinary
shares (or the potential for those sales even if they do not actually occur)
will have the effect of depressing the market price of our ordinary
shares.  This could impair our ability
to raise capital through the sale of our equity securities.

Selling and buying our securities may be
more difficult since they were transferred from the NASDAQ National Market to
the NASDAQ Small Cap Market

Our ordinary shares were
delisted from the NASDAQ National Market on September 3, 2002, and are
currently traded on the NASDAQ Small Cap Market. Consequently, selling (and
buying) our securities is more difficult because of:

| | possible reduction in security analysts and the
news medias coverage of us.                                                    
|- | ---------------------------------------------------------------------------------------------------------------------------------
| | many institutions are limited by their formation
documents in their ability to acquire securities traded on the NASDAQ Small
Cap.

These factors could
result in lower prices and larger spreads in the bid and ask prices for our
ordinary shares than might otherwise be obtained.

12

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Our shares are subject to
Rule 15g-9 under the Securities Exchange Act of 1934, as amended.  That rule imposes additional sales practice
requirements on broker-dealers that sell low-priced securities to persons other
than established customers and institutional accredited investors.  For transactions covered by this rule, a
broker-dealer must make a special suitability determination for the purchaser
and have received the purchasers written agreement to the transaction prior to
sale.  Consequently, the rule may affect
the ability of broker-dealers to sell our ordinary shares and may affect the
ability of holders to sell our ordinary shares in the NASDAQ Small Cap
Market.

We do not expect to distribute cash
dividends.

We have never paid a cash
dividend and do not expect to pay cash dividends in the foreseeable
future.

Risk
Factors Related to Operations in Israel

Conditions in Israel affect our operations.

We are incorporated under
the laws of, and our offices and most of our production facilities are located
in, the State of Israel.  Although
almost all of our sales are made to customers outside of Israel, we are
nonetheless directly influenced by the political, economic and military
conditions affecting Israel.  Any major
hostilities involving Israel or the interruption or curtailment of trade
between Israel and its present trading partners could have a material adverse
effect on our business, financial condition and results of operations.  Israels economy has been subject to
numerous destabilizing factors, including a period of rampant inflation in the
early to mid-1980s, low foreign exchange reserves, fluctuations in world
commodity prices, military conflicts and civil unrest.  Since the establishment of the State of
Israel in 1948, a state of hostility has existed, varying in degree and
intensity, between Israel and its Arab neighbors.  In addition, Israel and companies doing business with Israel have
been the subject of an economic boycott by the Arab countries since Israels
establishment.

Although Israel has
entered into various agreements with certain Arab countries and the Palestine
Liberation Organization, and various declarations have been signed in
connection with efforts to resolve some of the economic and political problems
in the Middle East, there has been an increase in unrest since September 2000
and which has continued with varying levels of severity into 2003.  We do not believe that the political and
security situation has had any material impact on our business. However, some
potential customers have been more hesitant to do business with us due to the
political and security situation in Israel. In addition, certain of our
business partners and potential partners from Europe and the Far East have
declined to travel to Israel during periods of heightened unrest or tension,
forcing us to make alternative arrangements where necessary. We can give no
assurance that security and political conditions will have no deleterious
effects in the future.  Any hostilities
involving Israel or the interruption or curtailment of trade between Israel and
its present trading partners could adversely affect our operations.  Furthermore, most of our manufacturing
facilities are located in Israel, which is currently experiencing civil unrest,
terrorist activity and military action. Since we do not have a detailed
disaster recovery plan that would allow us to quickly resume manufacturing, we
could experience serious disruption of our manufacturing if acts associated
with this conflict result in any serious damage to our manufacturing facility.
Our business interruption insurance may not adequately compensate us for losses
that may occur and any losses or damages incurred by us could have a material
adverse effect on our business. We cannot predict whether a full resolution of
these problems will be achieved or the nature of any such resolution.

13

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

Many of our employees in
Israel are obligated to perform military reserve duty. In the event of severe
unrest or other conflict, individuals could be required to serve in the
military for extended periods of time. In response to the increase in terrorist
activity and the renewed Palestinian uprising, there has been a significant call
up of military reservists, and it is possible that there will be additional
call-ups in the future.  Our operations
could be disrupted by the absence for a significant period of time of one or
more of our key employees or a significant number of our other employees due to
military service. Such disruption could harm our operations.

It may be difficult to enforce a U.S.
judgment against us, our officers and directors and the Israeli experts named
in this annual report.

Service of process upon
our directors and officers and the Israeli experts named herein, substantially
all of whom reside outside the United States, may be difficult to effect within
the United States.  Furthermore,
substantially all our assets are located outside the United States.  Accordingly, you may not be able to enforce
any judgment obtained in the United States against us or such individuals or
entities in the United States.

It may also be difficult
to enforce civil liabilities under the U.S. federal securities laws in original
actions instituted in Israel.  However,
subject to certain limitations, Israeli courts may enforce foreign final
executory judgments, including those of the United States, for liquidated
amounts in civil matters obtained after due process before a court of competent
jurisdiction (according to the rules of private international law currently
prevailing in Israel) that recognizes and enforces similar Israeli judgments,
provided that:

| | adequate service of process has been effected and
the defendant has had a reasonable opportunity to defend;                    
|- | -------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                
| | such judgments or their enforcement are not contrary
to the law, public policy, security or sovereignty of the State of Israel;

14

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| | such judgments were not obtained by fraudulent means
and do not conflict with any other valid judgment in the same matter between
the same parties; and
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                        
| | an action between the same parties in the same
matter is not pending in any Israeli court at the time the lawsuit is
instituted in the foreign court.  

|ITEM 4. | INFORMATION ON THE COMPANY.
|------- | ---------------------------

History
and Development of the Company

Arel Communications and
Software Ltd. (Arel or the Company) has been a leading provider of
end-to-end interactive distance learning systems since 1997. During 2002, the
Company expanded its target market, and today Arel offers an integrated video,
voice and data conferencing solution enabling corporate communication and
e-learning applications.   We market the
Arel IDEALTM family of interactive distance learning products, as
well as our conferencing solution.  Our
manufacturing facility and executive offices are located at 3 Hayarden Street,
Post Office Box 76, Yavne, 70600 Israel and our telephone number is
+972-8-942-0880.  Our website is
www.arel.net.  Information on our
website is not incorporated by reference in this annual report.

Our legal and commercial
name is Arel Communications and Software Ltd. We were established in Israel in
1982 and operate under the Israel Companies Law - 1999.  From 1982 to 1988, we operated as a division
of a company controlled by Argaman Industries Ltd.   Since 1988, we have been operating as an independent company. In
1994 we had two divisions: Arcom and IDEAL. In
December 1994, we consummated an initial public offering.  At such time, our ordinary shares were quoted
on the NASDAQ National Market.

In July 1996, we entered
into an agreement with Elron Electronic Industries Ltd. for the formation of
our subsidiary Arelnet Ltd. to exploit our ARCOM technology and Elrons i-Fax
technology for the transmission of faxes and other messages over the
Internet.  Through Arelnet Ltd., we
engaged in the design, development, production and marketing of Internet
Protocol (IP) telephony products and value-added communication and messaging solutions
for telephone carriers, Internet service providers and other network providers.
Following the transfer to Arelnet of our technology relating to ARCOM, we
focused our research, development and marketing efforts exclusively on our
IDEAL products for the broadband market. This focused effort has resulted in
our success in penetrating the North American market of e-Learning solutions
delivered via satellite connectivity.

On April 12, 2000, we
completed a private placement of $8,500,000 with Soros Fund Management L.L.C
and Keppel Communications Pte. Ltd. Under the terms of the private placement,
funds advised by Soros Fund Management purchased from us 200,000 newly issued
shares of Arel at an aggregate price of $3,400,000 and Keppel purchased from us
300,000 newly issued shares of Arel for an aggregate price of $5,100,000.

15

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In June 2000, we spun off
our subsidiary Arelnet to our shareholders whereby we distributed 0.30733 of an
ordinary share of Arelnet for each of our ordinary shares then outstanding, or
an aggregate of 2,900,040 ordinary shares of Arelnet, to our holders of record
as of the close of business on June 8, 2000. Following the spin-off, we held
approximately 17.79% of the issued share capital of Arelnet. In connection with
the spin-off, Arelnet consummated an underwritten initial public offering of
1,000,000 ordinary shares of Arelnet in Israel, with gross proceeds to Arelnet
of approximately $4,000,000, at an initial price of approximately $4.00 per
ordinary share. The ordinary shares of Arelnet are currently traded on the Tel
Aviv stock exchange. Arelnets ordinary shares are not registered under the
United States securities laws nor are they listed for trading on any United
States stock exchange or quoted on the NASDAQ.

In August 2000, we
purchased substantially all of the assets of W2COM, LLC, an
application driven communications provider of interactive video, data &
network integration services and distance learning services. We operate the
acquired business through our subsidiary, Arel Learning Solutions, Inc. For
further information see Item 7. Major Shareholders and Related Party
Transactions.

Following the approval of
our audit committee and our board of directors, we participated in Arelnets
rights offering and purchased 76.958 units under Arelnets prospectus dated May
30, 2001.  Each unit is comprised of 45
ordinary shares of Arelnet and 20 options for which we paid 3,463,110 NIS
(approximately $829,000 at such time). The options expire on June 30, 2003. In
addition, in September 2001, we acquired 600,978 shares of Arelnet from Leader
Tec Ltd. for approximately $82,000. As of May 31, 2002, we hold approximately
17.87% of the issued share capital of Arelnet.

In the second and third
quarters of 2001, we implemented a strategic realignment in order to cut costs
and improve our operating efficiencies. As part of these measures, we laid off
approximately 20% of our workforce as compared to June 30, 2001 and we reduced
our inventory levels by 10%.

In June 2002, we
appointed Mr. Philippe Szwarc as our new chief executive officer. Mr. Szwarc
brings more than 10 years of experience in the networking and telecommunication
industries during which time he held several executive positions, mainly as a
chief executive officer. In the third quarter of 2002, the Company appointed Mr.
Daniel Yelin as its new chief financial officer. Mr. Yelin brings financial and
operational experience both from publicly held and private companies.

Effective
September 3, 2002, our ordinary shares were transferred from the NASDAQ
National Market and are currently traded on the NASDAQ Small Cap Market.

In 2002, the board of
directors approved restructuring plans totaling $2,301,000 (including $750,000
in respect of impairment of property and equipment), which were primarily
designed to enable us to substantially reduce our operating expenses level. We
reduced our workforce from 86 employees on January 1, 2002 to 51 on December
31, 2002. For more information about the restructuring plans and the
restructuring expenses, see Item 5 Operating and Financial Review and
Prospects.

16

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Business
Overview

The
Market

As the global market
expands, corporations, universities, governmental agencies and other
organizations are looking for collaborative solutions that efficiently provide
content and enable audio and video interaction to large numbers of participants
at remote locations at their desktops. 
In order to achieve this objective, Arel has developed the Integrated
Conferencing Platform (ICP), an effective, fully synchronized video, audio and
data-enabled interactive conferencing and collaboration solution that optimize
the use of existing network resources available to distributed enterprises.

Arels technology
provides a hybrid solution, covering different types of interaction
methodologies (including one-to-many, many-to-many and one-on-one), end-points
(including interactive response units, personal computers and personal digital
assistants (PDAs)), delivery methods (live and archived on demand sessions),
network types (satellite and terrestrial), supported bandwidths (narrowband
dial-up up to high speed broadband), which can interoperate simultaneously,
even within the same session.

The first component of
the ICP, which is geared to the distance training market and which we sell as
the Arel IDEALTM has been our traditional application, having begun
to sell products to this market since 1997. Our IDEALTM suite of
e-Learning products offers a training solution to participants at multiple
remote locations via satellite, Intranet or Internet networks.

During 2002, we expanded
our product offering as a second component to the ICP, in order to augment our
served market to include the conferencing and collaboration market. By
providing integrative interactive and synchronized video, voice and data
conferencing and collaboration, Arel is currently positioned to fill the gap
between video conferencing and web-collaboration software over existing
corporate networks, to provide a real converged networking solution.

17

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Products

The Integrated
Conferencing Platform (ICP) is the technological basis for Arels solutions for
both distance training and corporate conferencing and collaboration
requirements.

AREL IDEAL: The complete eLearning and
Distance Training solution

Arel IDEAL is an
advanced solution that combines the critical aspects of verbal and visual
communication  two-way video and audio synchronized with rich content,
collaboration, discussion groups, application sharing and live real time
interaction. The communications platform reaches large numbers of people in
real-time through the combination of satellite, internet or intranet networks.

---

---

Arels IDEAL is comprised
of the following major components:

| | Interactive Desktop Training Arel Spotlight                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|  | The Arel Spotlight desktop solution provides easily
operated and effective live sessions, including video and rich interactive
content delivered directly to the desktop, at the office, at home or on the
road. Arel Spotlight is a scalable application that combines quality video
with two-way audio and data transfer to enable live delivery at any desktop
connected to the Internet or an enterprise Intranet. Arel Spotlight offers
live collaboration tools such as application sharing, whiteboard annotations,
discussion groups, chat and guided browsing.                                                                                                                                                                               
| 
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | Arel Spotlight On-Demand                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|  | Arel Spotlight On-Demand extends the benefits of
live delivery, enabling asynchronous transmission and streaming of
interactive self-paced sessions to increase the versatility and flexibility
of the IDEAL solution. Advanced recording of live sessions assist the
delivery of synchronized high quality video and rich content, maintaining the
indexing and interaction of content such as questions and tests. Interaction
which occurred during the live session is recorded including chat sessions
and application sharing , keeping all the content and social parts of the
session. Attendance, performance and grades are sent over the network during
the participation in the recorded session for traceability and evaluation
purposes.
| 
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | Broadband or Satellite Training - Arel VirtualClass                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|  | Operating over any type of broadband network,
VirtualClass brings the classroom to the participants, reducing training
costs and enables real-time interactivity and just-in-time distribution of
mission-critical knowledge. While live video and media-rich content are
displayed on a TV monitor, each remote VirtualClass site is equipped with a
PC software - based controller that manages audio and data interaction via
Interactive Response Units (IRUs).                                                                                                                                                                                                                                                                                   
| 

19

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| | Training and Communications Portal - Arel Campus                                                                                                                                                                                                                                                                                                                                                                                                                       
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|  | Arel Campus serves as the
systems portal and provides users with vital access to both personal and
administrative data. Using the Campus, participants can launch and attend
live and recorded on-demand sessions, preview course content, take off-line
on-demand quizzes, and communicate with presenters and expert assistants.
Arel Campus provides data on course details and scheduling, registration,
presenters, individual progress, grades and accreditation.
| 
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | Advanced Delivery Suite for Presenters - Arel Presenter                                                                                                                                                                                                                                                                                                                                                                                                                
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|  | Arel Presenter enables the delivery of different
types of rich interactive content to remote desktop participants, with
control over the video size, remote content navigation, and live interaction.
The single application screen is similar to the remote participants desktop
application. The entire session can also be recorded enabling participants to
take the session on-demand.                                                                            
| 
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | Learning Management and Administration LMS - Arel Learning
Manager                                                                                                                                                                                                                                                                                                                                                                                                     
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|  | Arel IDEAL is equipped with a built-in database and
management server that handles the administration and control of vast amounts
of curriculum content and multiple participants. The learning manager offers
an environment for registration and management of participants, presenters
and sites, courses scheduling and server configuration. Arel Learning
Managers built-in import / export mechanism allows for easy integration with
external databases.      
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | Interactive Delivery Content - Arel Author                                                                                                                                                                                                                                                                                                                                                                                                                             
|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|  | Arels Author is a stand-alone authoring and content
assembly application that enables the presenter or content developer to
pre-plan the lessons sequence of content and activities (agenda). This
application supports various content item types like PowerPoint slides
(including animation), web pages and graphics, video clips, customized
question layouts and templates, tests, presenter notes as well as control
over display and navigation parameter      
| 

20

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| | Editor of Recorded Sessions for Publishing - Arel Producer
                                                                                                                                                                                                                                                                                                 
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                              
|  | Arel Producer enhances Arels on-demand capabilities
by offering a post-production editing environment. Arel Producer enables the
user to modify and edit recorded sessions by cutting out undesired items, changing
the items order, replacing outdated content and replacing old presentations
with recently recorded segments.                           
| 
|  |                                                                                                                                                                                                                                                                                                                                                              
| | Evaluate Performance and Attendance
Information - Arel Evaluator                                                                                                                                                                                                                                                                                            
|  |                                                                                                                                                                                                                                                                                                                                                              
|  | Arel Evaluator is a web-based tool for real-time
reviewing, comparing and analyzing participant performance and attendance.
The Evaluator provides the presenter or administrator with statistics and
information about individuals, groups and site progress at the course level
or at the level of its components (lessons, tests, surveys, and questions).
| 
|  |                                                                                                                                                                                                                                                                                                                                                              
| | Statistical Reports Generation - Arel Reporter                                                                                                                                                                                                                                                                                                              
|  |                                                                                                                                                                                                                                                                                                                                                              
|  | Arel Reporter is designed for training
administrators and presenters to automatically generate detailed, standard
and customized reports. The user may create customized administrative and
performance reports, or choose from available standard formats.                                                                                                  
| 

AREL CONFERENCE: A Synchronized Video,
Audio and Data Conferencing Solution

Arel Conference focuses
on offering an effective integrated video audio and data enabled conferencing
solution for corporate communications, by optimizing the use of existing
network resources available to large distributed enterprises and service
providers, through the utilization of proprietary networking architecture and
video technologies over various networks, ranging from narrowband to broadband,
Intra-net, Virtual Private Networks (VPNs) and the public Internet.

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Integrated multiple video
windows, application and data sharing, chat, questions and whiteboard in a
single application assist in creating a teamwork and conferencing environment.
Administration over the net allows for auto-management and includes user and
authorization management, creation and scheduling of conferences, email
invitations and Microsoft-Outlook/Exchange Calendar integration.

| | Audio, Video and Collaboration                                                                                                                                                                                                                                                                                                                                
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                               
|  | Live
conferencing of synchronized audio, video and data - Arels
live interactive application, Arel Conference, is a narrowband video-enabled
and media rich application that includes collaboration and interaction
capabilities. Attendees may speak and be seen, freely share documents, use
whiteboard tools and chat.                                    
|  |                                                                                                                                                                                                                                                                                                                                                               
|  | Multiple
video windows - Depending on camera and bandwidth
availability, multiple video windows can be displayed on screen. The combined
bandwidth of an audio and video window can be as low as 20kbps.                                                                                                                                                      
|  |                                                                                                                                                                                                                                                                                                                                                               
|  | Collaborative
interaction Attendees may collaborate using whiteboard,
chat, application sharing, instant yes/no polling, questions and surveys to
complement audio and video interaction.                                                                                                                                                                    
|  |                                                                                                                                                                                                                                                                                                                                                               
|  | Sharing
moderator desktop with attendees The person managing a
session, a moderator, can demonstrate the operation of any software running
on their PC to remote participants regardless of if they have that software
installed. In addition, the moderator may grant a participant the option of
working on that software for sharing or training purposes.
|  |                                                                                                                                                                                                                                                                                                                                                               
|  | Creating
pop items - Agenda items may be created and sent during the
live event. Creating pop items during a session enables the moderator to send
PowerPoint presentations, share documents and spread sheets or initiate a
browsing session during a live conference.                                                                                       
|  |                                                                                                                                                                                                                                                                                                                                                               
|  | Over
the shoulder capability- The moderator can view an
attendees desktop or any open application for an application sharing
session. This functionality may serve to monitor advancement and
understanding, provide software training assistance or technical support.                                                                                    
|  |                                                                                                                                                                                                                                                                                                                                                               
|  | Handing
over moderator capabilities to attendees - At any point the
moderator can hand over the control of the moderators functionality to any
of the present attendees.  The
attendee receives all the moderators capabilities to lead the conference.
The moderator can regain control at any time.                                                       

22

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---

|  | Agenda
items  Any pre-prepared agenda items are seen immediately
by all attendees upon entering the Conference in the agenda area. The
moderator can send/launch the agenda items to the attendees. The content can
be pre-cached automatically to the attendees PC prior to the conference for
improved performance during the session.  
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                             
| | Web Management and Administration                                                                                                                                                                                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                                                             
|  | Arels conferencing and communications portal, Arel
Campus offers administration over the net for the conferencing platform. Arel
Campus supports the live conferencing event by providing tools for creating,
scheduling, editing, inviting attendees, previewing information and billing.                                                 
|  |                                                                                                                                                                                                                                                                                                                                             
|  | Informative
communication center  The Arel Campus portal home page
provides a snapshot of todays scheduled conferences and provides links to
enable, among other things, easy data exchange, viewing the agenda and
details viewing, conference creation, editing, inviting attendees,
scheduling, virtual space creation, administration.
| 
|  |                                                                                                                                                                                                                                                                                                                                             
|  | Arels conferencing and communications portal, Arel
Campus offers administration over the net for the conferencing platform. Arel
Campus supports the live conferencing event by providing user-friendly tools
for creating, scheduling, editing, inviting attendees, previewing information
and billing.                                   
|  |                                                                                                                                                                                                                                                                                                                                             
|  | Creation
of conferences  Creation of a conference is done over the
web and includes self-scheduling, content creation and assembly, and the
ability to invite conference attendees by e-Mail.                                                                                                                                              
|  |                                                                                                                                                                                                                                                                                                                                             
|  | Inviting
attendees from the database or external guests The system
provides search mechanisms to assist in finding internal attendees details
from the database and in inviting external guests to take part in a
conference.                                                                                                             
|  |                                                                                                                                                                                                                                                                                                                                             
|  | Customizable
invitations by e-mail  Automatic customizable invitation
of virtual space regular attendees and invitation of other attendees is
available. The e-Mail invitation includes links to install the client
software from the Arel Campus portal and to directly enter the conference.                                             

23

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| | Microsoft-Outlook/Exchange
integration - Upon receipt of an e-mail invitation, the
attendee can push the conference event into the MS-Outlook Calendar by
clicking on a link in the e-mail. The event will be entered into the users
Calendar and the user may join the conference by clicking a link directly
from the Outlook Calendar.                                                                                                                                                                                                                                                                                                                                                                       
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Conferences
can be launched from an e-mail, calendar and portal 
attendees can join conferences using one of several different paths. The
e-mail invitation includes a link that can be used to join the session and
the calendar environment (like MS-Outlook / Exchange) can be used for joining
a conference. Arel Campus allows selecting the conference and launching it or
joining an existing conference with the conference ID.                                                                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Conference
security- A conference can be password-protected by
assigning a password to the conference upon creation. Attendees will be
requested to enter the conference password upon joining the Conference.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Preparing
an agenda for a conference - The agenda builder enables a
user to create a list of items that will be presented or shared during a live
conference. Items may include topics, PowerPoint presentations, HTML pages,
pictures, video clips and documents. The agenda is available to attendees
prior to the conference and enables them to prepare for the conference. It
offers an organized structure to easily find and launch slides and other
content during the conference.                                                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Pre-caching
of agenda items improves performance - attached slides and
other content are automatically downloaded to an attendees PC prior to the
session to prevent delays in presenting and sharing documents and to improve
the performance and bandwidth utilization.                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Previewing
conference schedule - A scheduling page presents the
conferences schedule in a daily, weekly or monthly display.From this page a user can directly
join a conference or preview its details.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Easy
administration of a series of conferences  Virtual Spaces
A conference may be conducted as a one-time event or as a part of a
continuous series of events. For example a marketing forum that meets once a
week or an on-going project team that meets in order to report progress,
share ideas and discuss issues. A virtual space is a shared area related to a
group of people and a subject. It is comprised of a series of conferences,
participants and shared content. Participants, who are assigned to a certain
virtual space, become such spaces members. All the space members are
automatically invited to the space conferences and have access to the shared
agenda, references and files.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | User
management and authorization capabilities - User
information is stored in the database including, among others, names,
addresses, phone numbers, email addresses, registration data, authorizations
(for administrator, chairperson and attendee roles). Authorizations are
permissions to perform specific actions such as creating, scheduling,
editing, launching or attending a conference.                                                                                                                                                                                                                                                                                                             
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | Billing
capabilities  Intra-departmental billing for the use of
shared resources or billing for the use of a hosted service are supported.
Call Detail Record (CDR) information is collected in the Arel database and
can be exported as files to any external billing system.                                                                                                                                                                                                                                                                                                                                                                                                                                  

24

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Arel
Learning Solutions Services

Through Arel Learning
Solutions, Inc., we manage the business that we acquired from W2COM,
LLC.  Arel Learning Solutions business
consists of three units: videoconferencing; network services; and interactive
distance learning.  Following the
restructuring plan executed throughout 2002, Arel Learning Solutions refocused
its business to network services, supporting also
existing video-conferencing customers, and providing network and
video-conferencing Services.

Arel Learning Solutions
provides interactive videoconferencing capabilities to businesses and
organizations of all sizes. Our systems range from portable systems to complex
group systems.  Arel Learning Solutions
provides services that assist businesses and other organizations in linking
their information systems in order to facilitate information sharing and
videoconferencing.

Sales,
Distribution and Marketing

We market Arel products
through our U.S. subsidiaries, Arel Communications and Software, Inc., and
through independent value added resellers and agents worldwide. As of May 31,
2003, 12 in-house sales and system engineering personnel market and support our
systems. We have established relationships with several integrators and value
added resellers including: Convergent Media Systems and Canadian Business
Television. We seek to establish value added reseller relationships with
business television services providers that are integrators of video
broadcasting and networking projects for large and dispersed corporations.

Over 85% of our sales for
the last three years have been in the United States.  In 2002, we had 3 customers the revenues from each of which
exceeded 10% of our revenues. In 2001, we had one customer the revenue from
which exceeded 10% of our revenues. In 2000, we had two customers, the revenues
from each of which exceeded 10% of our revenues.  In 1999, we had four customers, the revenues from each of which
exceeded 10% of our total revenues. Our business is not seasonal and although
we rely on subcontractors for the production of our Interactive Response Units
and our Class Control Units, we believe that there are other sources of these
products and that it would not have a material affect on our business if it
became necessary to find alternative subcontractors.

Competition

Currently, the majority
of our business is in the distance learning market. There are two types of
systems that offer live interactions between trainees in remote locations and
the trainer: keypad (IRU)-based or desktop-based systems.  Our Arel VirtualClass can be configured to
offer either keypad, desktop based systems or both at the same time.

When the communication
network is provided via satellite, our main competitor in this area is One
Touch Systems.  Our satellite
connectivity supports live video of the instructor which is comparable to live
frontal classroom sessions.  One Touch
also offer live video via satellite networks and live interaction using
proprietary keypads.

25

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In 2000, we introduced
Arel Spotlight and Arel Spotlight On-Demand that are designed to provide
additional functionality delivered to the desktop over terrestrial
networks.  Our major competitors in the
live instructor-led sector are: Centra Software, Inc. and Interwise, Ltd. Both
have solutions that mainly rely on narrowband networks, which transmit low
quality multimedia content and low quality video, or no video at all.  Video transmission is primarily dependant on
the available bandwidth to the students desktop.

The conferencing market
is composed of players that focus on video-conferencing solutions (the
overwhelming majority of the North American market being shared by Polycom,
Inc. and Tandberg), or players that focus on web-based collaboration solutions.
The market for web-collaboration solutions is dominated by two companies, which
are application service providers (ASP) and operate under hosted services
business models: Webex Communications, Inc., and Placeware, Inc. (acquired in
the first quarter of 2003 by Microsoft). In video-conferencing, the competitive
solutions lack the seamless integration and synchronization of video and audio,
with data collaboration, and the ability to be delivered efficiently over
converged enterprise networks. In the web-conferencing arena, the majority of
our competitors do not provide video-conferencing capabilities synchronized
with their data. Some of our competitors offer their product as a hosted service,
which, for normal implementation results in high costs, compared to a CPE-based
solution (such as ours).

Organizational
Structure

We have two wholly owned
subsidiaries that we own through our U.S. holding company Arel Holdings,
Inc.:  Arel Communications and Software,
Inc. and Arel Learning Solutions, Inc.

Properties,
Plants and Equipment

Our executive offices,
research and development and manufacturing facilities are located in Yavne,
Israel. Our lease with respect to such space expires on February 1, 2004 and
may be renewed for additional one-year periods. The lease is for approximately
1,250 square meters.  Our annual lease
payments are approximately $48,000.  In
addition, Arel Communications and Software, Inc. leases office space in
Atlanta, Georgia.  The Atlanta lease
expires on October 31, 2004. Our annual lease payments for the Atlanta premises
are approximately $117,000 a year. Arel Learning Solutions, Inc. has lease
agreements for premises in several locations in the United States expiring at various
dates through August 31, 2004. Our aggregate annual lease payments for Arel
Learning Solutions, Inc. are approximately $65,000. The reduction in our rental
expenses in 2002 compared to 2001 is due to a buyout of our lease in our Dayton
and Chicago offices executed during the third quarter of 2002. Our rental
expenses totaled $317,000, $603,000, and $354,000, in 2002, 2001, and 2000,
respectively.  We believe that our
current facilities are adequate for our corporate, sales, development and
manufacturing operations as currently conducted.  In the event that additional facilities are required, we believe
that we could obtain such additional facilities without difficulty and at
commercially reasonable prices.

26

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Intellectual
Property Rights and Software Protection

Our success and ability
to compete are dependant to a significant degree on our proprietary
technology.  We rely primarily upon a
combination of trademark, copyright, know-how and trade secrets and contractual
restrictions to protect our intellectual property rights.  Arel IDEAL, Arel Spotlight, Arel
Spotlight-On-Demand, Arel Campus, Arel Learning Manager, Arel VirtualClass,
Arel Author, Arel Evaluator, Arel Reporter, The Ultimate Learning Experience, and
the Arel logo are either registered trademarks of Arel or are in the process of
being registered. We are currently preparing applications for the registration
of Arel Conference and Integrated Conferencing Platform (ICP). Any other
trademarks appearing in this document are the property of their respective
holders.

Our employees who have
access to confidential information are required to sign employee invention and
secrecy agreements.  We believe that
such measures provide only limited protection of our proprietary information,
and there is no assurance that our proprietary technology will remain a secret
or that others will not develop similar technology and use this technology to
compete with us.  Despite our efforts to
protect our proprietary rights, unauthorized parties may attempt to copy aspects
of our products or to obtain and use information that we regard as proprietary.

Governmental
Regulation Affecting the Company

As a company which
focuses on research and development and which receives grants in order to do so
from the Government of Israel, we are affected by the terms of the grants we
have received from the Office of the Chief Scientist of Israel.  Under the terms of these grants, we are
responsible to pay royalties based on the net sales of our products.  In addition, manufacturing of products
developed with these grants must be performed in Israel or, if consent to
manufacture abroad is received from the Office of the Chief Scientist of
Israel, increased royalties will be owed to the Chief Scientist of Israel.
Approval must be obtained to transfer technologies developed through projects
in which the government participates. 
See Item 5. Research and Development, Patents and Licenses, etc.

In addition, we receive
certain tax benefits and reduced tax rates from the Government of Israel.  See Item 10. Additional Information 
Taxation.  The entitlement to these
benefits is conditional upon our fulfillment of the conditions stipulated by
applicable law, regulations published thereunder and the instruments of
approval for certain programs.  In the
event of a failure to comply with these conditions, the benefits could be
canceled and we would be required to refund the amount of the benefits, in
whole or in part, with the addition of linkage differences and interest.

27

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|ITEM 5. | OPERATING AND FINANCIAL REVIEW AND
PROSPECTS.
|------- | ---------------------------------------------

Critical
Accounting Policies

Our discussion and
analysis of our financial condition and results of operations are based upon
our consolidated financial statements, which have been prepared in accordance
with accounting principles generally accepted in Israel. The preparation of
these financial statements requires us to make estimates and judgments that
affect the reported amounts of assets, liabilities, revenues and expenses, and
related disclosure of contingent assets and liabilities. We base our estimates
on historical experience and on various other assumptions that are believed to
be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are
not readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions. To facilitate the
understanding of our business activities, described below are certain
accounting policies that are relatively more important to the portrayal of our
financial condition and results of operations and require management subjective
judgments. We identified our most critical accounting policies to be those
related to revenue recognition and impairment of goodwill and other long-lived
assets. Please refer to Note 1 of our consolidated financial statements, which
are included in this Annual Report on Form 20-F for the year ended December 31,
2002 for a summary of all of our significant accounting policies.

Revenue recognition:

1)        Sale of products

We recognize revenue from
sale of products to end users and resellers upon transfer of title and risk of
loss for the products, provided that appropriate signed documentation of the
arrangement, such as a signed contract, purchase order or letter of agreement,
has been received, the fee is fixed and determinable and collectibility is
deemed probable. We do not, in the normal course of business, provide a right
of return to our customers. If uncertainties exist, revenue is recognized when
the uncertainties are resolved.In some cases, we grant
our customers an evaluation period, usually several months, to evaluate the
product prior to purchase. We do not recognize sales revenue from products
shipped to customers for evaluation until such products are actually purchased.

2)        Services rendered

Revenue from services
rendered is recognized ratably over the contractual period or as services are
performed.

Our revenue recognition
policy is significant because our revenue is a key component of our results of
operations. In addition, our revenue recognition determines the timing of
certain expenses, such as commissions and royalties. We follow very specific
and detailed guidelines in measuring revenue; however, certain judgments affect
the application of our revenue policy. Revenue results are difficult to
predict, and any shortfall in revenue or delay in recognizing revenue could
cause our operating results to vary significantly from quarter to quarter and
could result in future operating losses.

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Impairment of goodwill and other long-lived
assets

We have assessed the
impairment of goodwill and other long-lived assets whenever events or changes
in circumstances indicate that the carrying value may not be recoverable.
Examples of indicators, which could trigger an impairment review, are the
following:

| |  | Significant under performance relative to expected
historical or projected future operating results;             
| | - | -----------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                  
| |  | Significant changes in the manner of our use of the
acquired assets or the strategy for our overall business; and
| |   |                                                                                                                  
| |  | significant negative industry or economic trends.                                                                

When the carrying value
of goodwill and other long-lived assets may not be recoverable based upon the
existence of one or more indicators of impairment, we measure any impairment
based on a projected discounted cash flow method using a discount rate
determined by our management to be commensurate with current market assessments
of the time value of money and the risks specific to the asset.

For U.S. GAAP purposes,
we adopted in 2002 FAS 144 Accounting for the Impairment or Disposal of
Long-Lived Assets (FAS 144).  FAS 144
requires that long-lived assets, that are to be held and used by an entity be
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of the assets may not be recoverable. Under
FAS 144, if the sum of the expected future cash flows (undiscounted and
without interest charges) of the long-lived assets is less than the carrying amount
of such assets, an impairment loss would be recognized, and the assets are
written down to their estimated fair values.

Recently
Issued Accounting Pronouncements

In Israel

Accounting Standard No. 15

In February 2003, Accounting Standard No. 15 of the Israeli
Accounting Standards Board (the IASB) - Impairment of Assets, became
effective. This standard which is based on International Accounting standard
No. 36 requires a periodic assessment - at each balance sheet date - to
evaluate the need for a provision for the impairment of our non-monetary assets
- property and equipment and identifiable intangibles, including goodwill, as
well as investments in associated companies. 
As promulgated by the standard, its provisions are to be applied as of
January 1, 2003. Pursuant to the provisions of the standard, if any events
have occurred or changes in circumstances have taken place, which might
indicate that there has been an impairment of one or more of the above assets,
we are required to evaluate whether the carrying value of the investment in the
asset is recoverable from the cash flows anticipated from that asset, and, if
necessary, to record an impairment provision up to the amount needed to adjust
its carrying amount to its recoverable amount. The impairment loss is carried
directly to income.

29

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The recoverable amount of an asset is determined as being the greater of
the assets net selling price and its value in use to us. The assets value in
use is determined according to the present value of anticipated cash flows from
the continued use of the asset, including those expected at the time of its
future retirement and disposal.

We are making the necessary preparations in order to apply this standard
commencing with its first interim financial statements in 2003, and are
currently reviewing the expected implications, if any, on our financial
statements.

We have formerly applied the provisions of the U.S. standard dealing
with this issue that required an impairment loss to be recognized, only in the
event that the undiscounted cash flows from the asset were less than its
carrying value.

In the United States

FAS 143

In July 2001, the FASB issued SFAS 143, Accounting for Asset Retirement
Obligations(FAS 143). FAS 143 prescribes the accounting
for retirement obligations associated with tangible long-lived assets,
including the timing of liability recognition and initial measurement of the
liability. FAS 143 requires that an asset retirement cost should be capitalized
as part of the cost of the related long-lived asset and subsequently allocated
to expense using a systematic and rational method. FAS 143 is effective for
fiscal years beginning after June 15, 2002 (January 1, 2003 for the
company). We do not expect the adoption of FAS 143 to have a material effect on
our consolidated financial statements.

FAS 145

In April 2002, the FASB issued SFAS No. 145, Revision of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and
Technical Connections (FAS 145). 
Among other amendments and rescissions, FAS 145 eliminates the
requirement that gains and losses from the extinguishment of debt be aggregated
and, if material, classified as an extraordinary item, net of the related
income tax effect, unless such gains and losses meet the criteria in paragraph
20 of Accounting Principles Board Opinion No. 30, Reporting the Results of
Operation - Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions.  FAS 145 is partially effective for
transactions occurring after May 15, 2002 and partially effective for
fiscal years beginning after May 15, 2002. We do not expect the adoption
of FAS 145 to have a material effect on our consolidated financial statements.

30

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FAS 146

In June 2002, the FASB issued SFAS No. 146 Accounting for Costs
Associated with Exit or Disposal activities (FAS-146).  FAS-146 addresses financial accounting and
reporting for costs associated with exit or disposal activities and nullifies
EITF 94-3 Liability Recognition for Certain Employee Termination Benefits and
other Costs to Exit an Activity (including Certain Costs Incurred in a
restructuring).  FAS-146 required that a
liability for a cost associated with an exit or disposal activity to be
recognized when the liability is incurred. 
Under EITF 94-3, a liability for an exit cost as generally defined in
EITF 94-3 was recognized at the date of the commitment to an exit plan.  FAS 146 states that a commitment to a plan,
by itself, does not create an obligation that meets the definition of a
liability.  Therefore, FAS 146
eliminates the definition and requirements for recognition of exit costs in
EITF 94-3. Since any future restructuring will depend on facts and
circumstances, as of the date of these financial statements it is not possible
to determine the impact of this standard on the consolidated financial
statements.

FAS 148

In December 2002, the
FASB issued FAS No. 148, Accounting for Stock-Based Compensation - Transition
and Disclosure - an amendment of FASB Statement No. 123. FAS 148 amends FAS
123 to provide alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation. In
addition, FAS 148 amends the disclosure requirements of FAS 123 to
require prominent disclosures in the financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The transition guidance and annual disclosure
provisions of FAS 148 are effective for financial statements issued for fiscal
years ending after December 15, 2002.

We have elected to continue accounting for
employee stock based compensation in accordance with APB 25 and related
interpretations and have applied the disclosure provisions in FAS 148 in these
consolidated financial statements and the accompanying notes.

FIN 45

In November 2002, the FASB issued FASB
Interpretation No. 45 Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN
45). FIN 45 requires the guarantor to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. It also elaborates on the disclosures to be made by a
guarantor in its financial statements about its obligations under certain
guarantees that it has issued and to be made in regard of product warranties.
Disclosures required under FIN 45 are already included in these financial statements,
however, the initial recognition and initial measurement provisions of this FIN
are applicable on a prospective basis to guarantees issued or modified after
December 31, 2002. We do not expect the adoption of FIN 45 to have a material
effect on our consolidated financial statements.

31

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FIN 46

In January 2003, the FASB issued FASB
Interpretation No. 46  Consolidation of
Variable Interest Entities (FIN 46). Under this FIN entities are separated
into two populations: (1) those for which voting interests are used to
determine consolidation (this is the most common situation) and (2) those for
which variable interests are used to determine consolidation. The FIN explains
how to identify Variable Interest Entities 
(VIE) and how to determine when a business enterprise should include the
assets, liabilities, non controlling interests, and results of activities of a
VIE in its consolidated financial statements.

The FIN is effective as follows: for variable
interests in variable interest entities created after January 31, 2003 the FIN
shall apply immediately, for variable interests in variable interest entities
created before that date, the FIN shall apply - for public entities - as of the
beginning of the first interim or annual reporting period beginning after June
15, 2003. We do not expect the adoption of this FIN to have a material effect
on our consolidated financial statements.

FAS 149

In April 2003, the FASB
issued FAS No. 149, Amendment of Statement 133 on Derivative Instruments and
Hedging Activities. FAS 149 amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments
embedded in other contracts (collectively referred to as derivatives) and for
hedging activities under FAS 133, Accounting for Derivative Instruments and
Hedging Activities. FAS 149 is effective prospectively for contracts entered
into or modified after June 30, 2003 and prospectively for hedging
relationships designated after June 30, 2003.

We are currently analyzing
the impact of FAS 149 on our consolidated financial statements but do not
believe that on adoption, it will have a material impact on our results of
operations or financial position.

FAS 150

In May 2003, the FASB
issued FAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity. FAS 150 establishes standards
for classification and measurement in the statement of financial position of
certain financial instruments with characteristics of both liabilities and
equity. It requires classification of a financial instrument that is within its
scope as a liability (or an asset in some circumstances) because that financial
instrument embodies an obligation of the issuer. FAS 150 is effective for
financial instruments entered into or modified after May 31, 2003, and
otherwise is effective on the first interim period beginning after June 15,
2003.

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We are currently
analyzing the impact of FAS 150 on the consolidated financial statements but do
not believe that on adoption, it will have a material impact on our results of
operations or financial position.

Selected
Financial Data

The following selected
financial data has been derived from our audited financial statements,
including those incorporated in this annual report by reference.

Our financial statements
have been prepared in accordance with Israeli GAAP. Israeli GAAP varies in
certain respects from US GAAP. The selected financial data below has been
reconciled to reflect the effects of US GAAP (see also note 16 to our
consolidated financial statements, which are included herein). The financial
data set forth below should be read in conjunction with our consolidated
financial statements and notes thereto and the other financial information
appearing elsewhere in this annual report.

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Consolidated Statement of Operations
Data:

|                                                                        |  | Year ended December 31,   |        
|----------------------------------------------------------------------- |  | ------------------------- | -------
|                                                                        |  | 2002                      |        
|                                                                        |  |                           |        
|                                                                        |  | U.S. dollars in
thousands |        
|Revenues from sales and services                                        |  |                           | 5,941  
|Cost of sales and services                                              |  |                           | 3,604  
|                                                                        |  |                           |        
|Gross profit                                                            |  |                           | 2,337  
|Research and development expenses - net                                 |  |                           | 2,218  
|Selling, general and administrative                                     |  |                           |        
|Expenses                                                                |  |                           | 6,439  
|Amortization of goodwill                                                |  |                           | 283    
|Impairment of goodwill                                                  |  |                           | 4,575  
|Restructuring expenses and Impairment of Property and
Equip.            |  |                           | 2,301  
|                                                                        |  |                           |        
|Operating income (loss)                                                 |  |                           | (13,479
|Financial income (expenses) - net                                       |  |                           | 102    
|Impairment of investment in
Arelnet Ltd.                                |  |                           | *(279  
|                                                                        |  |                           |        
|Income (loss) before taxes on income                                    |  |                           | (13,656
|Taxes on income                                                         |  |                           |        
|                                                                        |  |                           |        
|Income (loss) from continued operations                                 |  |                           | (13,656
|                                                                        |  |                           |        
|Discontinued operations:                                                |  |                           |        
|Loss from operations                                                    |  |                           |        
|Gain on dilution of interest in Arelnet Ltd.                            |  |                           |        
|                                                                        |  |                           |        
|Total gain (loss) from discontinued operations                          |  |                           |        
|                                                                        |  |                           |        
|Net income (loss) for the year                                          |  |                           | (13,656
|                                                                        |  |                           |        
|Reconciliation to U.S. GAAP:                                            |  |                           |        
|Effect of the treatment of gain on dilution of
interest in
Arelnet Ltd. |  |                           |        
|                                                                        |  |                           |        
|Net income (loss) under U.S. GAAP                                       |  |                           | (13,656

|* | Under U.S. GAAP the Impairment of investment in
Arelnet is classified as operating expenses. As a result, operating loss in
2002 and 2001 under U.S. GAAP was $13,758 and $26,397, respectively.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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|                                                                      |  | U . S .   d o l l a r s |  
|--------------------------------------------------------------------- |  | ----------------------- | -
|                                                                      |  |                         |  
|Basic and diluted net income (loss)
  per share under Israeli
  GAAP: |  |                         |  
|Continued operations                                                  |  | (1.06                   | )
|Discontinued operations                                               |  |                         |  
|                                                                      |  |                         |  
|Net income (loss)                                                     |  | (1.06                   | )
|                                                                      |  |                         |  
|                                                                      |  |                         |  
|Net income (loss) per share under
  U.S. GAAP,                        |  |                         |  
|Basic:                                                                |  |                         |  
|Continued operations                                                  |  | (1.06                   | )
|Discontinued operations                                               |  |                         |  
|                                                                      |  |                         |  
|Net income (loss)                                                     |  | (1.06                   | )
|Diluted:                                                              |  |                         |  
|Continued operations                                                  |  | (1.06                   | )
|Discontinued operations:                                              |  |                         |  
|                                                                      |  |                         |  
|Net income (loss)                                                     |  | (1.06                   | )

|                                                         |  | December
  31,                                       | 
|-------------------------------------------------------- |  | ---------------------------------------------------- | 
|                                                         |  | 2002                                                 | 
|                                                         |  |                                                      | 
|                                                         |  | U.S.
  dollars in thousands, except number of shares | 
|Consolidated Balance Sheet Data:                         |  |                                                      | 
|Cash and Cash equivalents                                |  | 10,354                                               | 
|Short-term Investments                                   |  | 129                                                  | 
|Total current assets                                     |  | 14,594                                               | 
|Working capital                                          |  | 7,592                                                | 
|Total assets                                             |  | 15,440                                               | 
|Total current liabilities                                |  | 7,002                                                | 
|Total long-term liabilities, net of
  current maturities |  | 419                                                  | 
|Share capital                                            |  | 4                                                    | 
|Capital surplus (including warrants and
  options)       |  | 54,135                                               | 
|Total shareholders equity                               |  | 8,019                                                | 
|Balance Sheet Data under U.S. GAAP:                      |  |                                                      | 
|Shareholders equity                                     |  | 8,019                                                | 
|                                                         |  |                                                      | 
|Number of shares outstanding                             |  | 13,128,466                                           | 
|                                                         |  |                                                      | 

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Operating
Results

The following table sets
forth, for the periods indicated, our selected financial data as a percentage
of net sales:

|                                               |  | Year
  Ended December 31, |  
|---------------------------------------------- |  | ------------------------- | -
|                                               |  |                           |  
|                                               |  | 2002                      |  
|                                               |  |                           |  
|Revenues from sales & services                 |  | 100                       |  
|Cost of sales & services                       |  | 60.7                      |  
|Gross profit                                   |  | 39.3                      |  
|Research and development expenses, net         |  | 37.3                      |  
|Selling, general and administrative
  expenses |  | 108.4                     |  
|Amortization of goodwill                       |  | 4.8                       |  
|Impairment of goodwill                         |  | 77                        |  
|Restructuring expenses                         |  | 38.7                      |  
|Operating Loss                                 |  | (226.9                    | )
|Financial income, net                          |  | 1.7                       |  
|Impairment of investment in Arelnet Ltd.       |  | (4.7                      | )
|Loss before taxes on income                    |  | (229.9                    | )
|Taxes on income                                |  | -                         |  
|Loss after taxes on income                     |  | (229.9                    | )
|Discontinued operations:                       |  |                           |  
|Loss from operations                           |  |                           |  
|Gain on dilution of Interest in Arelnet Ltd.   |  |                           |  
|Net Loss                                       |  | (229.9                    | )

Overview.We operate in two reportable
segments; Segment A and Segment B as follows:

Segment A includes our
activities and those of our subsidiary, Arel Communications and Software, Inc.
This segments activities are focused on designing, producing, marketing,
integrating and supporting mainly our e-learning both satellite and terrestrial
based IDEAL products on a worldwide basis.

Segment B includes the
activities of Arel Learning Solutions Inc. In 2002, this segment was mainly
engaged in interactive video data, and network integration services.

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For information about our
reported segment profit or loss and assets, see notes 14a. and 14b. to our
consolidated financial statements, which are included herein as pages F-1 to
F-37.

In 1999, our consolidated
financial reports included the operations of Arelnet as a different reporting
segment. The operations of the Arelnet segment were discontinued in 2000
following the spin-off (see Item 4.  History and Development of the Company
above), and, therefore, are not presented as a reporting segment in our
financial statements.

The Risk Factors
Conditions in Israel affect our operations and Our results of operations may
be negatively affected by the obligation of our personnel to perform military
service in Item 3.  Risk Factors  Risks Related to Operations in Israel
are incorporated herein by reference.

Sales and Services.Sales and service
revenues consist of (i) new installations of our products and (ii) the
expansion, enhancement and upgrade of our products for existing customers.

Sales decreased 37% (or $3,471,000) from $9,412,000 in 2001 to
$5,941,000 in 2002. Sales of our IDEAL products in 2002 amounted to $3,685,000
a decrease of 36% compared to $5,721,000 in 2001. The decrease in sales and
service revenues mainly resulted from a reduction of orders attributable to the
slowdown in the world economy in general and in the communications sector in
particular. More specifically it resulted in longer than expected sales cycles
as well as an annual budget freeze in the distance learning field.

Revenues from interactive
video data, and network integration services amounted to $2,256,000 a decrease
of 39% compared to $3,691,000 in 2001. In 2000, we derived revenues from this
activity only from August 8, 2000, the date of acquisition of W2COM,
LLC. The decrease in revenues from services in this area is a result of
reorganization process that took few months and decreased our capability to
focus on sales and marketing.

In 2002, 79% of our sales
were in the United States compared to over 90% in 2001.  In 2002, we had 3 customers each of which
exceeded 10% of our revenues.  In 2001,
we had one customer, which exceeded 10% of our revenues.

Cost of Sales and Services. Cost of sales
and services consists of (i) materials, (ii) compensation costs, (iii)
subcontractors, and (iv) overhead. Cost of sales and services decreased 16.6%
(or $717,000) from $4,321,000 in 2001 to $3,604,000 in 2002. Cost of sales in
2002 and 2001 of Segment A were $2,045,000 and $1,571,000, respectively. Cost
of sales in 2002 and 2001 of Segment B were $1,559,000 and $2,750,000,
respectively. The decrease in cost of sales and services both in general and of
Segment B was primarily due to the decrease in sales and services revenues. The
increase in cost of sales and services of Segment A in 2002 was primarily due
to a change in the product mix (more hardware based product sales in 2002
versus more software based products sales in 2001). Cost of sales and services
decreased 47% (or $3,844,000) from $8,165,000 in 2000 to $4,321,000 in 2001.
This decrease was primarily due to the decrease in the volume of sales of our
products.

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Gross Profit. As a result of the decrease in
sales and services revenues, gross profit decreased 54.1% (or $2,754,000) from
$5,091,000 in 2001 to $2,337,000 in 2002. As a percentage of sales and
services, the gross profit decreased from 54.1% in 2001 to 39.3% in 2002. Gross
profit of Segment A decreased from $4,150,000 in 2001 to $1,640,000 in 2002.
Gross profit of Segment B decreased from $941,000 to $697,0000 in 2002. The
decrease in the gross profit is attributed mainly to the product mix changes in
2002 in Segment A and to a lesser extent the general decrease in sales. In
2002, the sales of high gross profit margins software based IDEAL products
represented a lower share compared to 2001. Gross profit decreased from
$6,913,000 in 2000 to $5,091,000 in 2001, a decrease of 26.3%. As a percentage
of sales and services, the gross profit increased from 45.8% in 2000 to 54.1%
in 2001. This increase was primarily due to the fact that in 2001 the sales of
high gross profit margins software based IDEAL products represented a higher
share compared to 2000.

Research and Development Expenses - net.
Research and development expenses consist primarily of salaries and related
costs of employees engaged in ongoing research and development, subcontractors
and, to a lesser extent, costs of materials, depreciation and other
expenditures. Research and development gross expenses (before   the participation of the Israeli Office of
the Chief Scientist (OCS)) decreased 20.9% to $2,218,000 in 2002 from
$2,804,000 in 2001. The decrease is mainly due to a reduction of headcount done
during 2002 as part of a restructuring plan. Research and development expenses
 net (after OCS participation) have increased by 14.1% from $1,943,000 to
$2,218,000.  This increase is due to the
fact that in 2002 we did not receive participation from the OCS. We have
recently received informal confirmation from the OCS that they have approved
our research and development program for 2003, which contemplates that we will
spend $2,000,000 on research and development. We expect the OCS to fund 50% of
our 2003 research and development program. Receipt of OCS funding and the exact
amount which will be provided are subject to our receipt of final written
confirmation from the OCS.

Research and development expenses  gross,
increased 51.7% to $2,804,000 in 2001 from $1,848,000 in 2000 (before OCS
participation). This increase in research and development expenses is primarily
due to the continued development of our IDEAL products line, including an
increase in compensation and costs related to the development of Arel
Spotlight. We will continue to invest in research and development in order to
maintain leading technology in the marketplace especially in developing a
narrowband Internet based interactive distance learning solution, such as Arel
Spotlight.  Research and Development
expenses in 2001 and 2000, net of OCS participations, which were $861,000 and
$652,000 respectively, amounted to $1,943,000 and $1,196,000 respectively.

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Selling, General and Administrative Expenses.
Selling expenses consist of costs relating to promotion, advertising, trade
shows and exhibitions, compensation, sales support, travel and travel-related
expenses. General and administrative expenses consist of (i) compensation
costs for administration, finance and general management personnel; and
(ii) office maintenance and administrative costs. Selling, general and
administrative expenses decreased 31% (or $2,884,000) from $9,323,000 in 2001
to $6,439,000 in 2002. This decrease is attributed primarily to the reduction
in headcount and selling expenses throughout the company with an emphasis in
Arel Learning Solutions. Selling, general and administrative expenses increased
by 46.4% (or $2,955,000) from $6,368,000 in 2000 to $9,323,000 in 2001. This is
due to the fact that in 2000, our subsidiary, Arel Learning Solutions, was
included in the consolidated results from August 2000 only, whereas in 2001,
Arel Learning Solutions was included in the consolidated results throughout the
entire period.   The increase in our
selling, general and administrative expenses in 2001 is also attributed to the
costs associated with the sales of Arel Learning Solutions products and
services.

Other Operating expenses. In 2002 and
2001, due to our decision to focus on the IDEAL sales and narrow down the
activities related to interactive video data and network integration services
and the continuing decline in the market, we evaluated the carrying amount of
the goodwill resulting from the acquisition of W2COM, LLC.
Accordingly and following estimates of discounted future cash flows, we
recorded impairment charges in the amounts of $4,575,000 and $14,576,000
respectively. We also recorded amortization of goodwill in 2002 in the amount
of $283,000 as compared to $1,795,000 in 2001. As of December 31, 2002, we have no goodwill
resulting from the acquisition of W2COM.

Operating (Loss). As a result of the
foregoing, in 2002, we had an operating loss of $6,320,000 (excluding
amortization and impairment of goodwill, restructuring expenses and impairment
of property and equipment of $7,159,000). Including amortization and impairment
of goodwill, restructuring expenses and impairment of property and equipment,
we had an operating loss of $13,479,000 in 2002. In 2001, we had an operating
loss of $6,175,000 (excluding amortization and impairment of goodwill,
restructuring expenses and impairment of property and equipment of
$17,332,000). Including amortization and impairment of goodwill, restructuring
expenses and impairment of property and equipment, we had an operating loss of
$23,507,000 in 2001. In 2000, we had an operating loss of $1,529,000.

Restructuring expenses.  The consolidated statements of operations
for the years ended December 31, 2002 and 2001, include restructuring expenses
resulting from several restructuring programs to reduce operating expenses due
to the dramatic and continuing slowdown in the economy in general, the
telecommunication sector in particular and our decision to refocus our strategy
in delivering conferencing and training solutions via terrestrial networks with
a primary focus on synchronous video/audio/data in narrowband bandwidths. These
programs resulted in reorganizing our R&D department, sales and marketing
departments worldwide as well as closing certain offices of Arel Learning
Solutions Inc. in the United States and to further down the activities related
with interactive video data, and network integration services. As part of the
2001 programs, we recorded restructuring expenses amounting to $961,000 in
respect of closure of certain offices ($518,000) and termination of employment
of 18 employees ($443,000). Through December 31, 2002, all amounts related to
this program have been paid. As part of the 2002 programs, we recorded
restructuring expenses and impairment of property and equipment amounting to
$2,301,000. The amounts include: termination of employment of 12 employees at a
total cost of $1,007,000 and downsizing and closing of facilities amounting to
$544,000. In addition, as a result of the restructuring, we recorded $750,000
as non-cash impairment of property and equipment, in respect of leasehold
improvements, office furniture and equipment and computer equipment. At
December 31, 2002, $852,000 of the amounts related to this program were not
paid yet and are scheduled to be disbursed during 2003.

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Financial Income - net. Financial income
consists of interest derived on short-term bank deposits, gain (loss) from the
change in market value of securities that we hold and expenses with respect to
bank commissions. Financial income decreased in 2002 to $102,000 from $883,000
in 2001.  Financial income decreased in
2001 to $883,000 from $914,000 in 2000. The decrease in 2002 is primarily due
to a decrease of interest rate for short and long terms deposits.

Impairment of investment in Arelnet.In
2002, we recorded an expense for the impairment in the value of our remaining
investment in Arelnet shares in the amount of $279,000 according to the fair
value of the Arelnet shares on the Tel-Aviv Stock Exchange on December 31,
2002. In 2001, we recorded an expense for the impairment in the value of our,
then, remaining investment in Arelnet shares in the amount of $2,890,000 in
2001

Net Loss. In 2002, we had a loss of
$13,656,000 as compared to loss of $25,514,000 in 2001. In 2000, we had a net
loss of $716,000 from continuing operations calculated after taxes on income
(in the amount of $101,000) and before loss from discontinued operations in the
amount of $390,000.

Liquidity
and Capital Resources

At December 31, 2002 and
2001, we had cash and cash equivalents of $10,354,000 and  $5,382,000 respectively, and marketable
securities and short term bank deposits valued at $129,000 and $8,340,000
respectively, which we believe can be readily sold to obtain additional cash as
needed. All debt obligations are on our balance sheet.  We have no
off-balance sheet debt obligations.

At December 31, 2002, we
had working capital of $7,592,000 and current ratio (current assets to current
liabilities) of 2.08:1. Since our inception, our operations have been funded
through capital contributions, bank loans, private investments, research and
development grants and cash flow from operations. In 2000, we raised
approximately $13,235,000 net of share issuance expenses from a private
placement to Soros Fund Management L.L.C. and Keppel Communications Pte. Ltd.
in April 2000, as well as due to options exercised by our employees and other
shareholders.

The balance of our NIS
monetary assets and monetary liabilities as of December 31, 2002, was $395,000
and $3,040,000, respectively. A portion of our salary expenses is NIS linked.
We strive to limit our exposure to currency fluctuations through natural
hedging, i.e., attempting to have similar levels of assets and liabilities in
NIS, to the extent possible. We do not use any derivatives for hedging
purposes.

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In 2002, net cash used in
our operating activities amounted to $3,260,000 as compared to net cash used in
operating activities of $1,446,000 in 2001. Accounts receivable decreased
$1,278,000 from $4,221,000 in 2001 to $2,943,000 in 2002.

Inventories
were reduced in 2002 by $1,097,000 from $2,265,000 in 2001 to 1,168,000 in
2002. The decrease in inventory is mainly due to a decrease in our purchases.
Net cash provided by our investing activities was $8,238,000 in 2002 compared
to net cash usage of $7,246,000 in 2001 for the following reasons:

| |  | We released in 2002, $8,172,000 to be used in
  operating activities compared with the investment in short-term bank deposits
  in the amount of approximately $6,523,000 in 2001.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                                                   
| |  | We invested in plant and equipment in the amount of
  approximately $174,000 in 2002 and $259,000 in 2001.                                                                        
| |   |                                                                                                                                                                                   
| |  | We invested, in 2001, $911,000 in Arelnet.                                                                                                                                        

Net
cash used in financing activities in 2002 and 2001 was $6,000 and $4,000
respectively.

We
anticipate that we will continue to incur significant operating expenses in
connection with the development and marketing of our products.  We believe that our current assets, together
with anticipated cash generated from operations, will be sufficient to meet our
cash requirements for working capital and capital expenditures for at least
twelve months following the date of this annual report.  Thereafter, if cash generated from
operations is insufficient to satisfy our liquidity requirements we may sell
additional equity or debt securities or seek to obtain a credit facility.

Our
principal commitments consist of outstanding operating leases for our companys
offices and facilities. The lease agreements expire at various dates in 2004.
Some of the lease agreements have renewal options. Annual minimum future rental
payments due by us and our subsidiaries are approximately as follows:

|                                                                                       | 2003 | 2004
|-------------------------------------------------------------------------------------- | ---- | ----
|Lease Obligations with regard to offices
  and facilities (U.S. dollars in thousands)* | 220  | 130 

*
See also note 8b. to our consolidated financial statements, which are included
herein as pages F-1 to F-37.

We are also committed to
pay royalties to the Government of Israel in respect to marketing expenses in
which the Government participated by way of grants. The royalties are payable
at the rate of 4% of the increase in export sales, up to the amount of the
dollar-linked grant received. In the case of no increase in export sales, we
are not obligated to pay any such royalties to the Government. The maximum
contingent liability in respect of royalties to the Government at December 31,
2002 is approximately $364,000.

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Research
and Development, Patents and Licenses, etc.

We
invest a significant amount of our resources on our internal research and
development operations. We believe that continued and timely development of new
products and enhancements to existing products are necessary to compete
effectively. We devote a significant portion of our resources (i) to developing
new products to better compete in a rapidly evolving market, (ii) to sustaining
and upgrading existing products by improving serviceability and adding new
capabilities and features, (iii) to decreasing the cost of owning and operating
such products, and (iv) to maintaining close relationships with our customers
to identify their product needs.

In
2000, 2001, and 2002, we applied for grants from the Office of the Chief
Scientist of the Israeli Ministry of Industry and Trade. The Government of
Israel encourages research and development projects oriented towards products
for export through the Office of the Chief Scientist. Under the terms of these
grants, a royalty of 3-5% of the net sales of products developed from a project
funded by the Office of the Chief Scientist must be paid, beginning with the
commencement of sales of products developed with grant funds and ending when
100-150% of the dollar value of the grant is repaid. The grants are subject to
interest at an annual rate of LIBOR for 12 months applicable to dollar
deposits, which will accrue annually based on the LIBOR rate published on the
first day of each year. The terms of
Israeli government participation also require that the manufacture of products
developed with government grants be performed in Israel, unless a special
approval has been granted by the Office of the Chief Scientist. Such approval,
if granted, is generally subject to an increase in the total amount to be
repaid to the Office of the Chief Scientist to between 120% and 300% of the
amount granted, depending on the extent of the manufacturing to be conducted
outside of Israel. Separate Israeli government consent is required to transfer
to third parties technologies developed through projects in which the
government participates. Such restrictions do not apply to exports from Israel
of products developed with such technologies.

A
recent amendment to the Research and Development Law has moderated the
restriction on the transfer of funded technology and provides that the
restriction on manufacturing outside of Israel shall not apply to the extent that
plans to so manufacture were declared when applying for funding. The amended
law also adds criteria which applicants must satisfy in order to obtain Office
of the Chief Scientist funding. For further details see Item 10, Additional
Information - Taxation below.

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The Office of the Chief
Scientist (the OCS) has approved our plan for the period from June 1999 till
May 2000 for approximately $1,031,000. According to the approval $309,000
representing 30% were to be provided by the OCS, of which, as of May 31, 2003,
we received $269,000 after submission of the final completion certificate. The
OCS has approved our plan for the period from June 2000 till May 2001 for
approximately $1,686,000. According to the approval $843,000 representing 50%
were to be provided by the OCS, of which, as of May 31, 2003, we received $642,
000 after submission of the final completion certificate.  The OCS has approved our plan for the period
from June 2001 till December 2001 for approximately $916,000. According to the
approval $458,000 representing 50% were to be provided by the OCS, of which, as
of May 31, 2003, we received $413,000, after submission of the final completion
certificate. As of May 31 2003 we do not expect to receive additional funds
from the OCS for the above plans.  The
OCS has not approved our application for 2002. We have recently received
informal confirmation from the OCS that they have approved our research and
development program for 2003, which contemplates that we will spend $2,000,000
on research and development. We expect the OCS to fund 50% of our 2003 research
and development program. Receipt of OCS funding and the exact amount, which
will be provided, are subject to our receipt of final written confirmation from
the OCS.

Under the terms of the
OCS grants, we must pay royalties, usually at rates between 3-5% of the sales
of products developed with such grants, up to a dollar-linked amount equal to
100% to 150% of such grants. Grants received under programs approved after
January 1, 1999, are subject to interest at an annual rate of LIBOR for 12
months applicable to dollar deposits, which accrue annually based on the LIBOR
rate published on the first day of each year.
In 2002, we paid $37,000 in royalty payments to the Government of
Israel. In 2000, we paid $265,000 in royalty payments to the Government of
Israel of which $34,000 was credited towards royalty payments, which were to be
made in 2001.  As of May 31, 2003,
the maximum amount of the contingent liability in respect of royalties to the Government
amount to approximately $ 1,366,000.

As
of May 31, 2002, our research and development staff consisted of 24 employees,
all of whom are located in Israel and most of who hold advanced technical
degrees.  Our research and development
staff engages in developing interactive distance learning software for
satellite and Internet delivery.  In
1999, our gross research and development expenditures were approximately
$1,081,000 in 2000, they were approximately $1,848,000 in 2001, they were
approximately $2,804,000 and in 2002, they were $2,218,000.  We expect to continue to commit substantial
resources to research and development in the future.

Trend Information

As a result of the tragic
terrorist attacks in the U.S. on September 11, 2001, there has been a growing
demand for systems that enable virtual meetings, and on-line group
collaboration work as people have reduced the amount of flying that they
do.  This trend has led to what is known
as corporate communication and collaboration. In line with our competitive
advantage in the e-learning and conferencing field, we focus on media-rich
based, video-enabled, live and interactive e-learning and conferencing systems
with all the collaboration functionality required by the corporate
communication market.

An additional trend is
the negative effect of the worldwide economic slowdown, which has also been
influenced by the September 11, 2001 terrorist attacks in the U.S., on both
technology-based companies and customers and potential customers and business
partners of ours. This has led to postponements of orders and in the execution
of projects which has resulted in greater fluctuations in our period to period
results. Despite the continued dynamism of the e-learning industry and the
resulting business opportunities, which in part, are a result of the worldwide
economic slowdown and the September 11, 2001 terrorist attacks, the e-learning
market is delicate and more tenuous than in the past and has witnessed an
increase in the frequency of positive and negative cycles.

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As bandwidth expands, the
e-Learning and conferencing industries are shifting from using a dedicated
infrastructure (usually satellite for course delivery and H323-based for
conference delivery) to terrestrial converged networks.  The majority of our sales in 2002 were in
through dedicated infrastructure delivery. We foresee that as we progress we
will sell more in the e-learning/training terrestrial and conferencing segment
of the market.  However, with the goal
of remaining the leader as a provider of across-the-board hybrid training and
conferencing solutions, we continue to position ourselves in the media-rich,
live and on-demand interactive e-learning delivery and synchronized
conferencing and collaboration platform domain, by concentrating in both
dedicated and converged (public internet, VPNs and intranet) networks. Through
the Arel Integrated Conferencing Platform suite of products, with their
distributed database and synchronization with our delivery and conferencing
applications, we are unique in that we offer all of the modules required for
successful e-learning solutions on a single platform, including administration,
registration, scheduling, content authoring, post-session analysis and
reporting.

|ITEM
  6. | DIRECTORS,
  SENIOR MANAGEMENT AND EMPLOYEES.
|--------- | ---------------------------------------------

As of June 1, 2003, our
directors, senior management and key employees are as follows:

|Name                  | Age | Position
  with the Company                        
|--------------------- | --- | ---------------------------------------------------
|Izhak Gross           | 56  | Chairman of the Board                              
|Shimon Klier          | 65  | Director                                           
|Mitchell E. Jones     | 40  | Director                                           
|Shlomo Shalev         | 39  | Director                                           
|Leslie S. Banwart     | 54  | Director                                           
|Asher Schapiro        | 71  | Director                                           
|Rimon Ben Shaoul*     | 58  | Director                                           
|Amos Sapir            | 64  | Outside Director                                   
|Ms. Ephrat Bronfeld** | 56  | Outside Director                                   
|Philippe Szwarc       | 39  | Chief Executive Officer                            
|Zvi Klier             | 37  | President                                          
|Danny Yelin           | 39  | Chief Financial Officer                            
|Moshe Ben Yishai      | 44  | President of Arel Communications and Software, Inc.

| | *  | Mr. Rimon Ben-Shaul serves as an alternate director
  for Mr. Ron Harel.                                                                                                                                                                                            
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | ** | The Board of Directors of the Company has nominated
  Ms. Efrat Bronfeld for election at the Annual Shareholders Meeting to be held
  on July 16, 2003, as an outside director. Ms. Bronfeld has advised us that
  she will serve as an outside director if elected.

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Izhak Gross has served as a director
since 1988 and as our chief executive officer from 1988 until May 2002. He has
been chairman of our board of directors since 1997 and served as our president
from 1988 to 1997. He is also a director of Arelnet Ltd. Prior to 1988, Mr.
Gross served as a managing director of Arel Computers and Software (1982) Ltd.,
a company which was then controlled by Argaman Industries Ltd. Mr. Gross
received a Bachelor of Science degree in Physics from the Technion, Israel
Institute of Technology.

Shimon Klier has served as a member of
the board of directors since 1988 and was chairman through 1996. Zvi Klier is
an alternate director for Shimon Klier. Since 1996, he has been chief executive
officer and chairman of the board of directors of Imarad Imaging System Ltd.Mr. Klier is the founder of Arel
Energy Ltd., developers of solar energy systems, and has been its chairman of
the board and president since 1982. From 1972 until 1989, Mr. Klier served as a
managing director of Argaman Industries Ltd. and Chairman of its Technology
Division. Mr. Klier received a Bachelor of Science degree in Industrial
Engineering from the Technion, Israel Institute of Technology.

Shlomo Shalev has been a director of
our company since January 2002. Mr. Shalev has served as a vice president of
Ampal (Israel) Ltd., a subsidiary of Ampal-American Israel Corporation whose
shares are traded on NASDAQ since 1997. From 1994-1997, Mr. Shalev served as
Israels vice counsel for economic affairs in San Francisco, California. From
1993-1994, he served as an economic advisor to the general manager of Israels
Ministry of Industry and Trade. Mr. Shalev also serves as a member of the board
of directors of numerous Israeli companies. Mr. Shalev holds a Masters of
Business Administration degree from the University of San Francisco and a Bachelor
of Arts degree in Economics from Ben-Gurion University.

Mitchell E. Jones joined us in August
2000 with our acquisition of W2COM and served as chief executive
officer and president of Arel Learning Solutions until September 2001. Mr.
Jones has served on our board of directors since June 2001. In 1988, Mr. Jones
founded Space Asset Management Inc. and managed it until 1994 when he founded
NCKID (North Central Kentucky Industrial Development).  In 1995, Mr. Jones founded W2COM,
LLC and served as its chief executive officer until our acquisition of W2COM,
LLC in August 2000.  Mr. Jones received
a Bachelor of Science degree in Aeronautical Engineering from Embry-Riddle
University.

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Leslie Banwart has been a director of
our company since January 2002. Since 1996 Mr. Banwart has served as the
President of CYMI, Ltd., a family office located in Dayton, Ohio, which
provides various services to the family as well as the familys foundation. In
such capacity, one of Mr. Banwarts many responsibilities is to ensure that
strategic planning objectives are being properly implemented.  Prior to joining CYMI, Mr. Banwart was a
partner with Arthur Andersen, LLC, where he served for 25 years.  Mr. Banwart holds a Bachelors of Science
degree in Accounting from Ferris State University in Big Rapids, Michigan.

Asher Schapiro has been a director of
our company since January 2002.  In
1985, Mr. Schapiro founded a US based computerized marketing company and, since
its formation, serves as its chairman of the board.  Mr. Schapiro serves on the board of several Israeli high-tech
companies, including Arelnet, Imagine and First Access.  Since 1998, Mr. Schapiro serves as a senior
consultant to Keppel T&T, a Singapore based company in the
telecommunications arena that has invested in Israeli companies.

Rimon Ben Shaoul has been a director
of our Company since November 27, 2002. Since February 2001, Mr. Shaoul served
as co-chairman, president and chief executive officer of Koonras Technologies
Ltd., an investment company controlled by Polar Investments Ltd. From June
1997, Mr. Shaoul served as the president and chief executive officer of Clal
Industries and Investments Ltd., one of Israels largest holding companies
primarily investing in the industrial and high-tech sectors. Mr. Shaoul also
served as a member of the board of directors of Clal (Israel) Ltd. and of
various subsidiaries thereof. Between the years 1985 and June 1997, Mr. Shaoul
served as the president and chief executive officer and a member of the board
of directors of Clal Insurance Company Ltd., and as the chairman or member of
the board of directors of various subsidiaries thereof. Mr. Shaoul holds a
Bachelor of Arts degree in Economics and a Master of Business Administration
both from Tel-Aviv University.

Amos Sapir has served as an outside
director of our company since June 2001. 
Since 1997, Mr. Sapir has held several positions.  He served as chairman of Maalot (the Israel
Securities Rating Company Ltd.), a board member of various private and public
companies, chairman of a kibbutz and an economic and business consultant. From
1980 to 1997, he held several management positions at Clal (Israel) Ltd. Mr.
Sapir has a Bachelor of Arts degree in Economics and International Relations
from the Hebrew University of Jerusalem, a Masters in Business Administration
and a PhD from Columbia University, New York.

Ms. Ephrat Bronfeld is to be nominated
as an Outside Director for the Company in the upcoming Annual Shareholders
Meeting to be held on July 16, 2003. From 1996 until 2002, Ms. Bronfeld served
as chief executive officer of Tahal, a subsidiary of Tahal Consulting Engineers
Ltd. From 1994-1996, Ms. Bronfeld served as an assistant to the Vice President
of business development of Housing and Construction Holding Co. Ltd. Between
1988 and 1993, Ms. Bronfeld served as the Chief Economist of Koor Industries
Ltd. Prior to joining Koor, Ms. Bronfeld served as an executive for Negev
Phosphates Ltd. for 8 years. Between 1976 to 1978, she served as an officer in
the Israeli Ministry of Finance. Ms. Bronfeld holds a Bachelors of Arts degree
in Economics and French and a Masters of Arts degree in Economics, both from
the Hebrew University of Jerusalem.

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Zvi Klier has served us in different
roles since 1991. He served as the General Manager of the IDEAL division since
January 1996 and is currently our president. Prior to that, he was the product
manager of IDEAL since its initiation in 1993 and was responsible for several
engineering and development tasks at Arel. 
Mr. Klier has a Bachelor of Science degree in Electrical Engineering
from the Technion, Israel Institute of Technology and a Masters in Business
Administration from INSEAD, France. Zvi Klier is Shimon Kliers son.

Philippe Szwarc was appointed as our
chief executive officer in May 2002. 
Mr. Szwarc joins Arel with over ten years of experience in the
networking and telecommunications industries, during which time he held several
senior executive positions.  In these
capacities, Mr. Szwarc consistently developed companies toward high revenue
growth and profitability and identified new market opportunities.  Between 1995 and 2001, Mr. Szwarc served in
various positions with MRV Communications, a world leader in optical components
and networking whose shares are traded on the NASDAQ.  While at MRV, Mr. Szwarc served as chief executive officer of
Nbase Communications from 1995 to 1997, and chief executive officer of iTouch
Communications from 1998 to 2000.  Mr.
Szwarc holds a Masters in Business Administration degree from INSEAD, the
European Institute of Business Administration, and a Bachelor of Science degree
in Computer Science from the Technion, Israel Institute of Technology.

Danny Yelin was appointed as our Chief
Financial officer in July 2002. Mr. Yelin joins Arel with over 10 years of
experience with publicly and privately held companies in the telecommunication
and software industry, in which he held senior Financial and Operating
positions. Between 1995 and 1998, Mr. Yelin served in various positions in MRV
Communications (MRVC), first as the CFO and VP Operations in Nbase
Communications, an MRVC wholly owned subsidiary, and later as the Corporate
Controller for the entire group. From 1998 to 2000, Mr. Yelin served as the
CFO/COO of Worldsite.com, an Internet Business Development company in Los
Angeles. From 2000 to 2002 Mr. Yelin served as the Senior VP of Operations for
Sphera Corp, a Boston based software company. 
Mr. Yelin holds a Masters degree in Business Administration from INSEAD,
the European Institute of Business Administration, and a Bachelor of Science
degree in Industrial Engineering from the Technion, Israel Institute of
Technology.

Moshe Ben Yishai serves as President
of Arel Communications and Software Inc. He joined Arel in 1996 as Executive
Vice President of Marketing & Sales. In 1998, he took on his current
responsibilities, spearheading the marketing and distribution of our IDEAL
system in the U.S. and Canada. Prior to joining Arel, he served in various
positions over a 10-year period with Orbit Advanced Technologies, Netanya,
Israel. He has a Bachelor of Science degree in Mechanical Engineering from
Fairleigh Dickinson University and an Masters in Business Administration from
New York University.

Compensation of Officers and Directors

The aggregate direct remuneration
paid to, or reserved for, all persons as a group who served in the capacity of
director or executive officer during the year ending December 31, 2002, was
approximately $1,114,000. This includes $191,000 set aside for or accrued to
provide pension, retirement or similar benefits as well as amounts we expended
for automobiles made available to our officers, expenses (including business
travel, professional and business association dues and expenses) reimbursed to
officers and other fringe benefits commonly reimbursed or paid for by companies
in Israel.

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In February 1994, we
entered into a three-year employment agreement with Mr. Gross. Although the
term of this agreement was not been formally extended, the parties acted
according to its terms.  In May 2002, we
entered into an agreement with Mr. Izhak Gross, pursuant to which he ceased
serving as our Chief Executive Officer but will serve as Active Chairman of our
board of directors.  Mr. Gross is one of
our founders who served as our Chief Executive Officer since 1988 and as
Chairman of our board of directors since 1997. For a further description of the
agreement see Item 7.  Related Party
Transactions below.

Board Practices

Our articles of
association provide for a board of directors of not less than two and not more
than eight members, unless determined otherwise by a general meeting of our
shareholders.  All directors are elected
to serve until their successors are elected at the next annual general meeting
of shareholders. Officers are appointed by and serve at the pleasure of the
board of directors.

Our Articles of
Association provide that any director may, by written notice to us, appoint
another person to serve as a substitute director and may cancel such
appointment. Under the Israel Companies Law, there shall not be appointed as a
substitute director, any person who is not himself qualified to be appointed as
a director or a person who is already serving as a director or a person who is
already serving as a substitute director for another director. The term of
appointment of a substitute director may be for one meeting of the board of
directors or for a specified period or until notice is given of the
cancellation of the appointment.

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

| |  | an employment relationship;                                             
| | - | ------------------------------------------------------------------------
| |  | a business or professional relationship maintained
  on a regular basis;
| |  | control; and                                                            
| |  | service as an office holder.                                            

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

48

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Outside directors are to
be elected by a majority vote at a shareholders meeting, provided that either:

| |  | the majority of shares voted at the meeting,
  including at least one-third of the shares held by non-controlling
  shareholders voted at the meeting, vote in favor of election of the director;
  or
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   |                                                                                                                                                                                                       
| |  | the total number of shares held by non-controlling
  shareholders voted against the election of the director does not exceed one
  percent of the aggregate voting rights in the company.             

The
initial term of an outside director is three years and may be extended for an
additional three years.  Outside
directors may be removed only by the same percentage of shareholders as is
required for their election, or by a court, and then only if the outside
directors cease to meet the statutory qualifications for their appointment or
if they violate their duty of loyalty to the company.  Each committee of a companys board of directors that is
authorized to exercise a function of the board must include at least one
outside director, while the companys audit committee must include all of its
outside directors.

An outside director is entitled
to compensation as provided in regulations adopted under the Companies Law and
is otherwise prohibited from receiving any other compensation, directly or
indirectly, in connection with service provided as an outside director.  Mr. Sapir was elected by our shareholders to
serve as an outside director in June 2001 at our Extraordinary General Meeting
of Shareholders. At the same meeting, another outsider director was elected.
Such person has since resigned from his position.

The Board of Directors of
the Company has nominated Ms. Efrat Bronfeld for election at the Annual
Shareholders Meeting to be held on July 16, 2003, as an outside director to
serve for a period of three years and until her respective successor is duly
elected, and has qualified. Ms. Bronfeld has advised us that she will serve as
an outside director if elected.

In
addition, pursuant to the listing requirements of the NASDAQ Small Cap Market,
we are required to have at least two independent directors on our board of
directors.

The
Companies Law requires public companies to appoint an audit committee.  The responsibilities of the audit committee
include identifying irregularities in the management of the companys business
and approving related party transactions as required by law.  An audit committee must consist of at least
three directors, including all of the outside directors of the company.  The chairman of the board of directors, any
director employed by or otherwise providing services to the company, and a
controlling shareholder or any relative of a controlling shareholder, may not
be a member of the audit committee.

49

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The
listing requirements of the NASDAQ Small Cap Market and, as mentioned, the
Israel Companies Law, require the establishment of an audit committee.  Currently, Messrs. Ben-Shaoul and Sapir
serve as the members of our audit committee. Following the election of Ms.
Ephrat Bronfeld as an additional outside director by our shareholders, she will
be added as the third member of our audit committee.

Under the Companies Law,
the board of directors of public companies must appoint an internal auditor,
nominated by the audit committee.  The
role of the internal auditor is to examine, among other matters, whether the
companys actions comply with the law and orderly business procedure.  Under the Companies Law, the internal
auditor may be an employee of the company but not an office holder, or an
affiliate, or a relative of an office holder or affiliate, and may not be the
companys independent accountant or its representative.

Employees

The following table sets
forth for the specified periods, the number of our employees engaged in the
specified activities, by geographic location.

|                                                                                                                    | Year
  ended
  December 31,
  2002 | Year
  ended
  December 31,
  2001 | Year
  ended
  December 31,
  2000
|------------------------------------------------------------------------------------------------------------------- | ---------------------------------- | ---------------------------------- | ----------------------------------
|Research and Development
Arel Communications and Software,
Ltd.                                                     | 25                                 | 34                                 | 33                                
|Installation and Technical Support
Arel Communications
and Software, Ltd.Arel Communications and Software, Inc.     | 23                                 | 13                                 | 13                                
|Marketing
Arel Communicationsand Software, Ltd.Arel Communications and Software, Inc.
Arel Learning Solutions, Inc. | 154                                | 3821                               | 7621                              
|Management and AdministrationArel
  Communications and
  Software, Ltd.Arel Learning
  Solutions, Inc.              | 42                                 | 88                                 | 1110                              
|Total                                                                                                               | 51                                 | 86                                 | 92                                

For the last three fiscal
years, we did not employ a significant number of temporary employees and
neither did any of our subsidiaries. 
Most of our employees have signed non-disclosure agreements covering all
of our proprietary information that they might possess or to which they have
access. We believe that we have satisfactory labor relations with our employees
and we have never experienced a work stoppage.

50

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Certain
provisions of the collective bargaining agreements between the Histadrut
(General Federation of Labor in Israel) and the Coordination Bureau of Economic
Organizations (including the Industrialists Associations) are applicable to
our employees in Israel by order of the Israeli Ministry of Labor. These
provisions concern principally the length of the workday, minimum daily wages
for professional workers, insurance for work-related accidents, procedures for
dismissing employees, determination of severance pay, and other conditions of
employment. We generally provide our employees with benefits and working
conditions beyond the required minimums. In addition to salary and other
benefits, certain of our marketing personnel are paid commissions based on our
performance in certain territories worldwide.

Israeli law generally
requires severance pay upon the retirement or death of an employee or
termination of employment without cause (as defined in the law). Severance pay
may be funded by Managers Insurance described below. The payments to Managers
Insurance on account of severance pay amount to approximately 8.33% of wages.
Furthermore, Israeli employees and employers are required to pay predetermined
sums to the National Insurance Institute, which is similar to the United States
Social Security Administration. Such amounts also include payments by the
employee for national health insurance. The total payments to the National
Insurance Institute are equal to approximately 14.6% of the wages (up to a
specified amount), of which the employee contributes approximately 66% and the
employer contributes approximately 34%.

Though not legally
required, we contribute funds on behalf of most of our employees to a fund
known as Managers Insurance. This fund provides a combination of savings
plan, insurance and severance pay benefits to the employee, giving the employee
payments upon retirement or death and securing the severance pay, if legally
entitled, upon termination of employment. We decide whether each employee is
entitled to participate in the plan, and each employee who agrees to participate
contributes an amount equal to 5% of his/her salary and we, the employer,
contribute between 13.3% and 15.8% of his/her salary.

Our success has been, and
will be, dependent to a large degree on our ability to retain the services of
key personnel and to attract additional qualified personnel in the future.
Competition for such personnel is intense. There can be no assurance that we
will be able to attract, assimilate or retain key personnel in the future and
the failure to do so would have a material adverse effect on our business,
financial condition and results of operations.

Share Ownership

Except as set forth
below, none of the named directors or employees own shares and/or options
amounting to 1% or more of our outstanding ordinary shares. Shimon Klier
beneficially owns 42,619 ordinary shares, which is 0.3% of our share
capital.  Zvi Klier beneficially owns
217,300 ordinary shares and options to purchase 240,000 ordinary shares, which
is 3.48% of our share capital.  The
weighted average exercise price of Zvi Kliers options is $2.572 per share, of
which 90,000 expire on July 30, 2005 and 150,000 March 31, 2006. Our chief
executive officer, Philippe Szwarc was granted options to purchase 500,000 of
our ordinary shares at an exercise price of $0.932 per share. These options can
be exercised in four tranches: 100,000 of such options may be exercised as of
each of May 1st of 2003, and 2004; and 150,000 of such options may
be exercised as of each of May 1st, 2005 and 2006.  Information regarding the shares owned by
Izhak Gross and Mitchell Jones is incorporated by reference to Item 7. Major
Shareholders.

51

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Employee Share Option Plans

We maintain the following
share option plans for our and our subsidiaries employees, directors and
consultants.  In addition to the
discussion below, please see note 9 to our consolidated financial statements,
which are included in this Annual Report on Form 20-F for the year ended
December 31, 2002.

On January 2, 1994, our
board of directors adopted a share option plan (the First Share Option Plan),
pursuant to which 300,000 ordinary shares were reserved for issuance upon the
exercise of options to be granted to our key employees and consultants.  The First Share Option Plan is administered
by the board of directors, which designates the optionees and dates of
grant.  Through May 31, 2003, 39,210
options were outstanding having a weighted average exercise price of $2.03 per
share. These options are non-assignable except pursuant to the laws of
descent.  The options are generally
exercisable over a period ranging from three to four years after the date of
grant.  The grantee is responsible for
all personal tax consequences of the grant and the exercise thereof. On
November 30, 1995, our board of directors adopted an additional share option
plan (the Second Share Option Plan), pursuant to which an additional 300,000
ordinary shares were reserved for issuance upon the exercise of options to be
granted to our key employees and consultants. Through May 31, 2003, 42,651of such
options were outstanding at exercise prices ranging from $1.11 to $1.88.  The terms of the Second Option Plan are
identical to those of the First Option Plan, except that the options are to be
issued at exercises prices equal to the fair market value of our shares on the
date of grant. On November 4, 1998, our board of directors adopted an
additional share option plan (the Third Share Option Plan), pursuant to which
an additional 400,000 ordinary shares were reserved for issuance upon the
exercise of options to be granted to our key employees and consultants. Through
May 31, 2003, 190,000 of such options were outstanding at exercise prices
ranging from $2.33 to $8.77.  The terms
of the Third Option Plan are identical to those of the First and Second Option
Plans, except that the options are to be issued at exercises prices equal to
the fair market value of our shares on the date of grant. On August 2, 2000,
our board of directors adopted an additional share option plan (the Fourth
Share Option Plan), pursuant to which an additional 1,125,000 ordinary shares
were reserved for issuance upon the exercise of options to be granted to our
key employees and consultants.  Through
May 31, 2003, 688,500 of such options were outstanding at exercise prices
ranging from $0.60 to $2.63.  The terms
of the Fourth Option Plan are identical to those of the First, Second and Third
Option Plans, except that the options are to be issued at exercises prices
determined by the share option committee on the date of grant.

52

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As of June 1, 2003,
options to purchase 567,500 shares previously granted by Arel to employees
under the above plans were forfeited as result of discontinuation of such
employees employment. Such shares are thus available for distribution under
the new 2003 option plan which we propose to adopt.

As of May 31, 2003,
960,361 of the options that we have issued to our employees and executive
officers were outstanding. The weighted average exercise price is $1.93 per
share 527,911 of these options were exercisable at May 31, 2003.

In the course of June
2003, the Company has engaged in finalizing and adopting a new share option
plan in order for its Israeli employees to be eligible for certain tax benefits
for options granted pursuant to the provisions of Section 102 of the Israeli
Income Tax Ordinance (New Version), 1961 as amended from time to time and, most
recently, by the Law Amending the Income Tax Ordinance (Number 132) 2002 (as
amended) and the rules promulgated thereunder (102 Option Plan - 2003), which
came into force on January 1, 2003 as part of the recent tax reform in Israel .
We intend to terminate the previous option plans and consolidate the
unallocated shares available thereunder together with the shares available as
result of forfeiture by departing employees and reserve them for issuance under
the 102 Option Plan  2003. We will have 515,885 options available for grant
under the 102 Option Plan  2003.

|ITEM
  7. | MAJOR
  SHAREHOLDERS AND RELATED PARTY
  TRANSACTIONS.
|--------- | ------------------------------------------------------

Major Shareholders

The following table and
notes thereto set forth certain information as of June 1, 2003, concerning the
beneficial ownership (as defined in Rule 13d  3 under the Securities Exchange
Act of 1934, as amended) of ordinary shares by (i) each person or entity who,
to the best of our knowledge, beneficially owned more than 5% of our
outstanding ordinary shares and (ii) all current directors, the nominees and
executive officers as a group.  The
voting rights of our major shareholders do not differ from the voting rights of
holders of all of our ordinary shares.

|                                                                                | Ordinary
  Shares/OptionsOwned(1)
|------------------------------------------------------------------------------- | ---------------------------------
|Name
  and Address                                                              | Number                           
|Izhak Gross
  3 Hayarden Street
  Yavne 70600, Israel                           | 992,619(2)                       
|Polar Communications Ltd.
  21 Haarbaa Street
  Tel Aviv 64739, Israel        | 2,453,271                        
|Clayton L Mathile TTEE
  10 Courthouse Pl SW
  Suite 1100, Dayton OH 45402, USA | 1,076,458(3)                     
|W2COM, LLC
  10 Courthouse Pl SW
  Suite 1100, Dayton OH 45402, USA             | 1,053,994                        
|Mitchell E. Jones
  10 Courthouse Pl SW
  Suite 1100, Dayton OH 45402, USA      | 1,263,150(4)                     
|All officers and directors as a group
  (4 persons)                             | 3,555,688(5) (6)                 

53

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|(1) | The table above includes
  the number of shares underlying options that are exercisable within 60 days
  of May 1, 2003. Ordinary shares subject to these options are deemed
  beneficially owned for the purpose of computing the ownership percentage of
  the person or group holding these options, but are not deemed outstanding for
  purposes of computing the ownership percentage of any other person.  To our knowledge, the persons and entities
  named in the table have sole voting and dispositive power with respect to all
  shares shown as beneficially owned by them, except as described below.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|(2) | Includes options to
  purchase 150,000 ordinary shares at an exercise price of $3.16 per share
  expiring on June 1, 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|(3) | According to a Schedule
  13D (amended), dated February 13, 2003, filed by Clayton A. Mathile, Mr.
  Mathile is the beneficial owner of 1,981,998 shares of which he has sole
  voting and dispositive power over 1,705,276 shares and shared voting and
  dispositive power over 276,722 shares.                                                                                                                                                                                                                                                                                                                    
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|(4) | Includes 120,000 options
  at an exercise price of $11. According to a Schedule 13G, dated April 7,
  2003, filed by Mitchell E. Jones, Mr. Jones is the beneficial owner of
  1,816,281 shares of which he has sole voting and dispositive power over
  1,539,559 shares and shared voting and dispositive power over 276,722 shares.                                                                                                                                                                                                                                                                               
|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|(5) | Includes 42,619 shares
  held by Mr. Shimon Klier, one of our directors, 217,300 shares held by Mr.
  Zvika Klier, one of our officers who is Mr. Shimon Kliers son and 700,000
  shares held by relatives of Mr. Shimon Klier. (6) Also includes options to
  purchase 610,000 ordinary shares at exercise prices ranging from $0.9 to
  $8.771 per share.                                                                                                                                                                                                                                                         

54

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As
of June 9, 2003, there were approximately 90 record holders of ordinary shares,
including approximately 72 record holders in the United States (who held
approximately 28% of our outstanding ordinary shares).

Related Party Transactions

Acquisition of W2COM, LLC -On
August 8, 2000, we acquired substantially all of the assets and business
activities of W2COM, LLC for an aggregate cash consideration of
$2,250,000 and 3,681,818 newly issued ordinary shares.  On August 8, 2000, we deposited 1,049,999 ordinary shares
with National City Bank, to secure W2Coms indemnification and post closing
obligations to us. On June 4, 2002, we commenced legal proceedings in the
Jerusalem District Court against M.E. Jones Sub, Ltd. (formerly W2COM,
LLC), M.E. Jones Inc., CYMI Ltd., Mitchell E. Jones and certain other named
parties seeking various remedies, including the return to us of the 1,049,999 ordinary shares
held in escrow. On June 12, 2002, M.E. Jones Sub, Ltd., M.E. Jones Inc., CYMI
Ltd., and Mitchell E. Jones filed a lawsuit in the Common Pleas Court of
Montgomery County, Ohio against us, Arel Learning Solutions, Inc., Mr. Izhak
Gross and the escrow agent, in which they seek various remedies in relation to
the 1,049,999 ordinary
shares held in escrow. The parties are currently in advanced settlement
negotiations to resolve these disputes.

Mitchell E. Jones Employment
Agreement - In May
2001, Arel Learning Solutions entered into a three-year employment agreement
with Mitchell E. Jones to serve as its president and chief executive
officer.  Mr. Jones began serving in
this role in August 2000 and was paid in accordance with the agreement since
that time.  Mr. Jones received an annual
salary of $240,000 in addition to employee benefits customary in Israel.  Mr. Jones was also granted options to buy
120,000 ordinary shares at $11.00 per share. In September 2001, Mr. Jones left
Arel Learning Solutions. Pursuant to the terms of a separation agreement reached
with Mr. Jones, Mr. Jones continued to receive his monthly salary and other
benefits through September 22, 2002. In addition, all of the options granted to
Mr. Jones to purchase 120,000 of our ordinary shares at $11.00 per share
vested.

Arelnets Rights Offering - In May 2001, we participated in Arelnets
rights offering and purchased 76.958 units under Arelnets prospectus dated May
30, 2001.  Each unit is comprised of 45
ordinary shares of Arelnet and 20 options for which we paid 3,463,110 NIS
(approximately $866,000 at such time). In addition, in September 2001, we
acquired 600,978 shares of Arelnet from Leader Tec Ltd. for approximately
$82,000. Our participation in the rights offering was approved by our audit
committee and our board of directors.

Agreement with Mr. Izhak Gross  - In May 2002, we entered into an agreement
with Mr. Izhak Gross, whereunder he ceased serving as our Chief Executive
Officer.  Mr. Gross is one of our
founders who served as our Chief Executive Officer since 1988 and as Chairman
of our board of directors since 1997. Pursuant to the agreement, Mr. Gross
agreed to conclude his service as our chief executive officer and serve as the
active chairman of our board of directors until such time that he or the board
of directors determines.  While serving
as active chairman, he will continue to receive his monthly salary of $12,500
and other benefits customary in Israel. 
In the event of the termination of Mr. Gross service as active
chairman, he will be entitled to his salary and other benefits for the
six-month period thereafter, including payment of $520 for every accrued but
unused vacation day.  As of the date of
the agreement, Mr. Gross had 163 accrued yet unused vacation days.  Additionally, the exercise period of
previously granted options to purchase 150,000 of our ordinary shares at an
exercise price of $3.16 per share has been extended until May 31, 2004.

55

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Employment Agreement with our Chief Executive Officer
- In May 2002, through our subsidiary Arel Communications and Software Inc., we
entered into a one-year agreement with Mr. Philippe Szwarc to serve as our
chief executive officer. Additionally, Mr. Szwarc agreed to serve, without
additional compensation, in one or more executive positions of any of our
affiliates or subsidiaries.  The
agreement will be automatically renewed for additional one-year periods, unless
earlier terminated by either of the parties. Mr.
Szwarc receives an annual gross salary of $ 150,000 and other customary
benefits. Mr. Szwarc will also be eligible to receive an annual performance-based
bonus of $100,000. On May 1, 2002, we granted Mr. Szwarc options to purchase 500,000 of our ordinary shares at
an exercise price of $0.932 per share. These options can be exercised in four
tranches: 100,000 of such options may be exercised as of each of May 1st
of 2003, and 2004; and 150,000 of such options may be exercised as of each of
May 1st, 2005 and 2006.

Employment Agreement with our Chief Financial OfficerIn July 15, 2002, we entered into an
employment agreement with Mr. Daniel Yelin to serve as our chief financial
officer. The term of the agreement will continue, unless earlier terminated by
either of the parties. We agreed to pay Mr. Yelin a monthly gross salary of
approximately $8,200.Mr. Yelin will
also be eligible to receive an annual performance-based bonus of $32,000. On
July 15, 2002, we granted Mr. Yelin options
to purchase 125,000 of our ordinary shares at an exercise price of $0.6 per
share. These options can be exercised in four tranches: 25,000 of such options
may be exercised as of July 15, 2003; 30,000 of such options may be exercised
as of July 15, 2004; and 35,000 of such options may be exercised as of each of
July 15, of 2005 and 2006.

|ITEM
  8. | FINANCIAL
  INFORMATION.
|--------- | ------------------------

Consolidated Statements and other Financial Information

Our consolidated
financial statements and other financial information are included herein as
pages F-1 to F-37.

Legal
Proceedings

On May 13, 2001, Mr. Tzvi
Chava filed a complaint against Arel Communications and Software Ltd. in the
Labour Court of Tel Aviv.  Mr. Chava is
a shareholder and director of two companies, which rendered consulting services
to our company between June 1995 and June 2000. Mr. Chava claims he was an
employee of our company until his dismissal in June 2000 and is claiming an
accrued bonus payment and certain severance benefits in the amount of 699,993
NIS (approximately $144,328). In September 2001, court referred mediation
proceedings commenced. In 2002, the claim was resolved in a mediation court.
Subsequent to the courts decision, the Company paid Mr. Chava the sum of
$67,350.

56

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See Item 7. Major
Shareholders and Related Party Transactions - Acquisition of W2COM,
LLC  for information concerning litigation with W2COM.

Other than the above
proceedings, we are not a party to any material litigation and are not aware of
any pending or threatened litigation that would have a material adverse effect
on our business or us.

Dividend Distributions

We do not intend to pay
cash dividends on our ordinary shares in the foreseeable future.  Our current policy is to retain earnings for
use in our business.

In the event that we
decide to pay a cash dividend from income that is tax exempt under our approved
enterprise status, we would be liable for corporate tax on the amount
distributed (including the corporate tax thereon) at the rate of up to
25%.  See note 10 to our consolidated
financial statements attached hereto as pages F-1 to F-37, which is
incorporated herein by reference.  An
Israeli company may only pay cash dividends out of retained earnings as
calculated under Israeli law.

Significant Changes

No significant changes
have occurred since the date of our consolidated financial statements included
in this annual report.

|ITEM
  9. | THE
  OFFER AND LISTING.
|--------- | ------------------------

Market
and Share Price History

Our ordinary shares had
been quoted on the NASDAQ National Market, under the symbol ARLC, since
December 1994. Effective September 3, 2002, our ordinary shares were delisted
from NASDAQ National and are currently traded on the NASDAQ Small Cap Market.
Our ordinary shares are not listed on any other stock exchange and have not
been publicly traded outside the United States.

The table below sets
forth the high and low bid prices of our ordinary shares, as reported by the
NASDAQ National Market and the NASDAQ Small Cap Market (after the shares were
delisted), during the indicated fiscal periods as reported by such exchange:

57

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|Period              | High   | Low   
|------------------- | ------ | ------
|May 2003            | $0.75* | $0.3* 
|April 2003          | $1.02* | $0.24*
|March 2003          | $0.32* | $0.21*
|February 2003       | $0.31* | $0.25*
|January 2003        | $0.33* | $0.25*
|December 2002       | $0.29* | $0.15*
|Fourth quarter 2002 | $0.33* | $0.13*
|Third quarter 2002  | $0.59  | $0.25 
|Second quarter 2002 | $0.97  | $0.48 
|First quarter 2002  | $1.15  | $0.77 
|Fourth quarter 2001 | $1.25  | $0.50 
|Third quarter 2001  | $1.80  | $0.80 
|Second quarter 2001 | $2.15  | $1.60 
|First quarter 2001  | $4.00  | $1.41 
|2002                | $1.15  | $0.13 
|2001                | $4.00  | $0.50 
|2000                | $23.94 | $2.63 
|1999                | $11.50 | $5.25 
|1998                | $5.13  | $2.00 

* From September 3, 2002
-- as quoted on the NASDAQ Small Cap.

Please see the discussion
under the heading Risk Factors Relating to our Ordinary Shares under Risk
Factors in Item 3 above regarding the possible effects resulting from the
delisting of our shares from the NASDAQ National Market.

|ITEM
  10. | ADDITIONAL
  INFORMATION.
|---------- | -------------------------

Memorandum and Articles of Association

Articles of Association

In
February 2000, the Companys Ordinance (New Version) -1983 was replaced by the
Companies Law.  Since our articles were
approved before the enactment of the Companies Law, they are not always
consistent with the provisions of the new law. 
In all instances in which the Companies Law changes or amends provisions
of the Companies Ordinance, and as such, our articles become inconsistent with
the Companies Law, the provisions of the Companies Law shall apply unless
specifically stated otherwise in the Companies Law.  Similarly, in all places that our articles refer to a section of
the Companies Ordinance that has been replaced by the Companies Law, the
articles shall be understood to be referring to the relevant section of the
Companies Law.

58

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Our objectives as stated
in our Memorandum of Association are to engage in any legal activity.

Currently we have one
class of outstanding securities, our ordinary shares, par value NIS 0.001 per
share. No preferred shares are currently authorized.

Holders of our ordinary
shares have one vote per share, and are entitled to participate equally in the
payment of dividends and share distributions and, in the event of our
liquidation in the distribution of property after satisfaction of liabilities
to creditors. In the event of our winding-up, the shares that we issued to W2COM
will be senior in liquidation to all of our other issued and outstanding
ordinary shares, up to the amount of $9.3 million (the Liquidation Preference
Amount).  This liquidation preference
will terminate at such time that a registration statement for shares received,
as consideration for the purchase of W2COM is declared effective by
the Securities and Exchange Commission. 
Prior to any termination of this liquidation preference, each sale of W2COM
shares to a third party (or its assigns and successors in interest) will reduce
the Liquidation Preference Amount by an amount equal to the dollar amount for
which the holder of the shares sold such shares to a third party. Our articles
may be amended by a resolution carried at a general meeting by 75% of those
whose vote is required. Shareholders rights may not be modified in any other
way unless otherwise expressly provided in the terms of issuance of the shares.

Our
articles require that we hold our annual general meeting of shareholders each
year no later than 15 months from the last annual meeting, at a time and place
determined by the board of directors, upon at least 7 days prior notice to our
shareholders or 21 days prior notice in the event that a special item is to be
discussed.  No business may be commenced
until a quorum of two or more shareholders are present in person or by
proxy.  Shareholders may vote in person
or by proxy, and will be required to prove title to their shares as required by
the Israel Companies Law pursuant to procedures established by the board of
directors.

Pursuant
to the Israel Companies Law, resolutions regarding the following matters must
be passed at a general meeting of the shareholders:

| |  | amendments to our articles;                                                                                                                                                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | appointment or termination of our auditors;                                                                                                                                                                                                                              
| |  | appointment and dismissal of directors;                                                                                                                                                                                                                                  
| |  | approval of interested party acts and transactions
  requiring general meeting approval as provided in Sections 255 and 268 to 275
  of the Israel Companies Law;                                                                                                        
| |  | increase or reduction of our authorized share
  capital and alterations of our share capital;                                                                                                                                                                            
| |  | a merger as provided in Section 320(2) of the Israel
  Companies Law;                                                                                                                                                                                                    
| |  | the exercise of the board of directors powers by a
  general meeting, if the board of directors is unable to exercise its powers
  and the exercise of any of its powers is vital for our proper management, as
  provided in Section 52(2) of the Israel Companies Law.

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Our
articles provide that the function of the annual general meeting of
shareholders will be to deliberate with respect to the following matters:

| |  | the profit and loss statements;                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the balance sheets;                                                                                                                                  
| |  | the ordinary reports and accounts of the directors
  and auditors;                                                                                   
| |  | to declare dividends;                                                                                                                                
| |  | to appoint auditors and to fix their salaries;                                                                                                       
| |  | to choose directors except insofar as the right to
  appoint or elect directors is reserved to the owners of a certain amount of a
  class of shares.

A
special meeting of our shareholders shall be convened by the board, at the
request of the directors, or by request of one or more shareholders holding at
least 5% of our issued share capital (the Petitioners).  Shareholders requesting a special meeting
must submit their proposed resolution with their request. If the directors do
not convene a meeting within 21 days from the date of the submission of the
demand as aforesaid, the Petitioners, or a part thereof representing more than
one half of the voting rights of all of them, may convene by themselves a meeting
upon 7 days notice to all shareholders. 
However, such a meeting shall not be held after two months have passed
since the date of the submission of the demand.

Our articles provide that
our board of directors may from time to time, at their discretion, borrow or
secure the payment of any sum of money for the fulfillment of our
objectives.  Our directors may raise or
secure the repayment of such sum in a manner, time and terms as they see fit.

The Israel Companies Law

The
Israel Companies Law codifies the fiduciary duties that office holders,
including directors and executive officers, owe to a company.  An office holder, is defined in the Israel
Companies Law, as a (i) director, (ii) general manager, (iii) chief business
manager, (iv) deputy general manager, (v) vice general manager, (vi) executive
vice president, (vii) vice president, (viii) another manager directly
subordinate to the managing director or (ix) any other person assuming the
responsibilities of any of the forgoing positions without regard to such
persons title.

The
Israel Companies Law requires that an office holder of a company promptly
disclose any personal interest that he or she may have and all related material
information known to him or her, in connection with any existing or proposed
transaction by the company. In addition, if the transaction is an extraordinary
transaction, as defined under Israeli law, the office holder must also disclose
any personal interest held by the office holders spouse, siblings, parents,
grandparents, descendants, spouses descendants and the spouses of any of the
foregoing, or by any corporation in which the office holder is a 5% or greater
shareholder, holder of 5% or more of the voting power, director or general
manager or in which he or she has the right to appoint at least one director or
the general manager.  An extraordinary
transaction is defined as a transaction not in the ordinary course of business,
not on market terms, or that is likely to have a material impact on the
companys profitability, assets or liabilities.

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In
the case of a transaction that is not an extraordinary transaction, after the
office holder complies with the above disclosure requirement, only board
approval is required unless the Articles of Association of the company provide
otherwise.  The transaction must not be
adverse to the companys interest.  If
the transaction is an extraordinary transaction, then, in addition to any
approval required by the Articles of Association, it must also be approved by
the audit committee and by the board of directors, and, under specified
circumstances, by a meeting of the shareholders.

Subject
to certain exceptions provided for in the Regulations to the Israel Companies
Law, agreements regarding directors terms of compensation require the approval
of the audit committee, board of directors and shareholders.  In all matters in which a director has a
personal interest, including matters of his/her terms of compensation, he/she
shall not be permitted to vote on the matter or be present in the meeting in
which the matter is considered. 
However, should a majority of the audit committee or of the board of
directors have a personal interest in the matter then:

| | a) | all of the directors shall be
  permitted to vote on the matter and attend the meeting in which the matter is
  considered; and
| | -- | -------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                
| | b) | the matter requires approval
  of the shareholders at a general meeting.                                                       

According
to the Israel Companies Law, the disclosure requirements discussed above also
apply to a controlling shareholder of a public company.  In general, extraordinary transactions with
a controlling shareholder or in which a controlling shareholder has a personal
interest, and agreements relating to employment and compensation terms of a
controlling shareholder require the approval of the audit committee, the board
of directors and the shareholders of the company. The term controlling
shareholder is defined for these purposes as a shareholder who has the ability
to direct the activities of a company, other than if this power derives solely
from the shareholders position on the board of directors or any other position
with the company.  The definition also
includes shareholders that hold 25% or more of the voting rights if no other
shareholder owns more than 50% of the voting rights in the company.

The
shareholder approval must either include at least one-third of the shares held
by disinterested shareholders who are present in person or by proxy at the
meeting (without taking abstaining votes into account), or, alternatively, the
total shareholdings of the disinterested shareholders who vote against the
transaction must not represent more than one percent of the voting rights in
the company.

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In
addition, a private placement of securities that will increase the relative holdings
of a shareholder that holds five percent or more of the companys outstanding
share capital, assuming the exercise of all of the securities convertible into
shares held by that person, or that will cause any person to become, as a
result of the issuance, a holder of more than five percent of the companys
outstanding share capital, requires approval by the board of directors and the
shareholders of the company.  However,
subject to certain exceptions, shareholder approval will not be required if the
aggregate number of shares issued pursuant to such private placement, assuming
the exercise of all of the convertible securities into shares being sold in
such a private placement, comprises less than twenty percent of the voting
rights in a company prior to the consummation of the private placement. Any
placement of securities that does not fit the above description may be issued
at the discretion of the board of directors.

Under
the Israel Companies Law, a shareholder has a duty to act in good faith towards
the company and other shareholders and refrain from abusing his power in the
company, including, among other things, when voting in the general meeting of
shareholders on the following matters:

| |  | any amendment to the Articles
  of Association;                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | an increase of the companys
  authorized share capital;                                                                                                   
| |  | a merger; or                                                                                                                                               
| |  | approval of interested party
  transactions that require shareholder approval as provided for in Sections
  255 and 268 to 275 of the Israel Companies Law.

In
addition, any controlling shareholder, any shareholder who knows that it
possesses power to determine the outcome of a shareholder vote and any
shareholder who has the power to appoint or prevent the appointment office
holder in the company is under a duty to act with fairness towards the
company.  The Israel Companies Law does
not describe the substance of this duty. The Israel Companies Law requires that
specified types of transactions, actions and arrangements be approved as
provided for in a companys articles of association and in some circumstances
by its audit committee, board of directors and by its shareholders. In general,
the vote required by the audit committee and the board of directors for
approval of these matters, in each case, is a majority of the disinterested
directors participating in a duly convened meeting.

Exchange
Controls

Pursuant
to a general permit issued under the Israeli Currency Control Law in May 1998,
substantially all transactions in foreign currency are permitted. Any dividends
or other distributions paid in respect of ordinary shares and any amounts
payable upon our dissolution, liquidation or winding up of affairs, as well as
the proceeds of any sale in Israel of our securities are freely repatriable
into non-Israeli currencies at the rate of exchange prevailing at the time of
conversion, provided that Israeli income tax has been paid on (or withheld
from) such payments.  Because exchange
rates between the NIS and the U.S. dollar fluctuate continually, U.S. shareholders
will be subject to any such currency fluctuation during the period from when
such dividend is declared through the date payment is made in U.S. dollars.

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We have never paid any
cash dividends on our ordinary shares and do not presently anticipate paying
any cash dividends in the foreseeable future. 
We intend to retain our earnings to finance the development of our
business.

Our Memorandum of
Association and Articles of Association do not restrict in any way the
ownership of the shares by nonresidents and neither the Memorandum of Association
nor the Articles of Association nor Israeli law, restrict the voting rights of
nonresidents.

Taxation

The following is a
summary of the current tax law applicable to companies in Israel, with special
reference to its effect on us.  The
following also contains a discussion of specified Israeli Government programs
benefiting us.  To the extent that the
discussion is based on tax legislation that has not been subject to judicial or
administrative interpretation, there can be no assurance that the views
expressed in the discussion will be accepted by the tax authorities in
question.

General
Corporate Tax Structure

In general, Israeli
companies are currently subject to company tax at the rate of 36% of taxable
income. However, as is in our case, the rate is effectively reduced for income
derived from an Approved Enterprise, as set forth below.

Law for
the Encouragement of Capital Investments, 1959

Certain of the facilities
of the Company have been granted Approved Enterprise status under the Law for
the Encouragement of Capital Investments, 1959, as amended (the Investment
Law). The Investment Law provides that a capital investment in eligible
facilities may, upon application to the Israel Investment Center, be designated
as an Approved Enterprise. Each certificate of approval for an Approved
Enterprise relates to a specific investment program delineated both by its
financial scope, including its capital sources and by its physical
characteristics, such as the equipment to be purchased and utilized pursuant to
the program. The tax benefits derived from any such certificate of approval
relate only to taxable income attributable to the specific Approved Enterprise.

Taxable income of a
company derived from an Approved Enterprise is subject to Company Tax at the
rate of 25% (rather than 36% as stated above) for the Benefit Period. The
Benefit Period is a period of seven years commencing with the year in which the
Approved Enterprise first generated taxable income (limited to twelve years
from commencement of production or fourteen years from the date of approval,
whichever is earlier) and, under certain circumstances (as further detailed
below), extending to a maximum of ten years from the commencement date. In the
event a company is operating under more than one approval or that its capital
investments are only partly approved (a Mixed Enterprise), its effective
Company Tax rate is the result of a weighted combination of the various
applicable rates.

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A company, which
qualifies as a Foreign Investors Company is entitled to further reductions
in the tax rate normally applicable to Approved Enterprises. Such benefits will
be granted only to enterprises that sought approval no later than December 31,
2002. Subject to certain conditions, a Foreign Investors Company is a
company which has more than 25% of its combined shareholders investment in
share capital (in terms of rights to profits, voting and the appointment of
directors) and in long term shareholders loans made by persons who are not residents
of Israel. The percentage owned by nonresidents of Israel for any tax year will
be determined by the lowest percentage of any of the above rights held by
nonresidents during that year. Such a company will pay Company Tax at reduced
rates for an extended ten-year (rather than the otherwise applicable
seven-year) period and is exempt from any other tax on the income from its
Approved Enterprise:

For a company with
foreign investment of:

| |                               | Company Tax Rate
| | ----------------------------- | ----------------
| | Over 25% but less than 49%    | 25%             
| | 49% or more but less than 74% | 20%             
| | 74% or more but less than 90% | 15%             
| | 90% or more                   | 10%             

Should our foreign
shareholdings exceed 25%, future Approved Enterprises would qualify for reduced
tax rates for an additional three years, after the seven years mentioned above.
However, there can be no assurance that we will attain approval for additional
Approved Enterprises or that the provisions of this law will not change or that
the abovementioned shareholding proportion will be reached for each subsequent
year.

In addition, a company
owning an Approved Enterprise approved after April 1, 1986 (or prior thereto
provided no government grants or loans had previously been granted regarding
such enterprise) may elect (as we have elected) to forego certain government
grants extended to Approved Enterprises in return for an alternative package
of tax benefits (the Alternative Package). Under the Alternative Package, a
companys undistributed income derived from an Approved Enterprise will be
exempt from company tax for a period of between two and ten years, depending on
the geographic location of the Approved Enterprise within Israel. Such company
will also be eligible for the regular tax benefits under the Investment Law for
the remainder of the Benefits Period.

A company that has
elected the Alternative Package and that subsequently pays a dividend out of
income derived during the tax exemption period from the Approved Enterprise(s)
will be subject to company tax in the year the dividend is distributed in
respect of the amount distributed, including the company tax thereon, at the
rate that would have been applicable had the company not elected the
Alternative Package (generally 25%). The dividend recipient is taxed at the
reduced rate applicable to dividends from Approved Enterprises (15% as compared
to 25%), if the dividend is distributed during the tax exemption period or
within a specified period thereafter. (In the event, however, that the company
also qualifies as a Foreign Investors Company, there is no such time limit.)
This tax must be withheld by the company at source, regardless of whether or
not the dividend is converted into foreign currency.

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Subject to certain
provisions concerning income subject to the Alternative Package, all dividends
are considered to be attributable to the entire enterprise and the effective
tax rate is the result of a weighted combination of the various applicable tax
rates.

The Investment Law also
provides that an Approved Enterprise is entitled to accelerated depreciation on
its property and equipment that are included in an approved investment program.
We have not utilized this benefit.

Several of our investment
programs have been granted the status of Approved Enterprise, with respect to
which we have elected the Alternative Package. Taxable income attributable to
our first program was tax exempt for a period of four years commencing in 1993
and is subject to income tax at a rate of 25% for a period of three years
thereafter. Taxable income attributable to the second program was tax exempt
for a period of two years commencing in 1995 and is subject to tax at a rate of
25% for a period of five years thereafter. Both of these Approved Enterprise
programs were assigned to Arelnet upon its incorporation. In 1996, we received
Approved Enterprise status with respect to an additional investment program.
Following the spin-off of our value-added communication and message switching
systems business to Arelnet, this program was split into two programs, with one
being assigned to Arelnet and one remaining with us. Taxable income
attributable to these programs are tax exempt for a period of four years with
respect to each program, commencing in the year in which the company owning the
program has taxable income and will be subject to income tax at a rate of 25%
for a period of three years thereafter. The Benefit Period with respect thereto
terminates at the end of 2010. In 2000, we received Approved Enterprise status
with respect to an additional investment program. Taxable income attributable
to this program is tax exempt for a period of two years, commencing in the year
in which the company has taxable income and will be subject to income tax at a
rate of 25% for a period of five years thereafter. The Benefit Period with
respect thereto terminates at the end of 2012. Since we have not derived
taxable income attributable to these programs, the abovementioned Benefit
Periods have not yet commenced.

The benefits available to
an Approved Enterprise are conditioned upon terms stipulated in the Investment
Law and the regulations thereunder and the criteria set forth in the applicable
certificate of approval. These conditions include the filing of periodic
reports and the requirement the minimum proportion of our paid-up capital to
our fixed assets is 30%. In the event that we do not fulfill these conditions
in whole or in part, the benefits can be cancelled and we may be required to
refund the amount of the benefits with the addition of linkage differences and
interest. We believe that our Approved Enterprises currently operate in
compliance with all applicable conditions and criteria, but there can be no
assurance that they will continue to do so in the future.

Law for
the Encouragement of Industrial Research and Development, 1984

Under
the Law for the Encouragement of Industrial Research and Development, 1984 (the
Research Law), research and development programs approved by the Research
Committee of the Office of the Chief Scientist (the Research Committee) are
eligible for grants or loans if they meet certain criteria, in return for the
payment of royalties from the sale of the product developed in accordance with
the program. Once a project is approved, the Office of the Chief Scientist will
award grants of up to 50% of the projects expenditures in return for
royalties, usually at rates between 3% to 5% of sales of products developed
with such grants, up to a dollar-linked amount equal to 100% to 150% of such
grants. Grants received under programs approved after January 1, 1999, are
subject to interest at an annual rate of LIBOR for 12 months applicable to
dollar deposits, which will accrue annually based on the LIBOR rate published
on the first day of each year.

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The
terms of these grants prohibit the manufacture outside of Israel without the
prior consent of the Research Committee. Such approval, if granted, is
generally subject to an increase in the total amount to be repaid to the Office
of the Chief Scientist to between 120% and 300% of the amount granted,
depending on the extent of the manufacturing to be conducted outside of Israel.
A recent amendment to the Research Law has provided that the restriction on
manufacturing outside of Israel shall not apply to the extent that plans to so
manufacture were declared when applying for funding.

The
Research Law also provides that know-how from the research and development,
which is used to produce the product, may not be transferred to Israeli third
parties without the approval of the Research Committee, and may not be
transferred to non-Israeli third parties at all. A recent amendment to the
Research Law has stressed, that it is not just transfer of know-how that is
prohibited, but also transfer of any rights in such know-how. Such restriction
does not apply to exports from Israel of products developed with such
technologies. Approval of the transfer may be granted only if the transferee
abides by all of the provisions of the Research Law and regulations promulgated
thereunder, including the restrictions on the transfer of know-how and the
obligation to pay royalties. There can be no assurance that the consents
described above, if requested, will be granted.

Tax
Benefits and Grants for Research and Development

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

Law for
the Encouragement of Industry (Taxes), 1969

The following preferred
corporate tax benefits are available to Industrial Corporations as defined
under the Law for the Encouragement of Industry (Taxes), 1969. We believe that
we qualify as an Industrial Corporation.

| | (a) | Deduction of purchases of know-how and patents over
  eight years for tax purposes.
| | --- | -----------------------------------------------------------------------------------

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| | (b) | Deduction for tax purposes of expenses incurred in
  connection with certain public securities issuances over three years.        
| | --- | ----------------------------------------------------------------------------------------------------------------------------------
| |     |                                                                                                                                   
| | (c) | Accelerated depreciation rates on equipment and
  buildings.                                                                      
| |     |                                                                                                                                   
| | (d) | Under specified conditions, an election to file
  consolidated tax returns with additional related Israeli Industrial
  Companies.

Taxation
under Inflationary Conditions

Under the Income Tax Law
(Inflationary Adjustments), 1985 (the Inflationary Adjustments Law), results
for tax purposes are measured in real terms, in accordance with the changes in
the Israeli consumer price index. The law also provides for the full taxation
of gains from the sale of certain traded securities, which would otherwise be
taxed at a reduced rate when derived by certain categories of corporate
taxpayers. We are taxed under the Inflationary Adjustments Law.

Capital Gains Tax

Israeli law imposes a
capital gains tax on the sale of capital assets by both residents and
non-residents of Israel. The law distinguishes between the Real Gain and the
Inflationary Amount. The Real Gain is the excess of the total capital gain
over the Inflationary Amount, computed on the basis of the increase in the
Israeli Consumer Price Index (CPI) between the date of purchase and the date of
sale. The Inflationary Amount accumulated prior to December 31, 1993 is taxed
at a rate of 10% for residents of Israel (reduced to no tax for non-residents
if calculated according to the exchange rate of the dollar instead of the
Israeli CPI), while the Inflationary Amount accumulated following December 31,
1993 is exempt from any capital gains tax. Until the end of the year 2002,
capital gains from the sale of our ordinary shares were generally exempt from
Israeli Capital Gains Tax. This exemption depended on the recognition of our
status as an Industrial Company and did not apply to a shareholder whose
taxable income is determined pursuant to the Israeli Income Tax Law (Inflation
Adjustments), 1985, or to a person whose gains from selling or otherwise
disposing of our securities are deemed to be business income.

As a result of the recent
tax reform legislation in Israel, gains from the sale of our ordinary shares
derived from January 1, 2003 and thereafter will in general be liable to
capital gains tax of up to 15%.  This
will be the case so long as our securities remain listed for trading on a
designated foreign stock market such as the NASDAQ.  However, according to the tax reform legislation, non-residents
of Israel will be exempt from any capital gains tax from the sale of our
ordinary shares so long as the gains are not derived through a permanent
establishment that the non-resident maintains in Israel, and so long as our
ordinary shares remain listed for trading as described above.  These provisions dealing with capital gains
are not applicable to an persons whose gains from selling or otherwise
disposing of our ordinary shares are deemed to be business income or whose
taxable income is determined pursuant to the Israeli Income Tax Law (Inflation
Adjustments), 1985; the latter law would not normally be applicable to
non-resident shareholders who have no business activity in Israel.

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Pursuant to the
U.S.--Israel Tax Treaty, the sale, exchange or disposition of ordinary shares
by a person who qualifies as a resident of the United States within the meaning
of the U.S.--Israel Tax Treaty and who is entitled to claim the benefits
afforded to such resident under the U.S.--Israel Tax Treaty (Treaty U.S.
Resident) will, in general, not be subject to the Israeli capital gains tax,
unless such Treaty U.S. Resident holds, directly or indirectly, shares
representing 10% or more of the voting power of the company during any part of
the 12-month period preceding such sale, exchange or disposition. A sale,
exchange or disposition of ordinary shares by a Treaty U.S. Resident who holds,
directly or indirectly, shares representing 10% or more of the voting power of
the company at any time during such preceding 12-month period would be subject
to Israeli tax if not otherwise exempt; however, under the U.S.--Israel Tax
Treaty, such Treaty U.S. Resident would be permitted to claim a credit for such
taxes against the U.S. income tax imposed with respect to such sale, exchange
or disposition, subject to the limitations applicable to foreign tax credits.

Taxation
of Nonresidents

Non-residents of Israel
are subject to income tax on income derived from sources in Israel. On
distributions of dividends other than bonus shares (stock dividends), income
tax at the rate of 25% (15% for dividends generated by an Approved
Enterprise) is withheld at source, unless a different rate is provided in a
treaty between Israel and the shareholders country of residence. The
U.S.-Israel Tax Treaty provides, in general, for a maximum tax of 25% on
dividends paid to a Treaty U.S. Resident. However, under the Investment Law,
dividends generated by an Approved Enterprise are taxed at the rate of 15% and
such rate is to be withheld at source.

Passive Foreign Investment Companies

In general, a foreign
corporation will be classified for U.S. tax purposes as a passive foreign
investment company (hereafter also referred to as a PFIC) in any taxable year
in which either (i) 75% or more of its gross income is passive income or (ii)
50% or more of the average value of its assets are held for the production of,
or produce, passive income. Passive income for these purposes includes items
such as dividends, interest, royalties, rents and gains from commodities and
securities transactions.

If a corporation is a
passive foreign investment company, a U.S. shareholder will be subject to one
of three alternative taxing regimes:

The simplest is the QEF
regime.  If the shareholder elects to
treat the PFIC as a qualified electing fund (QEF), then each year the
shareholder includes in its gross income a proportionate share of the PFICs
ordinary income and net capital gain.  A
second regime may be elected if the PFIC stock is marketable.  The U.S. shareholder may elect to mark the
stock to market each year.  At the end
of each taxable year, the shareholder recognizes gain equal to the excess of
the fair market value of the PFIC stock over the shareholders tax basis in the
stock.  (Losses may also be recognized
to the extent of previously recognized gains.)

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A U.S. shareholder making
neither of these elections is subject to the excess distribution regime.  The tax is triggered when the shareholder
receives an excess distribution from the PFIC.  An excess distribution is either (1) a distribution with respect
to stock that is greater than 125% of the average of such distributions over
the preceding three years, or (2) 100% of the gain from the disposition of
shares in the PFIC.

An excess distribution is
subject to special tax rules.  In most
cases, only a portion of it is included in the gross income of the U.S.
shareholder and taxed at normal rates. 
The remainder is never so included, but is used as the basis for
calculating a deferred tax amount, which is simply added to the shareholders
tax bill.

The deferred tax amount
is computed as follows.  The excess
distribution is first ratably allocated, share by share, to each day of the
shareholders holding period.  Portions allocated
to the current year, and to any pre-PFIC years (that is, years before 1987,
when there were no PFICs, or years before the first year in which the company
was a PFIC with respect to that shareholder), are included in ordinary income
for the current year.  Portions
allocated to prior PFIC years are hypothetically taxed at the highest marginal
rate in effect for those years (without regard to the shareholders actual rate
or to any deductions or credits for those years).  To this hypothetical tax is added the interest that the
shareholder would have paid if it were simply paying that tax late for that
year.  The sum of the tax and the
interest charge is the deferred tax amount, which cannot be offset or otherwise
affected by current net operating losses or other deductions.

A U.S. person who
inherits shares in a foreign corporation that was a PFIC in the hands of the
decedent (who did not make either of the elections described above), is denied
the otherwise available step-up in the tax basis of such shares to fair market
value at the date of death.  The U.S.
person steps into the shoes of the decedent and will be subject to the rules
described above.

Our status in any given
future year depends on our assets and activities in that year, although you
will be treated as continuing to own an interest in a passive foreign
investment company if we are a passive foreign investment company in any year
in which you own our shares, unless you make certain elections. We will
endeavor to notify U.S. holders of record in the event we conclude that we will
be treated as a passive foreign investment company for any taxable year to
enable U.S. holders to consider whether or not to elect to treat us as a
qualified electing fund for U.S. federal income tax purposes, to elect to
mark to market the ordinary shares or to become subject to the excess
distribution regime.

We recommend that you
consult your tax advisors in regard to tax issues, including issues relating to
a passive foreign investment company, which may affect your investment in our
company.

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Documents on Display

We
are required to file reports and other information with the Securities and
Exchange Commission (the SEC) under the Securities Exchange Act of 1934, as
amended, and the regulations thereunder applicable to foreign private issuers.
Reports and other information filed by us with the SEC may be inspected and
copied at the SECs public reference facilities described below.  Although as a foreign private issuer we are
not required to file periodic information as frequently or as promptly as
United States companies, we generally do publicly announce our quarterly and
year-end results promptly and file periodic information with the SEC under
cover of Form 6-K.  As a foreign private
issuer, we are also exempt from the rules under the Exchange Act prescribing the
furnishing and content of proxy statements and our officers, directors and
principal shareholders are exempt from the reporting and other provisions in
Section 16 of the Exchange Act.

You may review a copy of
our filings with the SEC, including any exhibits and schedules, at the SECs
public reference facilities in Room 1024, Judiciary Plaza, 450 Fifth Street,
N.W., Washington, D.C. 20549 and at the regional offices of the SEC located at
the Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. You may also obtain copies of such materials from the Public
Reference Section of the SEC, Room 1024, Judiciary Plaza, 450 Fifth Street,
N.W., Washington, D.C. 20549, at prescribed rates. You may call the SEC at
1-800-SEC-0330 for further information on the public reference rooms.  As a foreign private issuer we are not
required to file through the SECs EDGAR system and our periodic filings are
therefore not available on the SECs Web site. You may read and copy any
reports, statements or other information that we file with the SEC at the SEC
facilities listed above. These SEC filings are also available to the public
from commercial document retrieval services.

Any statement in this
annual report about any of our contracts or other documents is not necessarily
complete. If the contract or document is filed as an exhibit to the
registration statement, the contract or document is deemed to modify the
description contained in this annual report. We urge you to review the exhibits
themselves for a complete description of the contract or document.

|ITEM
  11. | QUANTITATIVE
  AND QUALITATIVE
  DISCLOSURE ABOUT MARKET RISK.
|---------- | --------------------------------------------------------------

General

The
currency of our primary economic environment is US dollars. However, we have
balances and activities in NIS.  We are
exposed to market risks arising from changes in currency exchange rates. We are
also exposed to equity-price and interest rate risks.

Exchange Rate Risk Management

Our
functional currency is the US dollar. 
We strive to limit our exposure through natural hedging, i.e.
attempting to have similar levels of assets and liabilities in NIS, to the
extent possible. However, this method of matching levels of assets and
liabilities of the same currency is not always achievable.

70

---

---

The
balance of our NIS monetary assets and monetary liabilities as of December 31,
2002 was $395,000 and 3,070,000, respectively. A portion of our salary expenses
is NIS linked.

Interest Rate Risk Management

We
are exposed to changes in interest rates due to the existence of assets with
different interest rates and maturity dates.

We
have approximately $10,200 thousands in dollar and dollar-linked fixed rate
interest-bearing, short-term deposits as of December 31, 2002.

Equity-Price Risk Management

We are exposed to changes
in marketable securities prices held at December 31, 2002. We hold Israeli
Government bonds classified as trading securities and stated at market value.
The dollar value of the bonds at December 31, 2002, was approximately $129
thousands.  We hold quoted shares
classified as available for sale.  The
dollar value of the quoted shares at December 31, 2002, was approximately $125
thousands.

|ITEM
  12. | DESCRIPTION
  OF SECURITIES OTHER THAN
  EQUITY SECURITIES.
|---------- | -----------------------------------------------------------

Not applicable.

PART II

|ITEM
  13. | DEFAULTS,
  DIVIDEND ARREARAGES AND
  DELINQUENCIES.
|---------- | ----------------------------------------------------

None.

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

None.

|ITEM
  15. | CONTROLS
  AND PROCEDURES
|---------- | -------------------------

An evaluation was
performed under the supervision and with the participation of our management,
including our chief executive officers and chief financial officer, of the
effectiveness of our disclosure controls and procedures (as defined in Rules
13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended).
Based on that evaluation, which was completed within 90 days of the filing date
of this annual report, our chief executive officers and chief financial
officer, concluded that our disclosure controls and procedures were effective
though we are constantly engaged in the process of improving these controls and
procedures. There have been no significant changes in our disclosure controls
or in other factors that could significantly affect disclosure controls
subsequent to the date of the evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.

71

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|ITEM
  16. | RESERVED
|---------- | --------

PART III

|ITEM
  17. | FINANCIAL
  STATEMENTS.
|---------- | -----------------------

Not applicable.

|ITEM
  18. | FINANCIAL
  STATEMENTS.
|---------- | -----------------------

See pages F-1 to F-37.

|ITEM
  19. | EXHIBITS.
|---------- | ---------

|1.1 | Articles of Association of Arel Communications and
  Software Ltd.*                                                                                                                                                                                                                                     
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                                                                         
|1.2 | Memorandum of Association of Arel Communications and
  Software Ltd.*                                                                                                                                                                                                                                   
|    |                                                                                                                                                                                                                                                                                                         
|4.1 | Asset Purchase Agreement among Arel Communications
  and Software Ltd., M.E. Jones, Inc., W2COM, LLC, W2COM
  International LLC, CYMI, Ltd. and Mitchell E. Jones, dated as of August 8,
  2000.**                                                                                                      
|    |                                                                                                                                                                                                                                                                                                         
|4.2 | Agreement among Arel Communications and Software
  Ltd., W2COM, LLC and CYMI, Ltd., dated as of August 8, 2000.**                                                                                                                                                                                       
|    |                                                                                                                                                                                                                                                                                                         
|4.3 | Escrow Agreement among Arel Communications and
  Software Ltd., W2COM, LLC and CYMI, Ltd., dated as of August 8,
  2000.**                                                                                                                                                                              
|    |                                                                                                                                                                                                                                                                                                         
|4.4 | Registration Rights Agreement among Arel
  Communications and Software Ltd., M.E. Jones, Inc., W2COM, LLC, W2COM
  International LLC, CYMI, Ltd. and Mitchell E. Jones, dated as of August 8,
  2000.**                                                                                                 
|    |                                                                                                                                                                                                                                                                                                         
|4.5 | Lease Agreement for premises in Yavne, Israel.***                                                                                                                                                                                                                                                       
|    |                                                                                                                                                                                                                                                                                                         
|4.6 | Lease Agreement dated October 26, 1998, between Arel
  Communications and Software, Inc. and The Mutual Insurance Company of New
  York for premises in Atlanta, Georgia.**                                                                                                                             
|    |                                                                                                                                                                                                                                                                                                         
|4.7 | Amendment No. 2 to Lease dated October 9, 2002,
  between Arel Acquisitions, Inc. (currently Arel Learning Solutions, Inc.) and
  Miller-Valentine Partners for premises in Dayton, Ohio, which was originally
  leased by W2COM, LLC and assigned to Arel Learning Solutions, Inc.
  on August 8, 2000.

72

---

---

|4.8  | Lease Termination Agreement dated September 26,
  2002, between Arel Communications and Software Ltd. and Rolling Meadows
  Delaware, Inc. for premises in Rolling Meadows, Illinois, which was
  originally leased by W2COM, LLC and assigned to Arel
  Communications and Software, Ltd. on August 8, 2000.
|---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|     |                                                                                                                                                                                                                                                                                                              
|4.9  | Chief Executive Officer Employment Agreement dated
  May 1, 2002 between Arel Communications and Software, Inc. and Philippe
  Szwarc.                                                                                                                                                                       
|     |                                                                                                                                                                                                                                                                                                              
|4.10 | Chief Financial Officer Employment Agreement dated
  July 15, 2002 between Arel Communications and Software, Ltd. and Daniel
  Yelin.                                                                                                                                                                        
|     |                                                                                                                                                                                                                                                                                                              
|8.1  | List of subsidiaries.                                                                                                                                                                                                                                                                                        
|     |                                                                                                                                                                                                                                                                                                              
|12.1 | Certification by Chief Executive Officer pursuant to
  section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                        
|     |                                                                                                                                                                                                                                                                                                              
|12.2 | Certification by Chief Financial Officer pursuant to
  section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                        
|     |                                                                                                                                                                                                                                                                                                              
|12.3 | Consent of Kesselman & Kesselman.                                                                                                                                                                                                                                                                            

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

| | *   | Incorporated by reference from our Registration
  Statement on Form F-1, File No. 33-76350, as amended, filed with the
  Commission on March 11, 1994.                                                   
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |     |                                                                                                                                                                                                          
| | **  | Incorporated by reference to our Annual Report on
  Form 20-F for the year ended December 31, 2000, filed with the Commission on
  or about June 25, 2001.                                               
| |     |                                                                                                                                                                                                          
| | *** | Includes English language summary of document.
  Incorporated by reference to our Annual Report on Form 20-F for the year
  ended December 31, 2001, filed with the Commission on or about June 28, 2002.

73

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---

SIGNATURES

Pursuant to the
requirements of Section 12 of the Securities Exchange Act of 1934, the
registrant certifies that it meets all the requirements for filing on Form 20-F
and has duly caused and authorized the undersigned to sign this annual report
on its behalf in the Town of Brookline, Massachusetts, on this 29 day of June 2003.

| |  | AREL COMMUNICATIONS AND SOFTWARE LTD.BY: /S/ Philippe Szwarc
Philippe SzwarcChief Executive Officer
| |  | -----------------------------------------------------------------------------------------------------------------

74

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---

CERTIFICATIONS

I, Philippe Szwarc,
certify that:

| | 1. | I have reviewed this annual report on Form 20-F of
  Arel Communications and  Software
  Ltd.;                                                                                                                                                                                                                                  
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 2. | Based on my knowledge, this annual report does not
  contain any untrue statement of a material fact or omit to state a material
  fact necessary to make the statements made, in light of the circumstances
  under which such statements were made, not misleading with respect to the
  period covered by this annual report;
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 3. | Based on my knowledge, the financial statements, and
  other financial information included in this annual report, fairly present in
  all material respects the financial condition, results of operations and cash
  flows of the registrant as of, and for, the periods presented in this annual
  report;                   
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 4. | The registrants other certifying officers and I are
  responsible for establishing and maintaining disclosure controls and
  procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the
  registrant and have:                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | a)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | b)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | c)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 5. | The registrants other certifying officers and I
  have disclosed, based on our most recent evaluation, to the registrants
  auditors and the audit committee of registrants board of directors (or
  persons performing the equivalent function):                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | a)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | b)                                                                                                                                                                                                                                                                                                                              

75

---

---

| | 6. | The registrants other certifying officers and I
  have indicated in this annual report whether or not there were significant
  changes in internal controls or in other factors that could significantly
  affect internal controls subsequent to the date of our most recent
  evaluation, including any corrective actions with regard to significant
  deficiencies and material weaknesses.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

June 29, 2003

| | /S/      PHILIPPE
  SZWARC
| | --------------------------
| |                           
| | Philippe
  Szwarc         
| | Chief Executive Officer   

76

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---

CERTIFICATIONS

I, Daniel Yelin, certify
that:

| | 1. | I have reviewed this annual report on Form 20-F of
  Arel Communications and Software Ltd.;                                                                                                                                                                                                                                     
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 2. | Based on my knowledge, this annual report does not
  contain any untrue statement of a material fact or omit to state a material
  fact necessary to make the statements made, in light of the circumstances
  under which such statements were made, not misleading with respect to the
  period covered by this annual report;
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 3. | Based on my knowledge, the financial statements, and
  other financial information included in this annual report, fairly present in
  all material respects the financial condition, results of operations and cash
  flows of the registrant as of, and for, the periods presented in this annual
  report;                   
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 4. | The registrants other certifying officers and I are
  responsible for establishing and maintaining disclosure controls and
  procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the
  registrant and have:                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | a)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | b)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | c)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| | 5. | The registrants other certifying officers and I
  have disclosed, based on our most recent evaluation, to the registrants
  auditors and the audit committee of registrants board of directors (or persons
  performing the equivalent function):                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | a)                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                 
| |    | b)                                                                                                                                                                                                                                                                                                                              

77

---

---

| | 6. | The registrants other certifying officers and I
  have indicated in this annual report whether or not there were significant
  changes in internal controls or in other factors that could significantly
  affect internal controls subsequent to the date of our most recent
  evaluation, including any corrective actions with regard to significant
  deficiencies and material weaknesses.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

June 29, 2003

| | /S/   DANIEL YELIN       
| | -------------------------
| |                          
| | Daniel
  Yelin           
| | Chief
  Financial Officer

78

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---

EXHIBIT 8.1

The
following table sets forth a list of our subsidiaries.

|Name
  of subsidiary                   | Jurisdiction
  of incorporation
|-------------------------------------- | -------------------------------
|Arel Holdings, Inc.                    | Ohio                           
|Arel Communications and Software, Inc. | Georgia                        
|Arel Learning Solutions, Inc.          | Ohio                           

79

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---

EXHIBIT 12.1

CERTIFICATION
PURSUANT TO
18 U.S.C SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In
connection with the Annual Report of Arel Communications and Software Ltd. (the
Company) on Form 20-F for the year ended December 31, 2002 as filed with the
Securities and Exchange Commission on the date hereof (the Report), I,
Philippe Szwarc, Chief Executive Officer of the Company, certify, pursuant to
18 U.S.C. section 1350, as adopted pursuant to section 906 of the
Sarbanes-Oxley Act of 2002, that to my knowledge:

| | 1. | the Report fully complies with the requirements of
  section 13(a) of the Securities Exchange Act of 1934; and                                          
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                         
| | 2. | the information contained in the Report fairly
  presents, in all material respects, the financial condition and results of operations
  of the Company.

|              | /S/ PHILIPPE SZWARC    
|------------- | -----------------------
|              | Philippe Szwarc        
|June 29, 2003 | Chief Executive Officer

A signed original of this
written statement required by Section 906 has been provided to the Company and
will be retained by the Company and furnished to the Securities and Exchange
Commission or its staff upon request.

80

---

---

EXHIBIT 12.2

CERTIFICATION
PURSUANT TO
18 U.S.C SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In
connection with the Annual Report of Arel Communications and Software Ltd. (the
Company) on Form 20-F for the year ended December 31, 2002 as filed with the
Securities and Exchange Commission on the date hereof (the Report), I, Daniel
Yelin, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C.
section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of
2002, that to my knowledge:

| | 1. | the Report fully complies with the requirements of
  section 13(a) of the Securities Exchange Act of 1934; and                                          
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                         
| | 2. | the information contained in the Report fairly
  presents, in all material respects, the financial condition and results of
  operations of the Company.

|              | /S/ DANIEL YELIN       
|------------- | -----------------------
|              | Daniel Yelin           
|June 29, 2003 | Chief Financial Officer

A signed original of this written statement required by Section 906 has
been provided to the Company and will be retained by the Company and furnished
to the Securities and Exchange Commission or its staff upon request.

81

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
2002 ANNUAL REPORT

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
2002 ANNUAL REPORT

TABLE OF
CONTENTS

|                                                           |                                               | Page(s) 
|---------------------------------------------------------- | --------------------------------------------- | --------
|REPORT OF
  INDEPENDENT AUDITORS                           | F-2                                          
|CONSOLIDATED
  FINANCIAL STATEMENTS - IN U.S. DOLLARS ($): |                                              
|                                                           | Balance sheets                                | F3 - F4 
|                                                           | Statements of operations                      | F-5     
|                                                           | Statements of changes in shareholders equity | F-6     
|                                                           | Statements of cash flows                      | F-7     
|                                                           | Notes to financial statements                 | F8 - F37

---

---

---

---

---

REPORT
OF INDEPENDENT AUDITORS

To the shareholders of

AREL COMMUNICATIONS AND SOFTWARE LTD.

We have audited the consolidated
balance sheets of Arel Communications and Software Ltd. (the Company) and its
subsidiaries as of December 31, 2002 and 2001 and the related consolidated
statements of operations, changes in shareholders equity and cash flows for
each of the three years in the period ended December 31, 2002. These financial
statements are the responsibility of the Companys Board of Directors and
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in
accordance with auditing standards generally accepted in Israel and in the
United States, including those prescribed by the Israeli Auditors (Mode of
Performance) Regulations, 1973. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by the Companys Board of Directors and management,
as well as evaluating the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.

In our opinion, based on our
audits, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of the Company and its
subsidiaries as of December 31, 2002 and 2001 and the consolidated results
of their operations, the changes in shareholders equity and their cash flows
for each of the three years in the period ended December 31, 2002, in
conformity with accounting principles generally accepted (GAAP) in Israel.

Accounting principles generally
accepted in Israel vary in certain respects from accounting principles
generally accepted in the United States of America. The application of the
latter would have affected the determination of consolidated loss for the years
ended December 31 2002, 2001 and 2000 to the extent summarized in note 16 to
the consolidated financial statements.

|Tel-Aviv, Israel |               | Kesselman & Kesselman
|---------------- | ------------- | ---------------------
|                 | March 6, 2003 |                      

F-2

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
CONSOLIDATED BALANCE SHEETS

|                                                                                                |                                                        | December 31,              |    
|----------------------------------------------------------------------------------------------- | ------------------------------------------------------ | ------------------------- | ---
|                                                                                                |                                                        |                           |    
|                                                                                                |                                                        | 2002                      |    
|                                                                                                |                                                        |                           |    
|                                                                                                |                                                        | U.S. dollars in thousands |    
|                                                                                                |                                                        |                           |    
|A 
  s  s  e  t  s                                                                              |                                                        |                           |    
|CURRENT
  ASSETS (note 11):                                                                     |                                                        |                           |    
|                                                                                                | Cash and cash equivalents (note 1j)                    |                           |    
|                                                                                                | Short-term investments (note 4)                        |                           |    
|                                                                                                | Accounts receivable (note 12a):                        |                           |    
|                                                                                                | Trade                                                  |                           |    
|                                                                                                | Other                                                  |                           |    
|                                                                                                | Inventories (note 1d)                                  |                           |    
|                                                                                                |                                                        |                           |    
|                                                                                                | T o t a
  l  current assets                            |                           |    
|                                                                                                |                                                        |                           |    
|INVESTMENTS
  AND LONG-TERM RECEIVABLE:                                                         |                                                        |                           |    
|                                                                                                | Investment in Arelnet Ltd. (note 2)                    |                           |    
|                                                                                                | Loans to employees, net of current maturities (note 5) |                           |    
|                                                                                                |                                                        |                           |    
|                                                                                                |                                                        |                           | 156
|                                                                                                |                                                        |                           |    
|PROPERTY AND
  EQUIPMENT(note 6):                                                               |                                                        |                           |    
|                                                                                                | Cost                                                   |                           |    
|                                                                                                | L e s s - accumulated depreciation and amortization    |                           |    
|                                                                                                |                                                        |                           |    
|                                                                                                |                                                        |                           | 690
|                                                                                                |                                                        |                           |    
|GOODWILL,net of provision for impairment
  and 
            accumulated amortization
  (note 3) |                                                        |                           |    
|                                                                                                |                                                        |                           |    
|                                                                                                |                                                        |                           |    
|                                                                                                | T o t a l  assets                                      |                           |    
|                                                                                                |                                                        |                           |    

| | By: /s/ Philippe Szwarc |  |                 
| | ----------------------- |  | ----------------
| |                         |  | )Philippe Szwarc
| | Chief Executive Officer |  | )               
| |                         |  |                 
| | By: /s/ Izhak Gross     |  |                 
| |                         |  | )Izhak Gross    
| | Chairman of the Board   |  | )               
| |                         |  |                 
| | By: /s/ Daniel Yelin    |  |                 
| |                         |  | )Daniel Yelin   
| | Chief Financial Officer |  | )               

F-3

---

---

|                                       |                                                                                                                                                                                                                                       | December 31,              | 
|-------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------- | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       |                                                                                                                                                                                                                                       | 2002                      | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       |                                                                                                                                                                                                                                       | U.S. dollars in thousands | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|Liabilities
  and shareholders equity |                                                                                                                                                                                                                                       |                           | 
|CURRENT LIABILITIES (note
  11):       |                                                                                                                                                                                                                                       |                           | 
|                                       | Short-term bank credit and current
  maturities
      of long term loan                                                                                                                                                               |                           | 
|                                       | Accounts payable and accruals:                                                                                                                                                                                                        |                           | 
|                                       | Trade                                                                                                                                                                                                                                 |                           | 
|                                       | Accrued restructuring costs                                                                                                                                                                                                           |                           | 
|                                       | Deferred revenues                                                                                                                                                                                                                     |                           | 
|                                       | Other (note 12b)                                                                                                                                                                                                                      |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       | T o t a l current liabilities                                                                                                                                                                                                         |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|LONG-TERM LIABILITIES:                 |                                                                                                                                                                                                                                       |                           | 
|                                       | Accrued severance pay, net (note 7)                                                                                                                                                                                                   |                           | 
|                                       | Other (note 12c)                                                                                                                                                                                                                      |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       | T o t a l long-term liabilities                                                                                                                                                                                                       |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|COMMITMENTS(note 8)                    |                                                                                                                                                                                                                                       |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       | T o t a l liabilities                                                                                                                                                                                                                 |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|SHAREHOLDERS EQUITY (note
  9):       |                                                                                                                                                                                                                                       |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       | Share capital - ordinary shares of NIS
  0.001 par value
     (authorized - December 31, 2002 and December 31, 2001
       30,000,000; issued and outstanding: December 31, 2002 - 
       and December 31, 2001 - 12,855,739 shares) |                           | 
|                                       | Capital surplus                                                                                                                                                                                                                       |                           | 
|                                       | Warrants and options                                                                                                                                                                                                                  |                           | 
|                                       | Accumulated deficit                                                                                                                                                                                                                   |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       | T o t a l shareholders equity                                                                                                                                                                                                        |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 
|                                       | T o t a l 
  liabilities and shareholders equity                                                                                                                                                                                     |                           | 
|                                       |                                                                                                                                                                                                                                       |                           | 

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

F-4

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
CONSOLIDATED STATEMENTS OF OPERATIONS

|                                                                        |                                                | Year ended December 31,                                |        
|----------------------------------------------------------------------- | ---------------------------------------------- | ------------------------------------------------------ | -------
|                                                                        |                                                |                                                        |        
|                                                                        |                                                | 2002                                                   |        
|                                                                        |                                                |                                                        |        
|                                                                        |                                                | U.S. dollars
  in thousands(except per share
  amount) |        
|                                                                        |                                                |                                                        |        
|REVENUES(note 14):                                                      |                                                |                                                        |        
|                                                                        | Sales                                          |                                                        |        
|                                                                        | Services                                       |                                                        |        
|                                                                        |                                                |                                                        |        
|                                                                        |                                                |                                                        | 5,941  
|                                                                        |                                                |                                                        |        
|COST OF SALES
  AND SERVICES(note 13a)                                  |                                                |                                                        | 3,604  
|                                                                        |                                                |                                                        |        
|GROSS PROFIT                                                            |                                                |                                                        | 2,337  
|RESEARCH AND
  DEVELOPMENT EXPENSES -net 
    (note 13b)                |                                                |                                                        | 2,218  
|SELLING,
  GENERAL AND ADMINISTRATIVE 
    EXPENSES(note 13c)           |                                                |                                                        | 6,439  
|AMORTIZATION
  OF GOODWILL (note 3)                                     |                                                |                                                        | 283    
|IMPAIRMENT OF
  GOODWILL(notes 1n and 3b)                               |                                                |                                                        | 4,575  
|RESTRUCTURING
  EXPENSES AND 
    IMPAIRMENT OF PROPERTY AND EQUIPMENT  |                                                |                                                        | 2,301  
|                                                                        |                                                |                                                        |        
|OPERATING
  LOSS                                                        |                                                |                                                        | (13,479
|FINANCIAL
  INCOME - net                                                |                                                |                                                        | 102    
|IMPAIRMENT OF
  INVESTMENT IN 
    ARELNET LTD. (note 2c)               |                                                |                                                        | 279    
|                                                                        |                                                |                                                        |        
|LOSS BEFORE TAXES ON INCOME                                             |                                                |                                                        | (13,656
|TAXES ON INCOME(note 10)                                                |                                                |                                                        |        
|                                                                        |                                                |                                                        |        
|LOSS FROM CONTINUED OPERATIONS                                          |                                                |                                                        | (13,656
|                                                                        |                                                |                                                        |        
|DISCONTINUED
  OPERATIONS (note 2):                                     |                                                |                                                        |        
|                                                                        | Loss from operations                           |                                                        |        
|                                                                        | Gain on dilution of interest in Arelnet
  Ltd. |                                                        |        
|                                                                        |                                                |                                                        |        
|                                                                        | T o t a l 
  loss from discontinued operations |                                                        |        
|                                                                        |                                                |                                                        |        
|LOSS FOR THE
  YEAR                                                     |                                                |                                                        | (13,656
|                                                                        |                                                |                                                        |        
|BASIC AND DILUTED LOSS PER SHARE(note 1m):                              |                                                |                                                        |        
|                                                                        | Continued operations                           |                                                        |        
|                                                                        | Discontinued
  operations                      |                                                        |        
|                                                                        |                                                |                                                        |        
|                                                                        | Loss                                           |                                                        |        
|                                                                        |                                                |                                                        |        
|WEIGHTED AVERAGE NUMBER OF SHARES (IN 
    THOUSANDS) BASIC AND DILUTED |                                                |                                                        | 12,856 
|                                                                        |                                                |                                                        |        
|                                                                        |                                                |                                                        |        

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

F-5

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY

|                               |                                                                                                | Share capital      |           | Capital
  surplus                                |    | Warrants
  and
  options |        | Accumulated
  deficit |      | Total   |        
|------------------------------ | ---------------------------------------------------------------------------------------------- | ------------------ | --------- | ------------------------------------------------ | -- | ------------------------ | ------ | --------------------- | ---- | ------- | -------
|                               |                                                                                                |                    |           |                                                  |    |                          |       
|                               |                                                                                                | Number of
  shares |           | Amount                                           |    |                          |        |                       |     
|                               |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        
|                               |                                                                                                |                    |           | U . S .  d o l l a r s   i n   t h o u s a n d s |   
|                               |                                                                                                |                    |           |                                                  |   
|BALANCE AT JANUARY 1, 2000     |                                                                                                | 7,869,392          |           | 3                                                |    | 17,361                   |        | 1,100                 |      | (622    | )      
|CHANGES
  DURING 2000:         |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        
|                               | Loss                                                                                           |                    |           |                                                  |    |                          |        |                       |      |         | (1,106 
|                               | Issuance of share capital in consideration for acquisition of 
    business (note 3)           |                    | 3,409,091 |                                                  | 1  |                          | 21,023 |                       |      |         |        
|                               | Issuance of share capital (note 9a(4))                                                         |                    | 500,000   |                                                  | ** |                          | *7,307 |                       | 570  |         |        
|                               | Exercise of warrants and options                                                               |                    | 1,075,256 |                                                  | ** |                          | 5,633  |                       | (275 | )       |        
|                               | Distribution of shares of Arelnet Ltd. to shareholders and taxes 
    related thereto (note 2) |                    |           |                                                  |    |                          |        |                       |      |         | (5,222 
|                               | Gain on dilution of interest in Arelnet Ltd.                                                   |                    |           |                                                  |    |                          | 1,414  |                       |      |         |        
|                               |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        
|BALANCE AT
  DECEMBER 31, 2000 |                                                                                                | 12,853,739         |           | 4                                                |    | 52,738                   |        | 1,395                 |      | (6,950  | )      
|CHANGES
  DURING 2001:         |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        
|                               | Loss                                                                                           |                    |           |                                                  |    |                          |        |                       |      |         | (25,514
|                               | Exercise
  of options                                                                          |                    | 2,000     |                                                  | ** |                          | 2      |                       |      |         |        
|                               |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        
|BALANCE AT DECEMBER 31, 2001   |                                                                                                | 12,855,739         |           | 4                                                |    | 52,740                   |        | 1,395                 |      | (32,464 | )      
|CHANGES
  DURING 2002 -        |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        
|                               | loss                                                                                           |                    |           |                                                  |    |                          |        |                       |      |         | (13,656
|                               |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        
|BALANCE AT DECEMBER 31, 2002   |                                                                                                | 12,855,739         |           | 4                                                |    | 52,740                   |        | 1,395                 |      | (46,120 | )      
|                               |                                                                                                |                    |           |                                                  |    |                          |        |                       |      |         |        

|*  | Net of share issuance expenses.       
|-- | --------------------------------------
|** | Represents an amount less than $1,000.

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

F-6

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An Israeli Corporation)
CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                                                                 |                                                                                     | Year ended December 31,   |        
|------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------- | ------------------------- | -------
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 |                                                                                     | 2002                      |        
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 |                                                                                     | U.S. dollars in thousands |        
|                                                                                                 |                                                                                     |                           |        
|CASH FLOWS
  FROM OPERATING ACTIVITIES:                                                          |                                                                                     |                           |        
|                                                                                                 | Loss                                                                                |                           | (13,656
|                                                                                                 | Adjustments required to reconcile loss to net cash used in operating
  activities:  |                           |        
|                                                                                                 | Depreciation and amortization of property and equipment                             |                           | 588    
|                                                                                                 | Impairment of property and equipment                                                |                           | 750    
|                                                                                                 | Amortization of goodwill                                                            |                           | 283    
|                                                                                                 | Impairment
  of goodwill                                                            |                           | 4,575  
|                                                                                                 | Decline in value of investment in Arelnet Ltd.                                      |                           | 279    
|                                                                                                 | Allowance for doubtful accounts                                                     |                           | 170    
|                                                                                                 | Deferred taxes                                                                      |                           |        
|                                                                                                 | Discount on (increase in value of) long-term loan to an employee                    |                           | 3      
|                                                                                                 | Exchange differences on long term loan                                              |                           | (2     
|                                                                                                 | Accrued employee rights upon retirement - net                                       |                           | 60     
|                                                                                                 | Capital loss on disposal of property and equipment                                  |                           | 36     
|                                                                                                 | Loss (gain) on realization and decrease in value of marketable
  securities - net   |                           | 10     
|                                                                                                 | Loss from discontinued operations                                                   |                           |        
|                                                                                                 | Changes in operating asset and liability items:                                     |                           |        
|                                                                                                 | Decrease (increase) in trade receivables (before allowance for doubtful
  accounts) |                           | 880    
|                                                                                                 | Decrease in other accounts receivable                                               |                           | 245    
|                                                                                                 | Increase (decrease) in accounts payable and accruals (including
  long-term)        |                           | 1,422  
|                                                                                                 | Decrease in inventories                                                             |                           | 1,097  
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 | Net cash used in operating activities                                               |                           | (3,260 
|                                                                                                 |                                                                                     |                           |        
|CASH FLOWS
  FROM INVESTING ACTIVITIES:                                                          |                                                                                     |                           |        
|                                                                                                 | Purchase of property and equipment                                                  |                           | (174   
|                                                                                                 | Proceeds from disposal of property and equipment                                    |                           | 186    
|                                                                                                 | Acquisition of business consolidated for the first time *                           |                           |        
|                                                                                                 | Investment in Arelnet Ltd.                                                          |                           |        
|                                                                                                 | Collection of long-term loan to an employee                                         |                           | 25     
|                                                                                                 | Long-term loan to employee                                                          |                           |        
|                                                                                                 | Short-term bank deposits - net                                                      |                           | 8,172  
|                                                                                                 | Acquisition of marketable securities                                                |                           | (4     
|                                                                                                 | Proceeds from sale of marketable securities                                         |                           | 33     
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 | Net cash provided by (used in) investing activities                                 |                           | 8,238  
|                                                                                                 |                                                                                     |                           |        
|CASH FLOWS
  FROM FINANCING ACTIVITIES:                                                          |                                                                                     |                           |        
|                                                                                                 | Issuance of share capital, net of share issuance expenses                           |                           |        
|                                                                                                 | Exercise of warrants and options                                                    |                           |        
|                                                                                                 | Repayment of long-term loan                                                         |                           | (1     
|                                                                                                 | Short-term bank credit - net                                                        |                           | (5     
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 | Net cash provided by (used in) financing activities                                 |                           | (6     
|                                                                                                 |                                                                                     |                           |        
|NET INCREASE
  (DECREASE) IN CASH AND CASH EQUIVALENTS                                           |                                                                                     | 4,972                     |        
|BALANCE OF
  CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                                      |                                                                                     | 5,382                     |        
|                                                                                                 |                                                                                     |                           |        
|BALANCE OF
  CASH AND CASH EQUIVALENTS AT END OF YEAR                                            |                                                                                     | 10,354                    |        
|                                                                                                 |                                                                                     |                           |        
|SUPPLEMENTAL
  DISCLOSURE OF CASH FLOW INFORMATION -
    CASH PAID DURING THE YEAR FOR:          |                                                                                     |                           |        
|                                                                                                 | Interest                                                                            |                           | 2      
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 | Income
  taxes                                                                      |                           | 81     
|                                                                                                 |                                                                                     |                           |        
|Supplementary information on investing and financing
  activities 
    not involving cash flows: |                                                                                     |                           |        
|                                                                                                 | As
  to spin-off of Arelnet Ltd in 2000, see note 2                                 |                           |        
|                                                                                                 | As to long-term loan in respect of purchasing a vehicle,
  see Note 12c             |                           |        
|* Acquisition of business consolidated for the first
  timein 2000, see also note 3:             |                                                                                     |                           |        
|                                                                                                 | Assets
  and liabilities of the business at date of acquisition:                    |                           |        
|                                                                                                 | Fixed
  assets                                                                      |                           |        
|                                                                                                 | Working
  capital                                                                   |                           |        
|                                                                                                 | Issuance
  of share capital                                                         |                           |        
|                                                                                                 | Amounts
  carried to goodwill                                                       |                           |        
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 |                                                                                     |                           |        
|                                                                                                 |                                                                                     |                           |        

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

F-7

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|NOTE
  1  - | SIGNIFICANT
  ACCOUNTING POLICIES                                                    
|----------- | -------------------------------------------------------------------------------------
|            |                                                                                      
|            | The significant accounting policies, applied on a consistent basis,
  are as follows:
|            |                                                                                      
|            | a.                                                                                   
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            |                                                                                      
|            | b.                                                                                   
|            |                                                                                      
|            |                                                                                      

F-8

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 1  - | SIGNIFICANT ACCOUNTING POLICIES
  (continued):
|--------- | ----------------------------------------------
|          |                                               
|          | c.                                            
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          | d.                                            
|          |                                               
|          |                                               
|          |                                               
|          | e.                                            
|          |                                               
|          |                                               
|          |                                               

| |                                |  | %    |  |             | 
| | ------------------------------ |  | ---- |  | ----------- | 
| |                                |  |      |  |             | 
| | Vehicles                       |  | 15   |  |             | 
| | Computer equipment             |  | 33   |  |             | 
| | Office furniture and equipment |  | 7-15 |  | (mainly 7%) | 

| |    | Leasehold
  improvements are amortized by the straight-line method over the term of the
  lease, which is shorter than the estimated useful life of the improvements.                                                                                                                 
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                       
| | f. | Goodwill                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                       
| |    | Goodwill representing the difference between the cost of investment
  in a subsidiary and the fair value of its underlying net assets at the time
  of acquisition, is amortized over a period of ten years, see also note 3. As
  to impairment of value of goodwill see also note 3.
| |    |                                                                                                                                                                                                                                                                                       
| | g. | Revenue
  recognition:                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                       
| |    | 1)                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                       

F-9

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 1  - | SIGNIFICANT ACCOUNTING POLICIES
  (continued):
|--------- | ----------------------------------------------
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          | h.                                            
|          |                                               
|          |                                               
|          |                                               
|          | i.                                            
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          | j.                                            
|          |                                               
|          |                                               
|          |                                               
|          | k.                                            
|          |                                               
|          |                                               

F-10

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 1  - | SIGNIFICANT ACCOUNTING POLICIES
  (continued):
|--------- | ----------------------------------------------
|          |                                               
|          | l.                                            
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          | m.                                            
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          | n.                                            
|          |                                               
|          |                                               

F-11

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 1  - | SIGNIFICANT ACCOUNTING POLICIES
  (continued):
|--------- | ----------------------------------------------
|          |                                               
|          | o.                                            
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          | p.                                            
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          |                                               
|          | q.                                            
|          |                                               
|          |                                               

F-12

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE
  2  - | DISCONTINUED
  OPERATIONS AND INVESTMENT IN ARELNET:
|----------- | ----------------------------------------------------
|            |                                                     
|            | a.                                                  
|            |                                                     
|            |                                                     
|            |                                                     
|            | b.                                                  
|            |                                                     
|            | c.                                                  
|            |                                                     
|            |                                                     
|            | d.                                                  
|            |                                                     
|NOTE
  3  - | ACQUISITION
  OF BUSINESS:                          
|            |                                                     
|            | a.                                                  
|            |                                                     
|            |                                                     

F-13

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE
  3  - | ACQUISITION
  OF BUSINESS (continued):
|----------- | --------------------------------------
|            |                                       
|            | b.                                    
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|            | c.                                    
|            |                                       
|            |                                       
|            |                                       
|            |                                       

F-14

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE
  3  - | ACQUISITION
  OF BUSINESS (continued):
|----------- | --------------------------------------
|            |                                       
|            | d.                                    
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|            |                                       
|NOTE 4  -   | SHORT-TERM INVESTMENTS:               

| |                                                 |                                                 | December 31                 |    
| | ----------------------------------------------- | ----------------------------------------------- | --------------------------- | ---
| |                                                 |                                                 |                             |    
| |                                                 |                                                 | 2002                        |    
| |                                                 |                                                 |                             |    
| |                                                 |                                                 | U.S. dollars
  in thousands |    
| |                                                 |                                                 |                             |    
| | Short-term bank deposits - linked to the dollar |                                                 |                             |    
| | Marketable securities:                          |                                                 |                             |    
| |                                                 | Israeli Government bonds - linked to the dollar |                             |    
| |                                                 | Israeli Government bonds - linked to the NIS    |                             |    
| |                                                 |                                                 |                             |    
| |                                                 |                                                 |                             | 129
| |                                                 |                                                 |                             |    

F-15

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 5  - | LONG-TERM LOANS TO EMPLOYEES:
|--------- | -----------------------------
|          |                              
|          | a.                           
|          |                              
|          | b.                           

| |                                                                            |  | December 31               |   
| | -------------------------------------------------------------------------- |  | ------------------------- | --
| |                                                                            |  |                           |   
| |                                                                            |  | 2002                      |   
| |                                                                            |  |                           |   
| |                                                                            |  | U.S. dollars in thousands |   
| |                                                                            |  |                           |   
| | Loan amount receivable                                                     |  |                           | 46
| | Less - unamortized discount based on
  imputed interest rate*              |  |                           | 5 
| |                                                                            |  |                           |   
| |                                                                            |  |                           | 41
| | L e s s - current maturities (included in
  accounts receivable - other) |  |                           | 10
| |                                                                            |  |                           |   
| |                                                                            |  |                           | 31
| |                                                                            |  |                           |   
| |                                                                            |  |                           |   
| | *      The imputed interest rate -
  5.5%.                                 |  |                           |   

| | c. | As of December 31, 2002, the expected
  annual principal payments of long-term loans to employees, commencing 2004,
  are as follows: 2004 - $ 8,400; 2005 - $8,400; 2006 - $8,400; 2007 - $5,800.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|NOTE 6  - | PROPERTY AND EQUIPMENT:
|--------- | -----------------------

| | a. | Composition of assets, grouped by major
  classifications, is as follows:
| | -- | -------------------------------------------------------------------------

| |                                              |                                  | December 31               |      
| | -------------------------------------------- | -------------------------------- | ------------------------- | -----
| |                                              |                                  |                           |      
| |                                              |                                  | 2002                      |      
| |                                              |                                  |                           |      
| |                                              |                                  | U.S. dollars in thousands |      
| |                                              |                                  |                           |      
| | Cost:                                        |                                  |                           |      
| |                                              | Vehicles                         |                           |      
| |                                              | Computer
  equipment             |                           |      
| |                                              | Office
  furniture and equipment |                           |      
| |                                              | Leasehold improvements           |                           |      
| |                                              |                                  |                           |      
| |                                              |                                  |                           | 2,183
| |                                              |                                  |                           |      
| | Accumulated depreciation and
  amortization: |                                  |                           |      
| |                                              | Vehicles                         |                           |      
| |                                              | Computer
  equipment             |                           |      
| |                                              | Office
  furniture and equipment |                           |      
| |                                              | Leasehold
  improvements         |                           |      
| |                                              |                                  |                           |      
| |                                              |                                  |                           | 1,493
| |                                              |                                  |                           |      

| | b. | Depreciation and amortization of fixed assets
  totalled approximately $588,000, $801,000, and $446,000 in 2002, 2001, and
  2000 respectively.                                                 
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                 
| | c. | In 2002, the Company recorded $750,000 as
  impairment of property and equipment 
  expenses in the consolidated statement of operations in connection
  with restructuring plan, see note13d.

F-16

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 6  - | PROPERTY AND EQUIPMENT(continued):                                                                                                                                                                                                                                                                                                                                                                        
|--------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          |                                                                                                                                                                                                                                                                                                                                                                                                           
|          | d.                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                                                                                                                                                                                                                                                                                                                                                                                                           
|          | e.                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                                                                                                                                                                                                                                                                                                                                                                                                           
|NOTE 7  - | ACCRUED SEVERANCE PAY LIABILITY                                                                                                                                                                                                                                                                                                                                                                           
|          |                                                                                                                                                                                                                                                                                                                                                                                                           
|          | Israeli
  labor law generally requires payment of severance pay upon dismissal of an
  employee or upon termination of employment in certain other
  circumstances.  The Company has
  recorded the liability as if it was payable at each balance sheet date on an
  undiscounted basis. This liability is computed based, upon the number of
  years of service multiplied by the latest monthly salary.
|          |                                                                                                                                                                                                                                                                                                                                                                                                           
|          | The severance pay
  liabilities covered by pension funds are not reflected in the financial
  statements as the severance pay risks have been irrevocably transferred to
  the pension funds.                                                                                                                                                                                                             
|          |                                                                                                                                                                                                                                                                                                                                                                                                           
|          | The
  amounts accrued and the portion funded by insurance policies are reflected in
  the financial statements as follows:                                                                                                                                                                                                                                                                                

| |                                                         |  | December 31               |    
| | ------------------------------------------------------- |  | ------------------------- | ---
| |                                                         |  |                           |    
| |                                                         |  | 2002                      |    
| |                                                         |  |                           |    
| |                                                         |  | U.S. dollars in thousands |    
| |                                                         |  |                           |    
| | Amount accrued                                          |  |                           | 811
| | L e s s - amount funded                                 |  |                           | 440
| |                                                         |  |                           |    
| | Unfunded balance, as presented in 
  the balance sheets |  |                           | 371
| |                                                         |  |                           |    

|          | The
  Group may only make withdrawals from the severance pay funds for the purpose
  of paying severance pay.                                                                                                                                   
|--------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          |                                                                                                                                                                                                                                                 
|          | The
  amounts of accrued severance pay as above cover the Groups severance pay
  liability in accordance with labor agreements in force and based on salary
  components, which in managements opinion, create entitlement to severance
  pay.
|          |                                                                                                                                                                                                                                                 
|          | Severance
pay expenses for the years ended December 31, 2002, 2001, and 2000,
totalled approximately $100,000, $109,000, and $151,000, respectively.                                                                                            
|          |                                                                                                                                                                                                                                                 
|NOTE 8  - | COMMITMENTS:                                                                                                                                                                                                                                    
|          |                                                                                                                                                                                                                                                 
|          | a.                                                                                                                                                                                                                                              
|          |                                                                                                                                                                                                                                                 
|          |                                                                                                                                                                                                                                                 
|          |                                                                                                                                                                                                                                                 
|          |                                                                                                                                                                                                                                                 

F-17

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 8  - | COMMITMENTS(continued):
|--------- | -----------------------
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          | b.                     
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|NOTE 9  - | SHAREHOLDERS EQUITY:  
|          |                        
|          | a.                     
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        
|          |                        

F-18

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 9  - | SHAREHOLDERS EQUITY(continued):
|--------- | --------------------------------
|          |                                 
|          | b.                              
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 

F-19

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 9  - | SHAREHOLDERS EQUITY(continued):
|--------- | --------------------------------
|          |                                 
|          |                                 

|                                                   |                           | Y e a r     e n d e d     D e c e m b e r   3 1 |          
|-------------------------------------------------- | ------------------------- | ----------------------------------------------- | ---------
|                                                   |                           |                                                 |          
|                                                   |                           | 2 0 0 2                                         |          
|                                                   |                           |                                                 |          
|                                                   |                           | Number                                          |          
|                                                   |                           |                                                 |          
|                                                   |                           |                                                 |          
|                                                   |                           |                                                 |          
|Options outstanding 
     at beginning of year     |                           |                                                 | 1,646,860
|Changes during the year:                           |                           |                                                 |          
|                                                   | Granted - at market value |                                                 |          
|                                                   | Exercised                 |                                                 |          
|                                                   | Forfeited/ Expired        |                                                 |          
|                                                   |                           |                                                 |          
|Options outstanding at end of year                 |                           |                                                 | 1,727,360
|                                                   |                           |                                                 |          
|Options exercisable at year end                    |                           |                                                 | 940,410  
|                                                   |                           |                                                 |          
|Weighted average fair value of
   options granted* |                           |                                                 |          
|                                                   |                           |                                                 |          

| | * | The fair value of each option grant is estimated on the date of grant
  using the Black-Scholes option-pricing model with the following weighted
  average assumptions: dividend yield of 0% for all years; Expected volatility
  of 152%, 157% and 75% for 2002, 2001 and 2000, respectively; Risk-free interest rate of 4.5%,
  2.5% and 6% for 2002, 2001, and 2000, respectively and expected life of 5
  years for 2002 and 2001 and 2 years for 2000.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  |  | c) | The following table summarizes information about options outstanding
  at December 31, 2002 (including options granted to the Companys senior
  officers):
| |  |  | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------

| | D e c e m b e r  3 1,  2 0 0 2 |                
| | ------------------------------ | ---------------
| |                                |                
| | Options outstanding            |                
| |                                |                
| | Exercise
  prices              |                
| |                                |                
| | $                              |                
| |                                |                
| |                                | 0.60
  - 0.93* 
| |                                | 1.11
  - 1.88**
| |                                | 2.03           
| |                                | 2.25           
| |                                | 2.33           
| |                                | 2.56           
| |                                | 2.63           
| |                                | 3.11           
| |                                | 4.44           
| |                                | 8.77           
| |                                | 11.00          
| |                                |                
| |                                |                
| |                                |                
| |                                |                

| | *  | Weighted average exercise price is $0.86 and $0.79, respectively for
  options outstanding and exercisable at December 31, 2002.
| | -- | --------------------------------------------------------------------------------------------------------------------------------
| | ** | Weighted
  average exercise price is $1.56 for options outstanding and exercised at
  December 31, 2002.                        

F-20

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 9  - | SHAREHOLDERS EQUITY(continued):
|--------- | --------------------------------
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 
|          |                                 

F-21

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 10  - | TAXES ON INCOME:
|---------- | ----------------
|           |                 
|           | a.              
|           |                 
|           |                 
|           |                 
|           |                 
|           |                 
|           |                 
|           |                 
|           | b.              
|           |                 
|           |                 
|           |                 
|           |                 
|           |                 
|           | c.              
|           |                 
|           |                 

F-22

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 10  - | TAXES ON INCOME (continued):
|---------- | ----------------------------
|           |                             
|           | d.                          
|           |                             
|           |                             
|           |                             
|           | e.                          
|           |                             
|           |                             
|           |                             
|           | f.                          
|           |                             
|           |                             

| |                      |                                           | December 31                 |        
| | -------------------- | ----------------------------------------- | --------------------------- | -------
| |                      |                                           |                             |        
| |                      |                                           | 2002                        |        
| |                      |                                           |                             |        
| |                      |                                           | U.S. dollars
  in thousands |        
| |                      |                                           |                             |        
| | In respect of:       |                                           |                             |        
| |                      | Severance pay                             |                             |        
| |                      | Vacation pay                              |                             |        
| |                      | Amortization and impairment of
  goodwill |                             |        
| |                      | U.S. operating loss carryforwards         |                             |        
| |                      | Israeli operating loss carryforwards      |                             |        
| |                      | Other                                     |                             |        
| |                      |                                           |                             |        
| |                      |                                           |                             | 20,111 
| |                      |                                           |                             |        
| | Valuation allowance* |                                           |                             | (20,111
| |                      |                                           |                             |        
| |                      |                                           |                             | -,-    
| |                      |                                           |                             |        

*       See
  note 1i.

| | g. | Tax assessments and
  carryforward tax losses                                                                                                                                                                   
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                 
| |    | Tax
  assessments filed by the company through the year ended December 31,
  1998 are considered to be final.                                                                                                   
| |    | Carryforward
  tax losses of the Company amounted to approximately $4.5 million at December
  31, 2002, with no expiration date.                                                                                
| |    |                                                                                                                                                                                                                 
| |    | The subsidiaries have not been assessed for tax purposes since
  incorporation.                                                                                                                                 
| |    | At December 31, 2002 the subsidiaries have federal
  net operating losses carryforward of approximately $29 million available
  to reduce further taxable income, which expires at various dates through
  2022.
| |    |                                                                                                                                                                                                                 
| | h. | Income (loss) from continued
  operations before taxes on income:                                                                                                                                               

| |               |  | 2002                        |         | 2001 |  | 2000 |        
| | ------------- |  | --------------------------- | ------- | ---- |  | ---- | -------
| |               |  |                             |         |      |  |      |        
| |               |  | U.S. dollars
  in thousands |        
| |               |  |                             |        
| | Israel        |  |                             | (5,248  | )    |  |      | (4,380 
| | United States |  |                             | (8,408  | )    |  |      | (21,134
| |               |  |                             |         |      |  |      |        
| |               |  |                             | (13,656 | )    |  |      | (25,514
| |               |  |                             |         |      |  |      |        

F-23

---

---

AREL
COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 11  - | MONETARY BALANCES IN NON-DOLLAR CURRENCIES:
|---------- | -------------------------------------------
|           |                                            
|           | a.                                         

| |              |                                                                       | Israeli currency (1)        |    
| | ------------ | --------------------------------------------------------------------- | --------------------------- | ---
| |              |                                                                       |                             |    
| |              |                                                                       | Unlinked                    |    
| |              |                                                                       |                             |    
| |              |                                                                       | U.S. dollars
  in thousands |    
| |              |                                                                       |                             |    
| | Assets:      |                                                                       |                             |    
| |              | Current assets:                                                       |                             |    
| |              | Cash and cash equivalents                                             |                             |    
| |              | Short-term investments                                                |                             |    
| |              | Accounts receivable:                                                  |                             |    
| |              | Trade                                                                 |                             |    
| |              | Other                                                                 |                             |    
| |              | Long-term loans to employees 
         (including current maturities) |                             |    
| |              |                                                                       |                             |    
| |              |                                                                       |                             | 354
| |              |                                                                       |                             |    
| |              |                                                                       |                             |    
| | Liabilities: |                                                                       |                             |    
| |              | Current liabilities:                                                  |                             |    
| |              | Short-term bank credit                                                |                             |    
| |              | Trade                                                                 |                             |    
| |              | Accounts payable and accruals - other                                 |                             |    
| |              | Long-term loan
         (including current maturities)                |                             |    
| |              |                                                                       |                             |    
| |              |                                                                       |                             | 959
| |              |                                                                       |                             |    
| |              |                                                                      
| | (1)          | Not including balances in Israeli currency linked to the dollar.     
| |              |                                                                      
| | (2)          | To the Israeli CPI.                                                  
| |              |                                                                       |                             |    

| | b. | Data regarding the exchange rate and the CPI:
| | -- | ---------------------------------------------

| |                                        |      | Exchange rate of one U.S.
  dollar |  | CPI*      | 
| | -------------------------------------- | ---- | ---------------------------------- |  | --------- | 
| |                                        |      |                                    |  |           | 
| |                                        |      | NIS                                |  | Points    | 
| |                                        |      |                                    |  |           | 
| | At
  end of year:                      |      |                                    |  |           | 
| |                                        | 2002 |                                    |  | NIS 4.737 | 
| |                                        | 2001 |                                    |  | NIS 4.416 | 
| |                                        | 2000 |                                    |  | NIS 4.041 | 
| | Increase
  (decrease) during the year: |      |                                    |  |           | 
| |                                        | 2002 |                                    |  | 7.3%      | 
| |                                        | 2001 |                                    |  | 9.3%      | 
| |                                        | 2000 |                                    |  | (2.7%)    | 

F-24

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 12  - | SUPPLEMENTARY BALANCE SHEET INFORMATION:
|---------- | ----------------------------------------

| |                                                |                                                                                                                                                   | December 31               |    
| | ---------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------- | ---
| |                                                |                                                                                                                                                   |                           |    
| |                                                |                                                                                                                                                   | 2002                      |    
| |                                                |                                                                                                                                                   |                           |    
| |                                                |                                                                                                                                                   | U.S. dollars in thousands |    
| |                                                |                                                                                                                                                   |                           |    
| | a.    Accounts
  receivable:                   |                                                                                                                                                   |                           |    
| |                                                |                                                                                                                                                   |                           |    
| |                                                | 1) Trade - net of allowance for doubtful
            accounts in the amount of                                                                    |                           |    
| |                                                |                                                                                                                                                   |                           |    
| |                                                | 2) Other:                                                                                                                                         |                           |    
| |                                                | Israeli Government departments and agencies                                                                                                       |                           |    
| |                                                | Employees                                                                                                                                         |                           |    
| |                                                | Prepaid expenses                                                                                                                                  |                           |    
| |                                                | Advances to suppliers                                                                                                                             |                           |    
| |                                                | Related parties                                                                                                                                   |                           |    
| |                                                | Sundry*                                                                                                                                           |                           |    
| |                                                |                                                                                                                                                   |                           |    
| |                                                |                                                                                                                                                   |                           | 488
| |                                                |                                                                                                                                                   |                           |    
| |                                                |                                                                                                                                                  
| |                                                | *At December 31, 2002, includes $45,000
  restricted certificate of deposit which is required as a collateral by
  providers of network services. |                          
| |                                                |                                                                                                                                                   |                          
| | b.    Accounts
  payable and accruals - other: |                                                                                                                                                  

| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | December 31               |      
| | ----------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------- | -----
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | 2002                      |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | U.S. dollars in thousands |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| |                         | Employees and employee institutions                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |                           |      
| |                         | Provision for vacation pay                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |                           |      
| |                         | Income tax payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                           |      
| |                         | Accrued expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                           |      
| |                         | Advances from customers                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |                           |      
| |                         | Related parties                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           | 3,157
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| | c.    Long-term
  loan: |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                         | Principal amount                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                           |      
| |                         | Less - current maturities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                           |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           | 48   
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      
| |                        
| |                         | On December 10, 2002 the Company received a long-term loan from a leasing company,
  with respect to purchase of a vehicle, in connection with an agreement with
  one of its employees. The loan, denominated in unlinked NIS in the original
  amount of $67,000, bears interest at the annual rate of 26%. The loan
  matures, commencing 2003, as follows: 2003 - $16,000, 2004 - $48,000. In
  connection with this loan the Company recorded a pledge on the vehicle in
  favor of the leasing company. Under the agreement between the Company
  and its employee, the
  employee undertakes to remain in his position until the end of 2004. At that
  time the vehicle will be transferred to his possession, net of taxes and any
  costs related to the transfer of ownership.
| |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |                           |      

F-25

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 12  - | SUPPLEMENTARY BALANCE SHEET INFORMATION (continued):
|---------- | ----------------------------------------------------
|           |                                                     
|           | d.                                                  
|           |                                                     
|           |                                                     
|           |                                                     
|           |                                                     
|           |                                                     
|NOTE 13  - | SELECTED INCOME STATEMENT DATA:                     
|           |                                                     
|           | a.                                                  

| |                                      |  | Year ended December 31,     |      
| | ------------------------------------ |  | --------------------------- | -----
| |                                      |  |                             |      
| |                                      |  | 2002                        |      
| |                                      |  |                             |      
| |                                      |  | U.S. dollars
  in thousands |      
| |                                      |  |                             |      
| | Materials and components 
  Consumed |  |                             | 1,671
| | Payroll and related expenses         |  |                             | 455  
| | Subcontractors                       |  |                             | 1,175
| | Depreciation and amortization        |  |                             | 72   
| | Other                                |  |                             | 231  
| |                                      |  |                             |      
| |                                      |  |                             | 3,604
| |                                      |  |                             |      
| | *  Including cost of services        |  |                             | 1,505
| |                                      |  |                             |      

| | b. | Research and development
        expenses - net:
| | -- | ------------------------------------------------

| | Total expenses                      |  |  | 2,218 |  |  |  | 2,804 |  |  |  | 1,848 |  | 
| | ----------------------------------- |  |  | ----- |  |  |  | ----- |  |  |  | ----- |  | 
| | L e s s - grants and participations |  |  |       |  |  |  | 861   |  |  |  | 652   |  | 
| |                                     |  |  |       |  |  |  |       |  |  |  |       |  | 
| |                                     |  |  | 2,218 |  |  |  | 1,943 |  |  |  | 1,196 |  | 
| |                                     |  |  |       |  |  |  |       |  |  |  |       |  | 

| | c. | Selling, general and
        administrative expenses:
| | -- | -----------------------------------------------------

| | Selling, net*                                               |  |  | 2,688 |  |  |  | 7,140 |  |  |  | 4,862 |  | 
| | ----------------------------------------------------------- |  |  | ----- |  |  |  | ----- |  |  |  | ----- |  | 
| | General and administrative                                  |  |  | 3,751 |  |  |  | 2,183 |  |  |  | 1,506 |  | 
| |                                                             |  |  |       |  |  |  |       |  |  |  |       |  | 
| |                                                             |  |  | 6,439 |  |  |  | 9,323 |  |  |  | 6,368 |  | 
| |                                                             |  |  |       |  |  |  |       |  |  |  |       |  | 
| | *  Net of Government
         participation, see note 8a(2) |  |  |       |  |  |  |       |  |  |  | 14    |  | 
| |                                                             |  |  |       |  |  |  |       |  |  |  |       |  | 

F-26

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 13  - | SELECTED INCOME STATEMENT DATA(continued):
|---------- | ------------------------------------------
|           |                                           
|           | d.                                        
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|NOTE 14  - | SEGMENT INFORMATION:                      
|           |                                           
|           | a.                                        
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|           |                                           
|           |                                           

F-27

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 14  - | SEGMENT INFORMATION(continued):
|---------- | -------------------------------
|           |                                
|           | b.                             

|                                                  |  | Segment A                 |  | Segment B* |  | Elimination of Intersegment
  balances |  | Consolidated | 
|------------------------------------------------- |  | ------------------------- |  | ---------- |  | -------------------------------------- |  | ------------ | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|                                                  |  | 2002                      |  | 2001       |  | 2000                                   |  | 2002         | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|                                                  |  | U.S. dollars in thousands |  |            |  |                                        | 
|                                                  |  |                           |  |            |  |                                        | 
|Revenues
  from external customers                |  | 3,429                     |  | 5,336      |  | 10,687                                 |  | 2,512        | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Depreciation
  and amortization                   |  | 269                       |  | 252        |  | 238                                    |  | 319          | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Amortization
  and impairment of goodwill         |  |                           |  |            |  |                                        |  | 4,858        | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Impairment
  of property and equipment            |  |                           |  |            |  |                                        |  | 750          | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Operating
  income (loss)                         |  | (5,551)                   |  | (2,307)    |  | 270                                    |  | (7,928)      | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Financial
  income (loss)                         |  | 123                       |  | 889        |  | 909                                    |  | (21)         | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Discontinued
  operations                         |  |                           |  |            |  | (390)                                  |  |              | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Segment profits (loss) from  continued operations |  | (5,707)                   |  | (4,308)    |  | 1,078                                  |  | (7,949)      | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Segment
  profits (loss)                          |  | (5,707)                   |  | (4,308)    |  | 688                                    |  | (7,949)      | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Segment
  assets                                  |  | 40,962                    |  | 43,221     |  | 29,732                                 |  | 760          | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Segment
  liabilities                             |  | 6,351                     |  | 3,872      |  | 4,505                                  |  | 27,352       | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Goodwill                                          |  |                           |  |            |  |                                        |  |              | 
|                                                  |  |                           |  |            |  |                                        |  |              | 
|Capital
  expenditures                            |  | 172                       |  | 69         |  | 428                                    |  | 2            | 
|                                                  |  |                           |  |            |  |                                        |  |              | 

*  Segment B operated from
August 8, 2000, see note 3.

F-28

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 14  - | SEGMENT INFORMATION(continued):
|---------- | -------------------------------
|           |                                
|           | c.                             

| |                          |  | Year ended December 31    |      
| | ------------------------ |  | ------------------------- | -----
| |                          |  |                           |      
| |                          |  | 2002                      |      
| |                          |  |                           |      
| |                          |  | U.S. dollars in thousands |      
| |                          |  |                           |      
| | IDEAL                    |  |                           | 3,685
| | IVC and network services |  |                           | 2,256
| |                          |  |                           |      
| |                          |  |                           | 5,941
| |                          |  |                           |      

| | d. | Geographic
  information:                                                                                                
| | -- | -------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                          
| |    | 1)                                                                                                                       
| |    |                                                                                                                          
| |    | 2)                                                                                                                       
| |    |                                                                                                                          
| | e. | Revenues from principal customers (single
  customers each of which exceeds 10% of total revenues in the relevant year)*:

| |            |  | Year ended December 31    |      
| | ---------- |  | ------------------------- | -----
| |            |  |                           |      
| |            |  | 2002                      |      
| |            |  |                           |      
| |            |  | U.S. dollars in thousands |      
| |            |  |                           |      
| | Customer A |  |                           | 676  
| | Customer B |  |                           | 1,080
| | Customer C |  |                           | 597  
| | Customer D |  |                           |      
| |            |  |                           |      
| |            |  |                           | 2,353
| |            |  |                           |      

*  All principal customers relate to segment A.

|NOTE 15  - | TRANSACTIONS WITH RELATED PARTIES:
|---------- | ----------------------------------
|           |                                   
|           | a.                                
|           |                                   
|           | b.                                
|           |                                   
|           |                                   

F-29

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16  - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND U.S. GAAP                                                                                                                                    
|---------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|           |                                                                                                                                                                                                        
|           | The Group prepares its financial statements in conformity with
  Israeli GAAP. As applicable to these financial statements, Israeli GAAP vary
  in certain respects from U.S. GAAP, as described below:
|           |                                                                                                                                                                                                        
|           | a.                                                                                                                                                                                                     
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           | b.                                                                                                                                                                                                     
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        
|           | c.                                                                                                                                                                                                     
|           |                                                                                                                                                                                                        
|           |                                                                                                                                                                                                        

F-30

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16  - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND U.S. GAAP (continued):
|---------- | --------------------------------------------------------------------------------
|           |                                                                                 
|           | d.                                                                              
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 
|           |                                                                                 

| |                                                       |  | Year ended December 31,   |       
| | ----------------------------------------------------- |  | ------------------------- | ------
| |                                                       |  |                           |       
| |                                                       |  | 2002                      |       
| |                                                       |  |                           |       
| |                                                       |  | U.S. dollars in thousands |       
| |                                                       |  |                           |       
| | Net cash used in operating activities                 |  |                           | (3,231
| |                                                       |  |                           |       
| | Net cash provided by (used in) investing
  activities |  |                           | 8,209 
| |                                                       |  |                           |       

| |  | 3) | Classification
  of Impairment of Investment in Arelnet Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |  | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  |    | In
  2002 and 2001, the Company recorded impairment in the value of investment in
  Arelnet as a result of other than temporary decline in the value of the
  investment. As a result, the Company recorded, both under Israeli GAAP and
  U.S. GAAP, approximately $279,000 and $2,890,000 loss under Impairment of
  Investment in Arelnet Ltd. in the statement of operations of 2002 and 2001,
  respectively. Under Israeli GAAP this amount was included as a component of
  non-operating expenses while under U.S. GAAP the impairment loss should be
  classified as part of the operating expenses.

F-31

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16 - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND U.S. GAAP
  (continued):
|--------- | ----------------------------------------------------------------------------------
|          |                                                                                   
|          |                                                                                   

| |                                                                                                    |  | Year ended December 31,     |        
| | -------------------------------------------------------------------------------------------------- |  | --------------------------- | -------
| |                                                                                                    |  |                             |        
| |                                                                                                    |  | 2002                        |        
| |                                                                                                    |  |                             |        
| |                                                                                                    |  | U.S. dollars
  in thousands |        
| |                                                                                                    |  |                             |        
| |                                                                                                    |  |                             |        
| | Operating loss as reported in these financial
  statements under Israeli GAAP                      |  |                             | (13,479
| | Effect of the classification of Impairment of investment in Arelnet
  Ltd. As an operating expense |  |                             | (279   
| |                                                                                                    |  |                             |        
| | Operating loss under U.S. GAAP                                                                     |  |                             | (13,758
| |                                                                                                    |  |                             |        

| | e. | Loss per share (EPS)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | Israeli GAAP relating to computation of EPS are described
  in note 1m. As
  applicable to the Group, the main difference between the Israeli GAAP and the U.S. GAAP methods of EPS
  computation is that shares to be issued upon exercise of warrants and options
  where the exercise of which is probable, are taken into account in the
  computation of basic loss per share under Israeli GAAP, whereas under U.S.
  GAAP - only the weighted average number of shares actually outstanding in the
  reported year is taken into account in computing basic loss per share while
  shares to be issued upon the exercise of warrants and options are included in
  the computation of diluted loss per share. Also the effect of including the
  incremental shares from the assumed exercise of warrants and options is
  calculated under Israeli GAAP based on the full number of outstanding
  warrants and options and imputed interest on the assumed proceeds from the
  exercise of such warrants and options, rather than the treasury stock method
  under U.S. GAAP.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | f. | Accounting
  for Goodwill                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | Under Israeli GAAP, goodwill is amortized in equal annual
  installments over a period of 10 years. For U.S. GAAP purposes, the Company
  adopted FAS 142 as of January 1, 2002. In conjunction with the adoption
  of FAS 142, the Company discontinued amortizing the goodwill and completed
  its transitional impairment review of goodwill. The Company has determined
  that there is no indication of impairment with respect to goodwill as of
  January 1, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | The Company identified its various reporting units, which consist of
  its reportable segments and for which separately identifiable cash flow
  information is available. The goodwill was allocated to segment
  B.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    | On September 2002, as a result of the continuing decline in the
  market which resulted in the restructuring program discussed in note 13d, the
  Company wrote down the balance of the goodwill which under U.S.
  GAAP amounted to
  $4,858,000 (the carrying amount of goodwill as at adoption date of FS
  142 - January 1, 2002).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

F-32

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16  - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND U.S. GAAP (continued):
|---------- | --------------------------------------------------------------------------------
|           |                                                                                 
|           |                                                                                 

| |                                                       |  | Year ended December 31,                       
| | ----------------------------------------------------- |  | ----------------------------------------------
| |                                                       |  |                                               
| |                                                       |  | 2002                                          
| |                                                       |  |                                               
| |                                                       |  | U.S. $in thousands (except
  loss per
  share)
| |                                                       |  |                                               
| |                                                       |  |                                               
| | Loss - under US GAAP                                  |  |                                               
| | Add, amortization of goodwill                         |  |                                               
| |                                                       |  |                                               
| | As adjusted                                           |  |                                               
| |                                                       |  |                                               
| | Loss per share - basic and diluted
     under US GAAP |  |                                               
| | Add - amortization of goodwill                        |  |                                               
| |                                                       |  |                                               
| | As adjusted                                           |  |                                               
| |                                                       |  |                                               
| |                                                       |  |                                               

| | g. | Impairment of long-lived assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | For
  U.S.GAAP
  purposes the Company adopted in 2002 FAS 144 Accounting for the Impairment
  or Disposal of Long-Lived Assets (FAS 144).  FAS 144 requires that long-lived assets, to be held and used by
  an entity be reviewed for impairment whenever events or changes in
  circumstances indicate that the carrying amount of the assets may not be
  recoverable. Under FAS 144, if the sum of the expected future cash flows
  (undiscounted and without interest charges) of the long-lived assets is less
  than the carrying amount of such assets, an impairment loss would be
  recognized, and the assets are written down to their estimated fair values.
  Under Israeli GAAP the Company used the methodology, as described in note 1n,
  for purpose of evaluating its long-lived assets.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | h. | FAS 123
  pro-forma information                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | Had compensation cost for the Companys plans been determined based
  upon the fair value of the awards granted as of the grant dates consistent
  with the method of SFAS 123, the Groups loss and loss per share
  under U.S. GAAP would
  have been changed to the pro-forma amounts indicated below:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

|                                        |  | Year ended December 31                        |        
|--------------------------------------- |  | --------------------------------------------- | -------
|                                        |  |                                               |        
|                                        |  | 2 0 0 2                                       |        
|                                        |  |                                               |        
|                                        |  | As reported                                   |        
|                                        |  |                                               |        
|                                        |  | U .S .  d o l l a r s  i n  t h o u s a n d s |        
|                                        |  |                                               |        
|Loss                                    |  |                                               | (13,656
|                                        |  |                                               |        
|Loss per basic and diluted
      share. |  |                                               | (1.06  
|                                        |  |                                               |        

F-33

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16  - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND
  U.S. GAAP(continued):
|---------- | ---------------------------------------------------------------------------------
|           |                                                                                  
|           | i.                                                                               

| |    |                                                                                | Year ended
  December 31    | 
| | -- | ------------------------------------------------------------------------------ | --------------------------- | 
| |    |                                                                                |                             | 
| |    |                                                                                | 2002                        | 
| |    |                                                                                |                             | 
| |    |                                                                                | U.S. dollars
  in thousands | 
| |    |                                                                                |                             | 
| | 1) | The effect on loss and comprehensive loss:                                     |                             | 
| |    |                                                                                |                             | 
| |    | Loss as reported in these financial
       statements under Israeli GAAP       |                             | 
| |    | Effect of the treatment of gain on dilution of
       interest in a subsidiary |                             | 
| |    |                                                                                |                             | 
| |    | Loss under U.S. GAAP                                                           |                             | 
| |    |                                                                                |                             | 
| |    | Other comprehensive loss:                                                      |                             | 
| |    | Unrealized losses on investment in Arelnet                                     |                             | 
| |    | Less- reclassification adjustment for losses
       included in net loss       |                             | 
| |    |                                                                                |                             | 
| |    | Other comprehensive loss                                                       |                             | 
| |    |                                                                                |                             | 
| |    | Comprehensive loss                                                             |                             | 
| |    |                                                                                |                             | 
| |    |                                                                                |                             | 

| | 2) | The effect on loss per share:                                                                                                           
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------
| |   
| |    |                                                                                                                                         
| |    |                                                                                                                                         
| |    |                                                                                                                                         
| |    |                                                                                                                                         
| |    | Under U.S. GAAP:                                                                                                                        
| |    | Basic and diluted - in
  dollars:                                                                                                       
| |    |                                                                                                                                         
| |    | Continued operations                                                                                                                    
| |    | Discontinued operations                                                                                                                 
| |    |                                                                                                                                         
| |    |                                                                                                                                         
| |    |                                                                                                                                         
| |    | Weighted average number of
  shares     issued and outstanding (in
  thousands) -     used in computation of
  basic and diluted     EPS
| |    |                                                                                                                                         
| |    |                                                                                                                                         

F-34

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16  - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND
  U.S. GAAP(continued):
|---------- | ---------------------------------------------------------------------------------
|           |                                                                                  
|           |                                                                                  

| |  |                                                                                                                 | Year ended December 31 | 
| |  | --------------------------------------------------------------------------------------------------------------- | ---------------------- | 
| |  |                                                                                                                 |                        | 
| |  |                                                                                                                 | 2002                   | 
| |  |                                                                                                                 |                        | 
| |  | Shareholders equity as
  reported in these     financial statements under
  Israeli GAAP                        |                        | 
| |  | Effect of the treatment of
  gain on dilution of     interest in a subsidiary
  (affects retained     earnings) |                        | 
| |  | Effect of the treatment of
  gain on dilution of     interest in a subsidiary
  (affects capital     surplus)*  |                        | 
| |  | Effect of available for
  sale securities                                                                       |                        | 
| |  | Less - reclassification
  adjustment for losses     included in net loss                                        |                        | 
| |  |                                                                                                                 |                        | 
| |  | Shareholders equity under
  U.S. GAAP                                                                           |                        | 
| |  |                                                                                                                 |                        | 

| | *  | Restated - as discussed in b above, under US GAAP, gain on dilution
  is recorded directly in equity, while under Israeli GAAP it is recorded in
  the statement of operations. Accordingly, there is no difference relating to
  this gain, between Israeli and US GAAP total shareholders equity.
  Consequently, prior years data was adjusted to reflect the effect of this
  gain on capital surplus.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                           
| | j. | Recently issued accounting
  pronouncements in the United States:                                                                                                                                                                                                                                                                                                                                         
| |    |                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | 1)                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                           

F-35

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16  - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND
  U.S. GAAP(continued):
|---------- | ---------------------------------------------------------------------------------
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  

F-36

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An
Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|NOTE 16  - | EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP
  AND
  U.S. GAAP(continued):
|---------- | ---------------------------------------------------------------------------------
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  
|           |                                                                                  

---

---

---

F-37

---

---