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SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, 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,
2003     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)

22 Einstein Street, Park Hamadah, Building 22
P.O.B. 4042, Kiryat Weizmann, Nes Ziona, 74140 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:          Yesx                No o

|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   | 5 
|         |                                                         |   
|ITEM 2.  | OFFER STATISTICS AND EXPECTED TIMETABLE                 | 5 
|         |                                                         |   
|ITEM 3.  | KEY INFORMATION                                         | 5 
|         | SELECTED FINANCIAL DATA                                 | 5 
|         | RISK FACTORS                                            | 5 
|         | RISK FACTORS RELATED TO OUR BUSINESS                    | 5 
|         | RISK FACTORS RELATING TO OUR ORDINARY SHARES            | 12
|         | RISK FACTORS RELATED TO OPERATIONS IN ISRAEL            | 14
|         |                                                         |   
|ITEM 4.  | INFORMATION ON THE COMPANY                              | 17
|         | HISTORY AND DEVELOPMENT OF THE COMPANY                  | 17
|         | BUSINESS OVERVIEW                                       | 18
|         | GOVERNMENTAL REGULATIONS AFFECTING THE COMPANY          | 26
|         | ORGANIZATIONAL STRUCTURE                                | 26
|         | PROPERTY, PLANTS AND EQUIPMENT                          | 26
|         | INTELLECTUAL PROPERTY RIGHTS AND SOFTWARE PROTECTION    | 27
|         |                                                         |   
|         |                                                         |   
|ITEM 5.  | OPERATING AND FINANCIAL REVIEW AND PROSPECTS            | 27
|         | CRITICAL ACCOUNTING POLICIES                            | 27
|         | SELECTED FINANCIAL DATA                                 | 29
|         | OPERATING RESULTS                                       | 32
|         | LIQUIDITY AND CAPITAL RESOURCES                         | 36
|         | RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC     | 38
|         | TREND INFORMATION                                       | 39
|         | OFF-BALANCE SHEET ARRANGEMENTS                          | 40
|         | CONTRACTUAL OBLIGATIONS                                 | 41
|         |                                                         |   
|ITEM 6.  | DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES              | 42
|         | COMPENSATION OF OFFICERS AND DIRECTORS                  | 45
|         | BOARD PRACTICES                                         | 46
|         | EMPLOYEES                                               | 49
|         | SHARE OWNERSHIP                                         | 50
|         |                                                         |   
|ITEM 7.  | MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS       | 52
|         | MAJOR SHAREHOLDERS                                      | 52
|         | RELATED PARTY TRANSACTIONS                              | 53
|         |                                                         |   
|ITEM 8.  | FINANCIAL INFORMATION                                   | 54
|         | CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION | 54
|         | LEGAL PROCEEDINGS                                       | 54
|         | DIVIDEND DISTRIBUTIONS                                  | 55
|         | SIGNIFICANT CHANGES                                     | 55
|         |                                                         |   
|ITEM 9.  | THE OFFER AND LISTING                                   | 55
|         | MARKET AND SHARE PRICE HISTORY                          | 55
|         |                                                         |   
|ITEM 10. | ADDITIONAL INFORMATION                                  | 56
|         | MEMORANDUM AND ARTICLES
  OF ASSOCIATION                | 56

2

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|          | EXCHANGE CONTROLS                                                              | 62
|--------- | ------------------------------------------------------------------------------ | --
|          | TAXATION                                                                       | 62
|          | DOCUMENTS ON DISPLAY                                                           | 69
|          |                                                                                |   
|ITEM 11.  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                     | 70
|          | GENERAL                                                                        | 70
|          | EXCHANGE RATE RISK MANAGEMENT                                                  | 70
|          | INTEREST RATE RISK MANAGEMENT                                                  | 70
|          | 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                                                        | 72
|          |                                                                                |   
|ITEM 16.  | [RESERVED]                                                                     | 72
|          |                                                                                |   
|ITEM 16A. | AUDIT COMMITTEE FINANCIAL EXPERT                                               | 72
|          |                                                                                |   
|ITEM 16B. | CODE OF ETHICS                                                                 | 72
|          |                                                                                |   
|ITEM 16C. | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                         | 72
|          |                                                                                |   
|ITEM 16D. | EXEMPTIONS FROM THE LISTING STANDARDS FROM AUDIT COMMITTEES                    | 73
|          |                                                                                |   
|ITEM 16E. | PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PARTIES            | 73
|          |                                                                                |   
|PART III  |                                                                                |   
|          |                                                                                |   
|ITEM 17.  | FINANCIAL STATEMENTS                                                           | 73
|          |                                                                                |   
|ITEM 18.  | FINANCIAL STATEMENTS                                                           | 73
|          |                                                                                |   
|ITEM 19.  | EXHIBITS                                                                       | 74

3

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LOGO

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 15 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.

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

4

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PART I

|ITEM 1. | IDENTITY OF DIRECTORS, SENIOR MANAGEMENT
  AND ADVISERS.
|------- | --------------------------------------------------------

Not applicable.

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

Not applicable.

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

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 Spotlight application suite for
  conferencing, collaboration and corporate training applications; | 
| |   |                                                                                                                                                                                    | 
| |  | competition
  and pricing;                                                                                                                                                         | 
| |   |                                                                                                                                                                                    | 
| |  | customer
  order deferrals in anticipation of introduction or enhancement of products by
  us or our competitors;                                                                  | 

5

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| |  | availability
  of bandwidth;                                                            
| | - | ----------------------------------------------------------------------------------------
| |   |                                                                                         
| |  | 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.

6

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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.

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 fully synchronized video,
voice and data conferencing market, the landscape of our competitors includes
companies such as Polycom, Inc., Webex, Placeware (acquired by Microsoft in
2003), Centra Software, Inc. (CTRA), InterWise Ltd, and First Virtual
Communications (FVCX). We expect to continue to be exposed to new competitors
in the near future. In the interactive distance learning market, our primary
direct competitor is One Touch Systems, Inc.  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.

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.

Between the years 2000-2002, we did not
generate net income on an annual basis. We incurred net losses of $1,106,000
(including amortization of goodwill of $878,000), $25,514,000 (including
amortization and impairment of goodwill, restructuring and impairment of property
and equipment, and impairment of investment of $20,222,000), and $13,656,000
(including amortization and impairment of goodwill, restructuring and
impairment of property and equipment, and impairment of investment of
$7,438,000) in 2000, 2001, and 2002, respectively. Although we generated net
income of $473,000 in 2003, our unaudited figures for the first quarter of 2004
show that we incurred a net loss of $1,005,000 in the first quarter of 2004,
and we may continue to operate at a loss in the future and may not 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.

7

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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 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.         

8

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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 upon 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
corporate training market for our ICP-based Arel Spotlight Campus application
is still developing.

The corporate training market for our Arel
Spotlight Campus e-learning solution for continuous blended live and on-demand
courses 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 solutions and the future growth
rate of these markets.  We cannot assure
you that the market for our Integrated Conferencing Platform (ICP) based Spotlight Campus application will develop, or that this
system or product 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
conferencing/collaboration market for our ICP-based Arel Spotlight Meeting and
Webinar applications is still developing.

During the course of 2002, we made a
strategic decision to expand our served market by providing an integrated
ICP-based enterprise software solution for conferencing and training
applications for converged IP 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.

9

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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.

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 employees or recruit additional qualified personnel.  In addition, our inability to recruit
additional 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 relative to complying with a wide variety of foreign laws and
  regulations;          
|  |                                                                                               
| | potentially adverse tax consequences; and                                                     
|  |                                                                                               
| | the failure to obtain approvals from foreign governmental bodies.                             

To date, we generally have not experienced
any material difficulties in collecting accounts receivable as a result of our
international sales.

10

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If we are
characterized as a passive foreign investment company for U.S. federal income
tax purposes, our U.S. shareholders will suffer adverse tax consequences.

Generally, if for any taxable year 75% or more of our gross income is
passive income, or at least 50% of our assets are held for the production of,
or produce, passive income, we may be characterized as a passive foreign
investment company (PFIC) for U.S. federal income tax purposes. If we are
characterized as a PFIC, our U.S. shareholders may suffer adverse tax
consequences, including having gains realized on the sale of our shares taxed
at ordinary income rates, rather than the capital gain rate. The determination that
we are a passive foreign investment company could also have an adverse effect
on the price and marketability of our shares. (See Item 10.  Additional Information  
Taxation  Passive
Foreign Investment Companies).

The
spread of the SARS epidemic or other epidemics could seriously harm our
profitability.

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 was most prominent in Asia and specifically China and Hong Kong. The
previous spread of SARS resulted in a slowdown in our business in China,
Singapore, Thailand and Taiwan, where most of our operations in the Far East
are situated. Recently, the spread of SARS has been reasonably brought under
control. However, in the event of an outbreak of SARS, or other contagious
diseases, our ability to travel to selected areas may be limited, and our
ongoing projects and future sales in such areas may be adversely affected.

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 revenues. Inflation and
U.S. dollar exchange rate fluctuations may, 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 mainly through natural hedging; but we are likely to remain exposed to
exchange rate fluctuations, which may increase the cost of our activities.

11

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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 cancelled 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 or tax benefits will be continued in the future, at their current
levels, or at all.  If these programs or
tax benefits are discontinued, our business, financial condition and results of
operations could be materially adversely affected.

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, our costs of being a public company have increased. New legislation,
such as the recently enacted Sarbanes-Oxley Act of 2002, has increased the burdens
and potential liabilities of being a public reporting company. This and other
proposed legislation may further increase the fees of our professional advisors
in the future and may cause our insurance premiums to rise.

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;                                

12

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| | 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.                  

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, particularly those in the fields
of communications, software and Internet, 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 may experience
difficulties in raising the additional financing necessary to effectively
operate and grow their businesses.  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 June 1, 2004, we had 13,128,466
ordinary shares outstanding, of which, 8,461,410 ordinary shares are freely
tradable.  The remaining 4,467,056
ordinary shares outstanding are restricted securities, as that term is
defined under Rule 144 of the Securities Act of 1933, as amended.  However, we are currently contemplating the
registration of a portion of these restricted securities, which would therefore
become freely tradable at such time as an F-3 registration statement, to be
prepared pursuant to the Securities Act of 1933, for the registration of such
ordinary shares becomes effective. Approximately 2,469,912 of the restricted
securities have been held for over 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.

13

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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 may
be more difficult because of:

| | a possible reduction in security analysts and the news medias
  coverage of us; and                                                                 
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------
| | provisions included in the formation documents of many institutions
  that limit 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.

Our shares are subject to Rule 15g-9
under the Securities Exchange Act of 1934, as amended.  The 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 research and development and operation 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 subjects of an economic boycott by the Arab
countries since Israels establishment.

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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, which has continued with varying
levels of severity into 2004.  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 on our business 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 research and development and operation  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.

The
results of our 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 have been significant call ups of military
reservists, and it is possible that there will be additional call-ups in the
future.  Our operations could be
disrupted and harmed 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.

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

Service of process upon those of our
directors and officers that do not reside in the United States or upon the
Israeli experts named herein, may be difficult to effect within 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.

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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;                          
|  |                                                                                                                                                            
| | 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.  

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

Provisions of Israeli corporate or tax law may have the effect of
delaying, preventing or making more difficult a merger or other acquisition of
us.  The Israeli Companies Law,
5739-1999, known as the Companies Law, generally requires that a merger be
approved by a companys board of directors and by shareholder vote at a
shareholders meeting that has been called on at least 21 days advance
notice.  Any creditor of a merging party
may seek a court order blocking the merger if there is a reasonable concern
that the surviving company will not be able to satisfy all of the obligations
of any party to the merger.  Moreover, a
merger may not be completed until at least 70 days have passed from the time
that the merger proposal was filed with the Israeli Registrar of Companies.

Other potential means of acquiring a public Israeli company might
involve significant obstacles, such as a requirement for court approval for the
acquisition.  In addition, a body of
case law has not yet developed with respect to the Companies Law.  Until this happens, uncertainties will exist
regarding its interpretation.

Israeli tax law treats some acquisitions, such as stock-for-stock
exchanges between an Israeli company and a foreign company, less favorably than
do U.S. tax laws.  For example, Israeli
tax law may subject a shareholder who exchanges our ordinary shares for shares
in another corporation to immediate taxation.

These provisions of Israeli corporate and tax law and the uncertainties
surrounding such law may delay, prevent or make more difficult a merger or
acquisition involving our company.  This
could prevent a change of control in our company and limit a shareholders
ability to receive a premium in a change of control transaction.

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

History and
Development of the Company

Our legal and commercial name is Arel Communications and Software
Ltd.  We were incorporated in Israel in
1982 and organized pursuant to the Israel Companies Ordinance, which was
replaced in February 2000 by the Israel Companies Law.  Our executive offices are located at 22
Einstein Street, Park Hamadah, Building 22, Post Office Box 4042, Kiryat
Weizmann, Nes Ziona, 74140 Israel, and our telephone number is
+972-8-940-7711.  Our website is www.arelcom.com.  Information on our web site is not
incorporated by reference in this registration statement.

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.

Recent
Developments

Since January 1, 2003, the following
important events have occurred:

Share purchase,
tender offer and resignation of the chairman of our board of directors

Our largest shareholder, Clayton L. Mathile is in the process of
increasing his 22.5% holdings in our
Company, by up to another 12%. The chairman of our board of directors, Mr.
Izhak Gross, has agreed to sell to Mr. Mathile his 6.4% stake in our Company,
amounting to 842,619 shares, at a price per share of $4.75. In accordance with
Israeli law, Mr. Mathile launched a partial tender offer, pursuant to which he
offered to purchase 5% of our shares for the same price of $4.75 per share. Mr.
Gross has agreed to sell his shares to Mr. Mathile in the tender offer.  Shares held by ordinary shareholders that
are tendered to Mr. Mathile will be accepted on a pro rata basis.  Within ten days following the tender offer,
Mr. Mathile will purchase shares held by Mr. Gross not purchased in the tender
offer.

Upon the consummation of the sale of his shareholdings, Mr. Gross will
resign from our board of directors. As agreed upon previously in an agreement
by and between us and Mr. Gross, upon his resignation, Mr. Gross shall receive his monthly salary
of $12,500 and other benefits
customary in Israel for the six-month
period following his resignation, including payments of $520 for every accrued
but unused vacation day. As of the date of the filing of this report, Mr. Gross
had 198 accrued yet unused vacation days.

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Establishment of
Arel Communications and Software EMEA, SAS.

In the first quarter of 2004, we established Arel Communications and Software EMEA,
SAS, our wholly-owned subsidiary in France, in order to increase our European
presence through the establishment of a European sales and marketing office.
The objective of this operation is to promote Arels products and services in
Europe, the Middle East and Asia. In January, we recruited our Vice President
of operations, Eric Le Guinec, a person with extensive business and operations
background. The subsidiary is an SAS (in French: Societe par Actions Simplifiee)
entity.

Settlement of
dispute with W2Com.

In March 2004, we settled our dispute with W2Com. Pursuant
to the Settlement and Release Agreement, which was entered into in October
2003,  (i) the parties to the dispute
irrevocably and unconditionally released each other from any and all claims,
(ii) we received $500,000 and 200,000 shares of the 1,049,999 shares which were
deposited in escrow were returned to us, and (iii) 849,999 shares of the
1,049,999 shares which were deposited in escrow were released to Clayton L.
Mathile, as Trustee under an Amended and Restated Agreement of Trust for
Clayton L. Mathile, dated June 18, 2001. In accordance with the Israel
Companys Law, the 200,000 shares that were returned to us have become dormant
shares. For more information regarding the W2Com settlement, see
Item 7, Related Party Transactions.

Separation Agreement
with Mr. Zvi Klier.

In May 2004, our former President, Mr. Klier, ended a term of thirteen
years of dedicated service to our Company. Mr. Klier had served us in various
roles since 1991. In July 2003, we entered into a separation agreement with Mr.
Klier under which Mr. Klier continued in our employ during the 10-month period
following the date of the separation agreement. For more information about the
separation agreement, see Item 7 Related Party Transactions.

For information regarding our principal capital expenditures and
divestitures in the last three financial years see Item 5. Operating and
Financial Review and Prospects.

Business Overview

The Market

We are in the business of providing interactive voice, video and data
web communication solutions for conferencing, collaboration and corporate
training applications that enable content, audio and video interaction in real
time between large numbers of participants at remote locations. As the global
market expands, corporations, universities, governmental agencies and other
organizations seek collaborative solutions that efficiently provide content and
enable audio and video interaction with large numbers of participants at remote
locations on their desktops.  In order
to achieve this objective, we develop,
market and sell an integrated suite of enterprise software applications
that allows geographically dispersed
users to work together in groups, attend online seminars, or webinars, and
panel discussions, participate in training courses, and have one-on-one
meetings with customers or colleagues. The Arel Spotlight application suite consists of Spotlight
Meeting,
Spotlight Webinar and Spotlight Campus.  Our
enterprise software allows users to speak, share data, share
applications, chat and see one another, all in real time.

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All Arel Spotlight applications are designed
using our Integrated Conferencing Platform (ICP) core software. ICP is a scaleable, secure, and network-friendly
software platform architected from the ground up to deliver synchronized,
real-time voice, video and data communication over converged IP (Internet
Protocol) networks. ICP provides seamless interoperability with existing video
conferencing, Public Services Telephone Networks (PSTN) and satellite based
corporate network infrastructures, and easy integration with existing corporate
knowledge-ware and information management systems.

Our universal conferencing software is an on-premise solution designed
for enterprise wide deployments. Our solution utilizes the existing IP network
and preserves prior investment in legacy video and voice systems. It also
enables large enterprises to migrate from off-network pay per usage services
to an on-network solution for greater control, cost-saving and integration
with internal systems. Arels ICP-based Spotlight application suite offers the
following universal conferencing capabilities to enable enterprises to extract
the greatest value from their network and information system infrastructures:

| | Universal media support
  for coordinated, real-time voice, video and data streams;                                                                                  
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Universal network support
  for seamless traversal of firewalls and proxies, and bandwidth QoS (quality
  of service) for all media streams on converged IP networks;
| | Universal protocol support
  for interoperability with existing PSTN, videoconferencing and satellite
  networks;                                                    
| | Universal application-level support
  for easy integration with information management systems and context
  sensitive contextual collaboration; and                 
| | Universal client support
  for ubiquitous connectivity from any end-user computing device.                                                                           

Our universal conferencing technology allows users with different types
of end-points (including desktops, laptops, interactive response units, and
even wireless handheld devices) to participate in live and archived on-demand
sessions over various networks (ranging from narrowband to broadband, Intranet,
Virtual Private Networks (VPNs) to the Internet). Our ICP-based rich-media, real-time communication software
makes meetings more effective and facilitates collaboration for key business
processes such as corporate and marketing communications, distance learning,
product development, customer relationship management, and supply chain
management.

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Products

Our integrated Spotlight application suite consists of Spotlight Meeting, Spotlight WebinarandSpotlight Campus, and provides a
comprehensive enterprise communications solution for:

| | One-to-many
  live interactive broadcasts and webinars;   
|- | ----------------------------------------------------------
| | Training and
  distance learning with evaluation measures;
| | Multipoint
  videoconferences for work groups;            
| | One-on-one
  collaborative meetings;                      
| | On-demand
  sessions with interactive playback features;  
| | Rich-media
  content authoring; and                       
| | Content
  distribution.                                   

Spotlight Meeting is
a highly collaborative interactive solution designed for small work-groups
collaboration, which supports ad-hoc or pre-scheduled meetings.

Spotlight Webinar is
a presenter-led solution for live and on-demand viewing of one time knowledge
delivery events to any size audience, which supports a self registration
process.

Spotlight Campusis
an instructor-led e-learning and distance training solution designed for continuous
blended live and on-demand courses, which includes powerful assessment,
evaluation and content authoring tools.

Live Interaction

Spotlight Meeting, Spotlight Webinar and Spotlight Campus all share a
common user interface for live interaction which incorporates the foundations
of dialogue - high quality video for face-to-face interaction, clear audio, and
rich supporting visuals and virtual collaboration. This interface includes integrated multiple video windows,
application and data sharing, chat, questions, whiteboard and recording
capabilities, all of which are designed to enable a feeling of teamwork while
in the conferencing environment.

More specifically, Arel Spotlight offers the following interactive
capabilities:

| |  | Multipoint video, designed to provide a sense of social
  presence and allow for communication through body language to enhance and
  affirm understanding;                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Optimized application
  sharing, designed to allow for productive collaboration sessions with
  improved image quality and low latency;                                                                                                                          
| |  | Creation of
  rich media agendas in preparation for a session containing items such as slides, web pages, documents and movie
  clips created using popular software applications, and the ability to add
  content items on-the-fly
  during the live session;

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| |  | Full
  featured web client, designed to give users complete real-time voice, video
  and data interactivity as well as no-install web client and telephony access
  for attending via regular phone or cell phone;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Over the shoulder control, which allows moderators to
  remotely view and control an attendees desktop or any other application;                                                                               
| |  | Non-intrusive
  private and public chat between attendees;                                                                                                                                                        
| |  | Color-coded whiteboard, enabling content annotations
  by multiple participants;                                                                                                                                  
| |  | The ability to use snapshots for annotating application
  sharing interactions;                                                                                                                                   
| |  | The ability
  for moderators to invite attendees on-the-fly during the live session using
  the Spotlight directory or MSN Messenger contact list;                                                              
| |  | Sharing of moderator privileges between different
  attendees during a live Spotlight Meeting;                                                                                                                    
| |  | Moderator power controls, designed to allow for
  muting and ejecting attendees;                                                                                                                                
| |  | Polling capabilities, designed to enable attendees to
  answer questions, vote and provide feedback during sessions; and                                                                                          
| |  | The ability for moderators to record live sessions for
  subsequent on-demand viewing.                                                                                                                            

Arel Spotlight Web
Management and Administration

The Arel Spotlight portal provides users with access to Spotlight Meeting, Spotlight Webinar and Spotlight
Campus administration tools for session creation and scheduling, agenda and
content viewing, inviting attendees, easy data exchange, etc.

| | Easy creation and scheduling of sessions                                                                                                                                                                                                                                            
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Users can
  create and launch a session by entering a topic name and clicking a start
  button, invite attendees using the Arel directory or an instant messenger
  contact list, and invite external guests via email.                                                           
| |                                                                                                                                                                                                                                                                                     
| | E-mail invitations and reminders                                                                                                                                                                                                                                                    
| | Users have
  access to customizable e-mail invitations and reminders, which  include direct links for entering
  sessions. First time users will be prompted to install the Arel Spotlight
  client software. Moderators can schedule reminder emails to be sent before a
  session.
| |                                                                                                                                                                                                                                                                                     
| | Instant meetings                                                                                                                                                                                                                                                                    
| | Arel Spotlight instant meeting capabilities enable
  users to swiftly launch, without prior reservation, a private meeting room
  using a personal link, which can be shared instantly via instant messaging or
  email.                                                            

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| | Session registration                                                                                                                                                                                                                                                     
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Live
  sessions can be either open
  or by invitation only.  Moderators can create an open session by
  distributing a link that will enable joining the session without the need to
  be invited. Guests can easily
  join a session directly within the login page.
| |                                                                                                                                                                                                                                                                          
| | Microsoft Outlook Integration                                                                                                                                                                                                                                            
| | Moderators can schedule and manage Arel events directly from Outlook.
  Participants can view and join upcoming Arel events from the Outlook
  calendar. Participants can import all their scheduled sessions to their Outlook calendar.                                 

Spotlight Client
Types & Access Methods

Arel Spotlight applications support different client types and access
methods to ensure that attendees can participate in conferencing and
collaboration events in the manner that takes full advantage of interactive
voice, video and data, as determined by the available capabilities of different
end user devices.

The Spotlight LIVE rich-media client provides a full set of interactive
voice, video and data collaboration capabilities. A no-install web viewer can
be used in limited bandwidth environments or in cases in which downloading
client software is not authorized. PSTN dial-in connections for voice
participation by phone are also supported as an alternative to fully integrated
voice, video and data over IP.

Integrated
Conferencing Platform (ICP) Core Software

ICP is the central component of all Spotlight applications. Designed
from the ground up to provide synchronized real-time voice, video and data
sharing over converged IP, ICP uses Microsoft .NET client-server architecture
to provide scalability, reliability and performance, while optimizing the use
of bandwidth.

ICP core software consists of:

| | Application Server,
  for handling messaging between Spotlight clients, collaboration
  functionality, audio and video distribution and conferencing and discussion
  groups.                                                                                                                                                                                                    
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                                                                                                  
| | Audio/Video Server, for handling all audio
  and video interaction, conferencing and distribution. The audio/video server
  can support up to hundreds of concurrent users, based on the nature of the
  communications protocol, connection speed, CODEC, which is the video standard
  for transmitting and receiving video streams, and the number of attendees or
  sessions.

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| | Web Server, provides a web services interface to the database
  and delivers live and on-demand content. ICP requires Microsoft Internet
  Information Server (IIS) and uses .NET technology to exchange data between
  the different clients, the different servers and the database.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                       
| | Database and Management Server,for content
  authoring and assembly, learning management, scheduling, content management,
  and reporting/evaluation tools. The information managed by this server
  database includes:                                                               

| |   Users administrative information;                           
| | ---------------------------------------------------------------
| |   Organizational structure and group management tools;        
| |   Site information and inventory management;                  
| |   Sessions administrative data;                               
| |   Content management (but not the content itself);            
| |   Courses, lessons, tracks and scheduling;                    
| |   Registration information (personal and by group);           
| |   Records of all attendance and performance of
  participants;
| |   Records of all logins and logouts;                          
| |   Records of client type used;                                
| |   Records of connection type used (PSTN or VOIP); and         
| |   System configuration and parameter information.             

| | Optional ICP
  components include:
|- | ----------------------------------

| |  | Media server
  for streaming recorded video-enabled sessions; and                  
| | - | -----------------------------------------------------------------------------------
| |  | PSTN gateway
  for enabling voice participation by phone rather than voice over IP.

|Spotlight Campus supports several specialized learning tools for training
applications.  This full-featured training solution is designed to cover all aspects of large corporate learning,
knowledge exchange and communications needs.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                       

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| | 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 participants desktop application. The entire
  session can also be recorded enabling participants to take the session
  on-demand.                                                                                                                                          
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Arel Learning Manager:
  Designed to take advantage of Arels ICP core software platform, Spotlight
  Campus is equipped with a built-in database and management server that
  handles the administration and control of curriculum content and
  participants. The learning manager offers registration and management of
  participants, presenters, sites, course scheduling and server configuration.
  Arel Learning Managers built-in import/export mechanism allows for
  integration with external LMSs (learning management system) and HR
  databases.
| | Arel Author: Arel
  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 such as PowerPoint slides (including animation), Web pages and
  graphics, video clips, customized question layouts and templates, tests,
  presenter notes, and allows for control over display and navigation
  parameters.                                                             
| | 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.                                                                                                                                                                                                     
| | Arel Evaluator:Arel
  Evaluator is a Web-based tool for real-time reviewing, comparing and
  analyzing of participant performance and attendance. 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 any of its
  components (lessons, tests, surveys, and questions).                                                                                                                                                                     
| | Arel Reporter:Arel
  Reporter is designed for training administrators and presenters to automatically
  generate standard and customized reports. The user may create customized
  administrative and performance reports or choose from more than 40
  standardized formats. It is possible to export Arels reports to different
  popular formats such as Microsoft Excel.                                                                                                                                                                                     
| | Arel VirtualClass:Operating
  over any type of broadband network, VirtualClass brings the classroom to the
  participants, reducing training costs and enabling real-time interactivity
  and just-in-time distribution. While live video and media-rich content is
  displayed on a TV monitor, each remote VirtualClass site is equipped with a
  PC-based controller that manages audio and data interaction via Interactive
  Response Units (IRUs).                                                                                                          

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Sales, Distribution and Marketing

We market Arel products through our U.S. subsidiary, Arel
Communications and Software, Inc., our French subsidiary, Arel Communications
and Software EMEA, SAS, and through independent value added resellers (VARs)
and agents worldwide. As of May 31, 2004, 18 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, Canadian Business Television and SpaceNet in North America, as well as
Comiris, Recoh and VTEC in Europe. 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 2003, we had 2 customers who
each accounted for over 10% of our revenues. In 2002, we had 3 customers who
each accounted for over 10% of our revenues. In 2001, one of our customers
accounted for over 10% of our revenues. 
Our business is not seasonal.

For further information and for a breakdown of our total revenues by
category of activity for each of the last three financial years see Item 5.
Operating and Financial Review and Prospects.

Competition

Our ICP-based Spotlight software for
interactive web communication is used for conferencing, collaboration and
corporate training application. The interactive web communication market is
composed of players that come from 3 converging markets. The first is video-conferencing
solutions (the overwhelming majority of the North American market being
shared by Polycom, Inc. and Tandberg). The second is web-based collaboration
solutions and 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). The third is the delivery of rich media business
communications solutions for interactive voice, video and data applications.
Several of the players in this market, which is the smallest yet fastest
growing market of the three, are expanding their focus from e-learning
applications to conferencing and collaboration. We focus on this rich-media business
communication market.  Our competitors
in this market are First Virtual Company (FVCX), Centra Software, Inc. (CTRA)
Interwise, Ltd. and Raindance (RNDC). Most of our customer base consists of
companies that have chosen our solution over the offerings of our competitors.
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 an in-house CPE-based
solution (such as ours) which is installed as an integral component of a
corporate information technology system. Companies which today are players in
video conferencing and/or web based collaboration markets are evolving their single-media
solutions to include rich-media capabilities, and it is reasonable to assume
that they will gradually attempt to become significant players in the third
market niche. For cases in which the communication network is
provided via satellite, our main competitor is One Touch Systems.  In this field, our satellite connectivity
supports live video of an instructor, which is comparable to live frontal
classroom sessions.  One Touch Systems
also offers live video via satellite networks and live interaction using
proprietary keypads.

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The above information regarding our competitive position is based on
both our internal market research as well external market surveys of our
industry.

Governmental Regulation Affecting the Company

Our company focuses on research and development and receives grants for
such purposes from the Government of Israel. We are thus 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.  Currently,
we have no intention of manufacturing our products abroad. See Item 5. Operating And Financial Review And
Prospects  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.

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., and one wholly owned subsidiary in France, Arel EMEA, SAS.

Properties, Plants and Equipment

In 2003, our executive offices were located in Yavne, Israel. The
annual lease payment for 2003 was approximately $85,000. Our executive offices,
research and development and manufacturing facilities are currently located in
Nes Ziona, Israel. Our lease with respect to such space expires in February
2009.  The lease is for approximately
850 square meters, and on an annualized basis, the lease and maintenance
payments for this property are approximately $91,000 for 2004.  Annual lease payments for subsequent years
are expected to increase at a rate of approximately 10% each year.  In addition, Arel Communications and
Software, Inc. leases office space in Atlanta, Georgia.  The Atlanta lease expires on October 31,
2009. 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 May 31, 2005. Our aggregate annual lease payments for Arel Learning
Solutions, Inc. are approximately $65,000. Our rental expenses totaled
$188,000, $317,000 and $603,000, in 2003, 2002, and 2001, respectively. In
February 2004, we entered into a one-year agreement for the lease of an
executive office in Nice, France, servicing our Arel Communications and
Software EMEA, SAS operations. Our annual lease payments for the French
premises are approximately $20,000 a year. 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
ProtectionOur 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. 
Universal Conferencing, Integrated Conferencing Platform, 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, Say IT Show IT Share IT, 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.

ITEM
5.  OPERATING AND FINANCIAL REVIEW AND PROSPECTS.

Critical Accounting
PoliciesOur 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 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. 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, 2003 for a summary of all of our significant
accounting policies.

27

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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.

Recently
Issued Accounting Pronouncements

In Israel
Accounting Standard No. 12

In October 2001, the Israel Accounting
Standards Board (the IASB) issued Israel Accounting Standard No. 12 -
Discontinuance of Adjusting Financial Statements for Inflation, which provided
for the discontinuance of adjusting financial statements for the effects of inflation,
as of January 1, 2003.  In
December 2002, Accounting Standard No. 17 was issued, postponing the
date from which Accounting Standard No. 12 was to be applied until
January 1, 2004.

28

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Upon implementation of Standard No. 12,
Clarifications Nos. 8 and 9 to Opinion 36 of the Institute of Certified Public
Accountants in Israel were cancelled and replaced as of January 1, 2004 by
Israel Accounting Standard No. 13 - Effect of Changes in Foreign Currency
Exchange Rates, which was issued at the same time as Standard No. 12. Most of
the provisions of Standard No. 13 correspond to the provisions which appeared
in the above-mentioned clarifications.

Since our financial statements are prepared
in U.S. Dollars and based on the provisions in paragraph 4 of Israeli
Accounting Standard No. 13, at this stage, it is expected that the
implementation of these standards will have no effect on our reports of our
operating results. We will continue using the U.S. Dollar  the primary
currency in which we conduct our operations  to measure our operations.

In the United States

FAS 132 (revised 2003)

In December 2003, the FASB
issued SFAS No. 132 (revised 2003), Employers Disclosures about Pensions and
Other Postretirement Benefits, an amendment of FASB Statements No. 87, 88 and
106, and a revision of FASB Statement No. 132 (FAS 132 (revised 2003)). This Statement revises the
obligation of employers
regarding disclosures relative to pension plans and other postretirement
benefit plans. The Statement does not change the measurement or recognition of
those plans. The new rules require additional disclosures regarding the assets,
obligations, cash flows, and net periodic benefit costs of defined benefit
pension plans and other postretirement benefit plans.

Part of the new disclosures
provisions are effective for 2003 calendar year-end financial statements, and
have been accordingly applied in our 2003 consolidated financial statements. We
are currently evaluating the
rest of the provisions of the Statement, which have yet to come into effect.

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 15 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.

29

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|Consolidated Statement of Operations Data:                                  |  |                           |   |         |   |         |   |        |   |       |  
|--------------------------------------------------------------------------- |  | ------------------------- | - | ------- | - | ------- | - | ------ | - | ----- | -
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|                                                                            |  | Year ended
  December 31, |  
|                                                                            |  | 2003                      |   | 2002    |   | 2001    |   | 2000   |   | 1999  |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|                                                                            |  | U.S. dollars in thousands |  
|Revenues
  from sales and services                                          |  | 10,118                    |   | 5,941   |   | 9,412   |   | 15,078 |   | 8,812 |  
|Cost of
  sales and services                                                |  | 3,701                     |   | 3,604   |   | 4,321   |   | 8,165  |   | 4,010 |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Gross profit                                                                |  | 6,417                     |   | 2,337   |   | 5,091   |   | 6,913  |   | 4,802 |  
|Research and
  development expenses - net                                   |  | 1,591                     |   | 2,218   |   | 1,943   |   | 1,196  |   | 724   |  
|Selling,
  general and administrative                                       |  |                           |   |         |   |         |   |        |   |       |  
|Expenses                                                                    |  | 4,195                     |   | 6,439   |   | 9,323   |   | 6,368  |   | 2,494 |  
|Amortization
  of goodwill                                                  |  |                           |   | 283     |   | 1,795   |   | 878    |   |       |  
|Impairment
  of goodwill                                                    |  |                           |   | 4,575   |   | 14,576  |   |        |   |       |  
|Restructuring
  expenses and Impairment of Property and
  Equipment.        |  |                           |   | 2,301   |   | 961     |   |        |   |       |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Operating
  income (loss)                                                   |  | 631                       |   | (13,479 | ) | (23,507 | ) | (1,529 | ) | 1,584 |  
|Financial
  income (expenses) - net                                         |  | (158                      | ) | 102     |   | 883     |   | 914    |   | 412   |  
|Impairment
  of investment in
  Arelnet Ltd.                                |  |                           |   | *(279   | ) | *(2,890 | ) |        |   |       |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Income
  (loss) before taxes on income                                      |  | 473                       |   | (13,656 | ) | (25,514 | ) | (615   | ) | 1,996 |  
|Taxes on
  income                                                           |  |                           |   |         |   |         |   | 101    |   | 51    |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Income
  (loss) from continued operations                                   |  | 473                       |   | (13,656 | ) | (25,514 | ) | (716   | ) | 1,945 |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Discontinued
  operations:                                                  |  |                           |   |         |   |         |   |        |   |       |  
|Loss from
  operations                                                      |  |                           |   |         |   |         |   | (803   | ) | (706  | )
|Gain on
  dilution of interest in Arelnet Ltd.                              |  |                           |   |         |   |         |   | 413    |   | 531   |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Total gain
  (loss) from discontinued operations                            |  |                           |   |         |   |         |   | (390   | ) | (175  | )
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Net income
  (loss) for the year                                            |  | 473                       |   | (13,656 | ) | (25,514 | ) | (1,106 | ) | 1,770 |  
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Reconciliation
  to U.S. GAAP:                                              |  |                           |   |         |   |         |   |        |   |       |  
|Effect of
  the treatment of gain on dilution of interest in
  Arelnet Ltd. |  |                           |   |         |   |         |   | (413   | ) | (531  | )
|                                                                            |  |                           |   |         |   |         |   |        |   |       |  
|Net income (loss) under U.S. GAAP                                           |  | 473                       |   | (13,656 | ) | (25,514 | ) | (1,519 | ) | 1,239 |  

* 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.

30

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|                                                                    |  |      |  |       |   |       |   |       |   |       |  
|------------------------------------------------------------------- |  | ---- |  | ----- | - | ----- | - | ----- | - | ----- | -
|                                                                    |  | 2003 |  | 2002  |   | 2001  |   | 2000  |   | 1999  |  
|Basic and diluted net income (loss) per share under Israeli
  GAAP: |  |      |  |       |   |       |   |       |   |       |  
|Continued
  operations                                              |  | 0.04 |  | (1.06 | ) | (1.98 | ) | (0.07 | ) | 0.29  |  
|Discontinued
  operations                                           |  |      |  |       |   |       |   | (0.04 | ) | (0.03 | )
|                                                                    |  |      |  |       |   |       |   |       |   |       |  
|Net income
  (loss) per share                                       |  | 0.04 |  | (1.06 | ) | (1.98 | ) | (0.11 | ) | 0.26  |  
|                                                                    |  |      |  |       |   |       |   |       |   |       |  
|                                                                    |  |      |  |       |   |       |   |       |   |       |  
|Basic and diluted net income (loss) per share under U.S.
  GAAP,    |  |      |  |       |   |       |   |       |   |       |  
|Basic:                                                              |  |      |  |       |   |       |   |       |   |       |  
|Continued
  operations                                              |  | 0.04 |  | (1.06 | ) | (1.98 | ) | (0.07 | ) | 0.26  |  
|Discontinued
  operations                                           |  |      |  |       |   |       |   | (0.08 | ) | (0.08 | )
|                                                                    |  |      |  |       |   |       |   |       |   |       |  
|Net income
  (loss) per share                                       |  | 0.04 |  | (1.06 | ) | (1.98 | ) | (0.15 | ) | 0.18  |  
|Diluted:                                                            |  |      |  |       |   |       |   |       |   |       |  
|Continued
  operations                                              |  | 0.04 |  | (1.06 | ) | (1.98 | ) | (0.07 | ) | 0.20  |  
|Discontinued
  operations:                                          |  |      |  |       |   |       |   | (0.08 | ) | (0.06 | )
|                                                                    |  |      |  |       |   |       |   |       |   |       |  
|Net income
  (loss) per share                                       |  | 0.04 |  | (1.06 | ) | (1.98 | ) | (0.15 | ) | 0.14  |  

|                                                           |  | December 31,                                       | 
|---------------------------------------------------------- |  | -------------------------------------------------- | 
|                                                           |  | 2003                                               | 
|                                                           |  |                                                    | 
|                                                           |  | U.S. dollars in thousands, except number of shares | 
|Consolidated Balance Sheet Data:                           |  |                                                    | 
|Cash and
  cash equivalents                                |  | 3,897                                              | 
|Short-term
  investments                                   |  | 4,106                                              | 
|Total current assets                                       |  | 12,249                                             | 
|Working
  capital                                          |  | 7,674                                              | 
|Total assets                                               |  | 13,478                                             | 
|Total
  current liabilities                                |  | 4,575                                              | 
|Total
  long-term liabilities, net of current
  maturities |  | 391                                                | 
|Share
  capital                                            |  | 4                                                  | 
|Capital
  surplus (including warrants and
  options)       |  | 54,155                                             | 
|Total
  shareholders equity                               |  | 8.512                                              | 
|Balance
  Sheet Data under U.S. GAAP:                      |  |                                                    | 
|Shareholders
  equity                                     |  | 9,017                                              | 
|                                                           |  |                                                    | 
|Number of
  shares outstanding                             |  | 13,055,739                                         | 

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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, |  
|---------------------------------------------- |  | ----------------------- | -
|                                               |  |                         |  
|                                               |  | 2003                    |  
|                                               |  |                         |  
|                                               |  | %                       |  
|                                               |  |                         |  
|Revenues from sales & services                 |  | 100                     |  
|Cost of sales & services                       |  | 36.6                    |  
|Gross profit                                   |  | 63.4                    |  
|Research and development expenses, net         |  | 15.7                    |  
|Selling, general and administrative
  expenses |  | 41.5                    |  
|Amortization of goodwill                       |  |                         |  
|Impairment of goodwill                         |  |                         |  
|Restructuring expenses                         |  |                         |  
|Operating Income (loss)                        |  | 6.2                     |  
|Financial income (expenses), net               |  | (1.5                    | )
|Impairment of investment in Arelnet Ltd.       |  |                         |  
|Net Income  (loss) for the
  year              |  | 4.7                     |  

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

Segment A includes the activities of Arel
Communications and Software Ltd. and those of our subsidiary, Arel
Communications and Software, Inc. This segments activities are focused on
designing, producing, marketing, integrating and supporting our Integrated
Conferencing Platform (ICP), including our traditional e-learning solutions
(IDEAL products) on a worldwide basis.

Segment B includes the activities of our
subsidiary, Arel Learning Solutions Inc. In 2003, this segment was mainly
engaged in interactive video data, and network integration services.

The following table sets forth our revenues
from each Segment in the last three years:

|          |  | Year ended December 31,   | 
|--------- |  | ------------------------- | 
|          |  |                           | 
|          |  | 2003                      | 
|          |  | U.S. dollars in thousands | 
|          |  |                           | 
|Segment A |  | 8,283                     | 
|Segment B |  | 1,835                     | 
|          |  |                           | 
|          |  |                           | 
|Total     |  | 10,118                    | 
|          |  |                           | 

For further information about our products
see Item 4. Information on the Company  Products. For further information
regarding our reported segment profit or loss and assets, see note 13b. of our
consolidated financial statements, which is included herein as pages F-1 to
F-36.

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

In 2003, sales increased by 70%  (or $4,177,000) from $5,941,000 in 2002 to $10,118,000 in
2003. Sales from our segment A (IDEAL and ICP) products amounted to $8,283,000
in 2003, an increase of 125% compared to $3,685,000 in 2002. The increase in
sales and services revenues was mainly a result of the successful completion of
long sales cycles, as well as the introduction of our new ICP platform, which
has contributed to our gain of new customers.

Our company began generating revenues from
segment B (interactive video data, and network integration services) on August
8, 2000 (the date of acquisition of W2COM, LLC). 
In 2003, revenues from this segment amounted to $1,835,000, a 19%
decrease compared to $2,256,000 in 2002. The decrease in revenues in this
segment was a result of our companys decision to shift its focus from the
network services business to introducing the ICP solution. As a result, the
network services business unit has generated fewer sales compared to 2002.

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Our revenues are mainly derived from sales to our customers located in
the US. In 2003, sales in the US constituted 94% of our total sales, as
compared to 79% in 2002.  In 2003, 2 of
our US customers each accounted for over 10% of our revenues.  In 2002, 3 of our US customers each
accounted for over 10% of our revenues. In 2003, 99% of our revenues were
derived from customers outside of Israel.

Cost of Sales and Services.
Cost of sales and services consists of (i) materials, (ii) payroll and related
expenses, (iii) subcontractors, and (iv) overhead.

Cost of sales and services increased slightly by 2.7% (or $97,000) from $3,604,000
in 2002 to $3,701,000 in 2003. Cost of sales and services of Segment A in 2003
and 2002 were $2,538,000 and $1,980,000, respectively. Cost of sales and
services of segment B in 2003 and 2002 were $1,163,000 and $1,624,000,
respectively. In segment A, the cost of sales and services increased slightly
despite the significant increase in sales, mainly as a result of a favorable mix of products and services. The
decrease of cost of sales and services in segment B was mainly due to a shift
in product mix between Network services and Video Integration.

Cost of sales and services decreased by 17% (or $717,000) from $4,321,000 in 2001 to $3,604,000 in 2002. This decrease
was primarily due to the decrease in the volume of sales of our products

Gross Profit. Gross
profits increased by 175% (or
$4,080,000) from $2,337,000 in 2002 to $6,417,000 in 2003. As a percentage of
sales and services, the gross profit increased from 39.3% in 2002 to 63.4% in
2003. Gross profit of segment A increased from $1,640,000 in 2002 to $5,745,000
in 2003. Gross profit of segment B decreased from $697,000 to $672,000 in 2003.
The increase in the gross profit for segment A is mainly attributed to: (i)
increase in volume sales from 2002 to 2003  part of our cost of sales is
fixed, accordingly, the increase in sales resulted in higher gross profit and
(ii) favorable mix of products and
services in 2003 compared to 2002  in 2003 a larger portion of sales
transactions was software based which carries higher margins. In segment
B, despite the significant 19% decrease in revenues, the decrease in gross
profit was an insignificant ($25,000) due to the more favorable product mix
sales in 2003 compared to the product mix in 2002.

Gross profit decreased 54% 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. This decrease was primarily due to the decrease
in sales mainly in the Segment A from 2001 to 2002.

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. Gross research and development expenses (before the participation
of the Israeli Office of the Chief Scientist (OCS)) decreased by 5% from
$2,218,000 in 2002 to $2,107,000 in 2003. Net research and development expenses
(after OCS participation) decreased by 28% from $2,218,000 in 2002 to
$1,591,000 in 2003.  This decrease is
attributed to the fact that in 2003, the OCS participated and granted us
$516,000, whereas in 2002 we did not receive such grants from the OCS.

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In 2002, gross research and development expenses decreased by 21% from
$2,804,000 in 2001 to $2,218,000 in 2002. This decrease in research and
development expenses was primarily due to the reduction in headcount and in
subcontractors costs. Net research and development expenses in 2002 and 2001
(net of OCS participations, which were $0 and $861,000 respectively) amounted
to $2,218,000 and $1,943,000, respectively.

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 solutions, such as Arel Spotlight.

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 53% (or $2,244,000) from
$6,439,000 in 2002 to $4,195,000 in 2003. This decrease is attributed primarily
to the reduction in headcount and selling expenses, which began in the third
quarter of 2002 as part of a restructuring plan, throughout the company, with
an emphasis on Arel Learning Solutions. In 2002, selling, general and
administrative expenses decreased by 31% (or $2,884,000) from
$9,323,000 in 2001 to $6,439,000 in 2002. During 2002 Arel implemented a
restructuring plan in which selling general & administrative costs were
reduced to better reflect the markets and the companys financial conditions.

Other Operating
Expenses. In
2003, we did not incur any impairment charges as we had in previous years. In
2002 and 2001, we recorded impairment charges in respect of goodwill in the
amounts of $4,575,000 and $14,576,000 respectively, resulting in the
writing-off of the entire goodwill balance in connection with the acquisition
of W2COM. We also recorded
amortization of goodwill in 2002 in the amount of $283,000 as compared to
$1,795,000 in 2001. Since
December 31, 2002, no impairment of goodwill has been recorded.

Restructuring expenses. 
In 2003, our Company did not record any new restructuring expenses.
During 2003, we continued the execution of the restructuring plans we submitted
in 2002.  As part of the 2002
programs, we recorded restructuring expenses and impairment of property and
equipment amounting to $2,301,000. This amount includes: termination of
employment of 12 employees at a total cost of $1,007,000 and downsizing and
closing of facilities at a total cost of $544,000. In addition, as a result of
the restructuring, we recorded a $750,000 non-cash impairment of property and
equipment, in respect of leasehold improvements, office furniture and equipment
and computer equipment. As of December 31, 2003 the balance of our accrued
restructuring costs was $22,000, which is expected to be paid during 2004.

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Operating Income (Loss).
In 2003, we recorded an operating income of $631,000.  In 2002, we recorded an operating loss of $13,479,000, including
amortization and impairment of goodwill, restructuring expenses and impairment
of property and equipment. In 2001, we recorded an operating loss of
$23,507,000, including amortization and impairment of goodwill, restructuring
expenses and impairment of property and equipment.  Excluding amortization and impairment of goodwill, restructuring
expenses and impairment of property and equipment, we recorded an operating
loss of $6,320,000 and  $6,175,000 in
2002 and 2001, respectively.

Financial Income (Expenses) - Net.
Financial income consists of interest income 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, as well as the influence of US Dollar
fluctuations versus the Israeli Shekel. In 2003, we recorded financial expenses
of $158,000 compared to a financial income of $102,000 in 2002.  The financial expenses were mainly
attributed to the sharp erosion of the US Dollar against the Israeli Shekel
during 2003. In addition, interest income decreased during 2003 mainly due to
the decrease in the Companys cash position as well as the continuously
decreasing interest rate in the US.

Impairment of investment in Arelnet.  In 2002, we recorded a $279,000 expense for
the impairment in the value of our remaining investment in Arelnet shares,
according to the fair value of the Arelnet shares on the Tel-Aviv Stock
Exchange on December 31, 2002. In 2001,
we recorded a $2,890,000 expense for the impairment in the value of our then
remaining investment in Arelnet shares. No changes occurred in 2003
relative to this investment. As of December 31 2003, our investment in ArelNet
amounted to $125,000.

Net Income (Loss).
In 2003, we recorded net income of $473,000, compared to net losses of $13,656,000 and $25,514,000 in 2002 and
2001, respectively.

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

For many years prior to 1986, the Israeli economy was characterized by
high rates of inflation and devaluation of the Israeli currency against the
U.S. dollar and other currencies. 
However, since the institution by the Israeli government of an economic
recovery program in 1985, inflation, while continuing, has been significantly
reduced and the rate of devaluation has been substantially diminished.
Inflation, therefore, has not had a material effect on our business.

Liquidity and
Capital Resources

At December 31, 2003 and December 31, 2002,
we had cash and cash equivalents of $3,897,000 and $10,354,000, respectively.
In addition, we had short-term investments in the form of marketable securities
and short-term bank deposits, valued at $4106,000 and  $129,000, respectively, which we believe can be readily sold to
obtain additional cash as needed. All debt obligations are on our balance
sheet.   At December 31, 2003, we had working capital of $7,674,000
and a current ratio (current assets to current liabilities) of 2.67:1. Since our inception, our
operations have been funded through capital contributions, bank loans, private
investments, research and development grants and cash flow from operations. The
balance of our NIS monetary assets and monetary liabilities as of December 31,
2003 was $2,820,000 and $3,335,000, 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 2003, net cash used in our operating
activities amounted to $1,827,000 as compared to $3,260,000 in 2002. The
improvement in 2003 compared with 2002 was primarily attributed to the
improvement in our operating results (change from net operating loss to a net operating income). Although we had
net operating income in 2003, we still had negative cash flow from operations.
This resulted from restructuring costs of approximately $830,000
paid in 2003 in respect of a restructuring plan initiated in 2002, as well as,
a major decrease in deferred revenues in the amount $1,871,000 due to the
recognition of a major support contract of over $1,000,000 throughout 2003 and
the recognition of approximately $800,000 in deferred license revenues. Although accounts receivable increased by
$823,000 from $2,889,000 in 2002 to $3,712,000 in 2003(mainly due to the
increase in sales), this was partly offset by the reduction in inventories,
which were reduced in 2003 by $634,000 from $1,168,000 in 2002 to $534,000 in
2003 (due to an increase in our sales, whereas we did not make significant
purchases in 2003).

Net cash used in investing activities in 2003
was $4,607,000, compared to net cash provided by our investing activities of
$8,238,000 in 2002 for the following reasons:

| |  | We
  invested  $3,969,000 in short term
  deposits (net of interest proceeds) compared to a release of  $8,172,000 in 2002 of  $8,172,000 in short-term deposits to be
  used in operating activities; and | 
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
| |   |                                                                                                                                                                                                            | 
| |  | We invested
  $500,000 in a long-term bank deposit in 2003.                                                                                                                                                | 

In 2003, capital expenditures amounted to $78,000, as compared to
$174,000 and $259,000 in 2002 and 2001, respectively. Capital expenditures in
2003 mainly included investments in computer equipment for our research and
development personnel and general office and furniture equipment. In 2002,
capital expenditures related primarily to investments
in computer equipment and motor vehicles purchased for our senior executives.
Capital expenditures in 2001 were primarily related to investments in computer
equipment for our research and development personnel and investments in
leasehold improvements in our former offices in Yavne, Israel. As of June 1,
2004, we had invested approximately $50,000 in leasehold improvements of office
facilities in our new location in Nes Ziona, Israel.

In 2003, we sold property and equipment related to leasehold
improvements from certain of our offices in the US for the amount of $29,000.
In 2002 and 2001, we had no capital divestitures.

As of June 1, 2004, we had no material commitments for future capital
expenditures or divestitures.

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Net cash used in financing activities in 2003
and 2002 was $23,000 and $6,000, 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.

Research and
Development, Patents and Licenses, etc.

We invest a significant amount of our
resources in 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 2001, 2002, and 2003, we applied for
grants from the Office of the Chief Scientist (the OCS) of the Israeli
Ministry of Industry and Trade. The government of Israel encourages research
and development projects oriented towards products for export through the OCS.
Under the terms of these grants, a royalty of 3-5% of the net sales of products
developed from a project funded by the OCS 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 the OCS has granted a special
approval.  Such approval, if granted, is
generally subject to an increase in the total amount to be repaid to the OCS 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 Law for the
Encouragement of Industrial Research and Development, 1984 (the Research 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 OCS funding.

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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.

The OCS has granted approval for our research
and development projects for the following periods:

From June 1999 until 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, 2004, we received $269,000 after
submission of the final completion certificate.

The OCS approved our plan for the period beginning
June 2000 and ending 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, 2004, we received $642,000 after submission of the final completion
certificate.

The OCS approved our plan for the period beginning
June 2001 and ending 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, 2004, we received $413,000, after submission of the final completion
certificate. As of May 31 2004, we do not expect to receive additional funds
from the OCS for the
above plans.

The OCS did not approve our application for
2002.

In 2003, the OCS approved our
application regarding the period beginning January 2003 and ending December 2003
for approximately $516,000. As of May 31st, 2004, we received
approximately $451,000.  After having
submitting a final report on May 5th 2004, we expect to receive the
remaining balance during 2004.

Under the terms of the OCS grants, we must
pay royalties. In 2003, we paid or accrued $24,000 in
royalty payments to the government of Israel. In 2002, we paid or accrued
$37,000 in royalty payments to the government of Israel. In 2001, no royalties
were paid or accrued to the government of Israel. As of December 31, 2003,
the maximum amount of the contingent liability in respect of royalties to the
government amounted to approximately $2,100,000.

As of May 31, 2004, 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 our Integrated Conferencing Platforms both through
terrestrial medias (Internet, Intranet, etc.) and Satellite. In 2001, our gross
research and development expenditures were approximately $2,804,000, in 2002,
approximately $2,218,000, and in 2003, approximately $2,107,000.  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 chosen to fly less frequently. 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.

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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 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.

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 2003 resulted from 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 leading 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 its 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.

Off-Balance Sheet
Arrangements

The Company is committed to pay royalties to the government of Israel
in respect of products in the research and development of which the government
participated by way of grants, computed at the rate of 3%-5% of the proceeds
from sales of such products, up to the dollar amount of the grants received. At
the time the participations were received, successful development of the
related projects was not assured. Royalties due to the government shall not
exceed the amount of participation, in dollar terms (in respect of research
grants commencing 1999, with the addition to dollar Libor interest).
In the case of failure of a project that was partly financed by royalty-bearing
government participations, the Company is not obligated to pay any such
royalties to the government. As of December 31, 2003, the maximum contingent
liability in respect of royalties to the government, amounted to approximately
$2,100,000.

The Company is committed to pay royalties to the government of Israel
in respect of 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. At December 31, 2003, the maximum contingent liability in
respect of these royalties amounted to approximately $280,000.

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

For further information see note 7b. of our consolidated financial
statements, which are included herein as pages F-1 to F-36.

Contractual Obligations

Our principal commitments consist of outstanding operating leases for
our Companys offices and facilities. In 2004, we entered into a five year
agreement for the lease of property in Nes Ziona Israel for the period
beginning March 2004 and ending in February 2009. Subsequently, we decided to
terminate our contract of our previous lease in Yavne, Israel.  Other of our lease agreements, mainly in the
US, expire on different dates in 2004, 2005 and 2009.

In addition, we lease motor vehicles through operating leases for
periods ending in 2005 and 2006.

The following table set forth below our contractual obligations and
other commercial commitments as of December 31, 2003 by category and by payments
due:

|                                                                                  |  | Payment due by period     | 
|--------------------------------------------------------------------------------- |  | ------------------------- | 
|                                                                                  |  |                           | 
|                                                                                  |  | Less than
  1 year        | 
|                                                                                  |  |                           | 
|                                                                                  |  | US dollars
  in thousands | 
|Long-Term
  Debt                                                                  |  | -                         | 
|Capital
  Lease Obligations                                                       |  | 52                        | 
|Operating
  Leases                                                                |  | 422                       | 
|Purchase
  Obligations                                                            |  | -                         | 
|Other
  Long-TermLiabilities Reflected on theRegistrants Balance Sheetunder GAAP |  | -                         | 

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

As of June 1, 2004, our directors, senior
management and key employees are as follows:

|Name                  |  | Age |  | Position with the Company                                
|--------------------- |  | --- |  | ---------------------------------------------------------
|                      |  |     |  |                                                          
|Izhak Gross(1)        |  | 57  |  | Chairman of
  the Board                                  
|George
  Morris(2)    |  | 59  |  | Director                                                 
|Rimon Ben
  Shaoul(3) |  | 59  |  | Director                                                 
|Shimon Klier          |  | 66  |  | Director                                                 
|Leslie S. Banwart     |  | 55  |  | Director                                                 
|Shlomo
  Shalev       |  | 40  |  | Director                                                 
|Asher
  Schapiro      |  | 72  |  | Director                                                 
|Amos Sapir            |  | 65  |  | Outside
  Director                                       
|Ephrat
  Bronfeld     |  | 57  |  | Outside
  Director                                       
|Philippe
  Szwarc     |  | 40  |  | Chief
  Executive Officer                                
|Eran Kariti           |  | 30  |  | Vice
  President of R&D                                  
|Danny Yelin           |  | 40  |  | Chief
  Financial Officer                                
|Moshe Ben
  Yishai(4) |  | 45  |  | President of
  Arel Communications and Software, Inc.    
|Eric Le Guiniec       |  | 35  |  | Vice
  President of Arel Communications and Software EMEA

|(1) | Mr.
  Gross is expected to resign from our board of directors in connection with
  the share purchase and tender offer described in Item 4 Recent Developments.                                                                                                                                                                                                                                                                           | 
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|(2) | Mr.
  Morris is expected to be nominated by our largest shareholder, Mr. Mathile,
  for the position of chairman of our board of directors following Mr. Gross
  resignation.                                                                                                                                                                                                                                                              | 
|(3) | Under
  the share purchase agreement between our Company and Polar Communications
  Ltd., as long as Polar holds as least 7.5% of our company,  Arel shall use its best efforts to cause
  [Polar] to be entitled to nominate such number of nominees to serve on the
  Board of Directors as reflects the pro-rata holding of [Polar] in
  Arel  Additionally, Polar may assign
  this right to any of its wholly owned subsidiaries. | 
|(4) | Mr.
  Ben Yishai served as President of Arel Inc. through December 31, 2003. These
  services are currently being provided by Growth Management LLC as a
  contractor whose primary service provider for the contract is Mr. Ben Yishai.                                                                                                                                                                                                    | 

Izhak Grosshas served as one of our directors since 1988.  He has served as chairman of our board of directors since
February 1997 and served as our chief executive officer from 1988 until May
2002. He also served as our president from 1988 to 1997. 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 holds
a bachelor of science degree in Physics from the Technion, Israel Institute of
Technology.

George Morrisbegan
serving as a director of our Company on July 2003.  He currently serves as a consultant to a number of companies and
serves on the board of directors of two private companies. Between May 1996 and
April 2000, Mr. Morris held the position of senior vice president and chief
financial officer of the Iams Company, a global pet food company that was
acquired by Proctor and Gamble in 1999. Between 1993 and 1996, he held various
positions with the Borden Corporation, including vice president of strategy,
chief financial officer and president of the pasta and sauce business, the
latter position which he held for almost 2 years before joining the Iams Company.
Between the years 1972 and 1993, Mr. Morris held various senior executive
positions with General Foods Corporation. Mr. Morris holds a bachelors degree
in business administration in accounting from St. Bonaventure University, a
masters of business administration degree from New York University, and has
studied in the advanced management program at the Amos Tuck Graduate Business
School at Dartmouth College.

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Rimon Ben Shaoulhas been a director of our Company since November 27, 2002. Since February
2001, Mr. Shaoul has 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.

Shimon Klierhas 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 Shalevhas 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.

Leslie S. Banwarthas 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.

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Asher Schapirohas 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.

Amos Sapirhas served as an outside director of our Company since June 2001.  Mr. Sapirs current term expires on June 25,
2004.  Mr. Sapir has consented to serve
as an outside director for an additional three-year term.  We intend to bring Mr. Sapirs continued
service as an outside director for shareholder approval in a shareholders
meeting to be held in the third quarter of 2004. Since 1997, Mr. Sapir has held
several positions.  He has 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.

Ephrat Bronfeldbegan serving as an outside director for the Company in July 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 and
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.

Philippe Szwarcwas
appointed as our chief executive officer in May 2002.  Prior to his joining Arel, Mr. Szwarc had 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.

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Eran Kariti, recognized in
Israels high-tech industry as one of the top specialists in Internet
technologies, was appointed Vice President of Research and Development at Arel
in July 2000. He is responsible for the development of Arels next generation
e-Learning technologies. Prior to his joining Arel, Mr. Kariti acquired over 10
years experience in establishing and managing research and development
divisions in leading Israeli companies in the Internet industry. He was
previously the head of research and development and one of the founders of
Hypernix, an Israeli start-up valued at $150M. Prior to this, he was the chief
consultant for a number of Israeli start-ups developing Data Communications and
Internet technologies. Mr. Kariti served as chief liaison between the Israeli
Air Force and external security and communications-based industries.

Danny Yelinwas appointed as our chief financial officer in July 2002. Prior to his
joining Arel, Mr. Yelin had 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 Yishaiserved
as President of Arel Communications and Software Inc. from 1998 through
December 31, 2003, and is currently the primary service provider of Growth
Management, LLC for the provision of these services.  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 a Masters in
Business Administration from New York University.

Eric Le Guiniecwas appointed Vice President of Arel Communication and Software EMEA, SAS
in January 2004. Mr. Le Guiniec joins Arel from First Virtual Communications
(FVC). Mr. Le Guiniec held a variety of positions at FVC in the U.S. and in
Europe in which he was responsible for establishing European operations and
managing all aspects of sales, pre-sales and business development. Prior to
joining FVC, Eric spearheaded the sales operation in France at Tekelec Europe
for the companys service provider products.

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, 2003, was approximately $1,662,000. This does not
include amounts set aside for or accrued to provide pension, retirement or
similar benefits, but does include amounts 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.

45

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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.  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. For
further information regarding these shares see Item 6. Directors, Senior
Management And Employees - Share Ownership.

In July 15, 2002, we entered into an
employment agreement with Mr. Daniel Yelin to serve as our chief financial
officer. 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. For further information regarding these shares see Item 6. Directors,
Senior Management And Employees - Share Ownership.

In February 1994, we entered into a three-year employment agreement
with Mr. Gross. Although the term of this agreement was not 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 serves
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. Mr.
Gross is expected to resign from our board of directors after the sale of his
shares to our largest shareholder, Mr. Clayton Mathile.  For a further description of the agreement
see Item 7  Related Party Transactions. 
For a further description of the share sale see Item 4  Recent
Developments.

In May 2004, our former President, Mr. Klier, ended a term of thirteen
years of dedicated service to our Company. In July 2003, we entered into a
separation agreement with Mr. Klier under which Mr. Klier continued in our
employ during the 10-month period following the date of the separation
agreement. For more information about the separation agreement, see Item 7
Related Party Transactions.

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.

46

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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.

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.

47

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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, and Ms. Efrat Bronfeld was elected by our shareholders
to serve as an outside director in July 2003. Mr. Sapirs current term expires
on June 25, 2004.  Mr. Sapir has
consented to serve as an outside director for an additional three-year
term.  We intend to bring Mr. Sapirs
continued service as an outside director for shareholder approval in a
shareholders meeting to be held in the third quarter of 2004.

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.

The listing requirements of the NASDAQ Small Cap Market and, as
mentioned, the Israel Companies Law, require the establishment of an audit
committee.
Messrs. Ben-Shaoul, Sapir, Banwart and Ms. Bronfeld currently serve as the members of our
audit committee.

Under the Companies Law, the board of directors of a public company
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.

Our board of directors established a compensation committee on January
7, 2004.  Ms. Efrat Bronfeld and Mr.
Izhak Gross were elected members of the committee, and Mr. Leslie Banwart was
elected chairman.  It is expected that
upon Mr. Gross resignation from our board of directors, his position on our
compensation committee will be filled by Mr. George Morris. The compensation
committee is responsible for the approval of the compensation terms of our
senior management and for providing recommendations to our board of directors
with respect to all stock option grants.

With the exception of the chairman of our board of directors, Mr. Izhak
Gross, we have not entered into service contracts with any of the members of
our board of directors and none of our board members will be provided with
termination benefits upon termination of their services.  For further information regarding our
agreement with Mr. Gross see Item 7. Related Party Transactions.

48

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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
|--------------------------------------------------------------------------- | ----------------------
|                                                                            |                       
|                                                                            | 2003                  
|                                                                            |                       
|Research and DevelopmentArel Communications and Software, Ltd.              | 26                    
|                                                                            |                       
|Installation and Technical Support
  Arel Communications and Software, Ltd. | 2                     
|Arel
  Communications and Software, Inc.                                    | 4                     
|                                                                            |                       
|Sales and MarketingArel Communications
  and Software, Ltd.                 | 2                     
|Arel
  Communications and Software, Inc.                                    | 5                     
|Arel
  Learning Solutions, Inc.                                             | 4                     
|                                                                            |                       
|Management and AdministrationArel
  Communications and Software, Ltd.       | 5                     
|Arel
  Communications and Software, Inc.                                    | 2                     
|Arel
  Learning Solutions, Inc.                                             | 2                     
|                                                                            |                       
|Total                                                                       | 52                    

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.

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.

49

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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 the employees 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 14.5% of the wages (up to a specified amount), of which
the employee contributes approximately 66% and the employer contributes
approximately 34%. In the past, National Insurance payments were made on
salaries up to a specified ceiling, but this ceiling was cancelled for the
period between June 2002 and July 2003.

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

The following are our only directors or employees who own shares and/or
options in our Company: George Morris, who holds shares and/or options
amounting to less than 1% of our outstanding ordinary shares, and Shimon Klier,
Philippe Szwarc, Danny Yelin and Izhak Gross, who each hold shares and/or
options amounting to 1% or more of our outstanding ordinary shares.

Shimon Klier beneficially owns 460,714 ordinary shares, which constitute
approximately 3.5% of our share capital. 
Our chief executive officer, Philippe Szwarc owns 192,857 shares and was
granted options to purchase 500,000 of our ordinary shares at an exercise price
of $0.932 per share, the aggregate of which constitutes approximately 5.3% of
our share capital. These options can be exercised in four tranches: 100,000 of
such options may be exercised as of each of May 1 of 2003, and 2004; and
150,000 of such options may be exercised as of each of May 1, 2005 and 2006.
Our Chief Financial Officer, Danny Yelin, owns 57,143 shares and has been
granted options to purchase 125,000 of our ordinary shares at an exercise price
of $0.60 per share, the aggregate of which constitutes approximately 1.4% of
our share capital. These options can be exercised in four tranches: 25,000 of
such options may be exercised as of each of July 15 of 2003, and 2004; and
35,000 and 40,000 of such options may be exercised as of July 15, 2005 and
2006, respectively.  Information
regarding the shares owned by Izhak Gross is incorporated by reference to Item
7. Major Shareholders.

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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 8 to our
consolidated financial statements, which are included in this Annual Report on
Form 20-F for the year ended December 31, 2003.

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 was administered by our board of directors, which designated
the optionees and dates of grant. The duration of the First Option Plan and its
options were for 60 months, and all unexercised or ungranted options from this
plan have therefore lapsed.

On November 30, 1995, our board of directors adopted a share option
plan (the Second 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 Second Share Option Plan is administered
by the board of directors, which designates the optionees and dates of grant.
The duration of these options is for 10 years. These options are issued at
exercise prices equal to the fair market value of our shares on the date of
grant and are non-assignable except pursuant to the laws of descent.  The options are generally exercisable over a
period ranging from the date of their grant to four years after the date of
such grant.  The grantee is responsible
for all personal tax consequences of the grant and the exercise thereof.

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. The terms of the Third
Option Plan are identical to those of the Second Option Plan.

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. The terms of the
Fourth Option Plan are identical to those of the Second and Third Option Plans,
except that the options are to be issued at exercise prices to be determined by
the share option committee on the date of grant.

As of May 31, 2004, 1,766,151 of the options, which we have issued to
our employees and executive officers, were outstanding. The weighted average
exercise price of these shares is $1.81 per share. 1,078, 326 of these options
were exercisable at May 31, 2004.

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

Major
Shareholders

The following table and notes thereto set forth certain information as
of June 1, 2004, concerning the beneficial ownership (as defined in Rule 13d 
3 under the Securities Exchange Act of 1934, as amended) of ordinary shares by
each person or entity who, to the best of our knowledge, beneficially owned
more than 5% of our outstanding ordinary shares. The voting rights of our major shareholders do not differ from
the voting rights of holders of all of our ordinary shares.

|                                                                                                                      |  | Ordinary
  Shares/Options
  Owned(1) |    
|--------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------ | ---
|                                                                                                                      |  |                                      |    
|Name and Address                                                                                                      |  | Number                               |    
|                                                                                                                      |  |                                      |    
|Izhak Gross*22 Einstein
  Street, Park Hamadah, Building 22
  P.O.B. 4042, Kiryat Weizmann, Nes Ziona, 74140
  Israel |  | 842,619                              |    
|                                                                                                                      |  |                                      |    
|Polar Communications Ltd.21 Haarbaa
  StreetTel Aviv
  64739, Israel                                                |  | 2,273,651                            |    
|                                                                                                                      |  |                                      |    
|Clayton L.
  Mathile TTEE*10
  Courthouse Pl SWSuite 1100,
  Dayton OH 45402, USA                                     |  | 2,940,415                            | (2)

| | *Mr. Gross has agreed to
  sell all of his holdings in the company to Mr. Mathile, and Mr. Mathile is
  expected to increase his holdings by up to 12% as a result of this share
  purchase and the partial tender offer he launched in connection with the
  share purchase. For more information regarding the share purchase and tender
  offer, see Item 4 Recent
  Developments.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(1) | The table
  above includes the number of shares and underlying options that are
  exercisable within 60 days of June 1, 2004. 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.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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|(2) | This figure
  is based upon a Schedule 13D (amended), dated May 3, 2004, filed by Clayton
  L. Mathile.
|--- | -------------------------------------------------------------------------------------------------------

As of June 1, 2004, there were approximately 89 record holders of
ordinary shares, including approximately 75 record holders in the United States
(who held approximately 72% 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 requested various
remedies in relation to the 1,049,999
ordinary shares held in escrow. On November 3, 2002, the W2Com
defendants filed a counter suit against us in the Jerusalem District Court and
a cross claim against Mr. Izhak Gross for $4,000,000 in damages and seeking
other remedies.

In March 2004, we settled our dispute with W2Com. Pursuant
to the Settlement and Release Agreement, which was entered into in October
2003,  (i) the parties to the dispute
irrevocably and unconditionally released each other from any and all claims,
(ii) we received $500,000 and 200,000 shares of the 1,049,999 shares which were
deposited in escrow were returned to us, and (iii) 849,999 shares of the
1,049,999 shares which were deposited in escrow were released to Clayton L.
Mathile, as Trustee under an Amended and Restated Agreement of Trust for
Clayton L. Mathile, dated June 18, 2001. In accordance with the Israel
Companys Law, the 200,000 shares that were returned to us have become dormant.

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
continues to receive his monthly salary of $12,500 and other benefits customary
in Israel.  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 was extended until May 31, 2004. These
options have expired. 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.  Mr. Gross is expected
to resign from our board of directors upon the completion of the sale of all of
his 6.4% holdings in our company to our largest shareholder, Mr. Clayton
Mathile. For further information regarding the share sale see Item 4 Recent
Developments. As of the date of the filing of this report, Mr. Gross had 198
accrued yet unused vacation days.

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Separation Agreement with Mr. Zvi Klier In
­­­May 2004, Mr. Klier ended his service as our president. In July 2003, we
entered into a separation agreement with Mr. Klier under which Mr. Klier
continued in our employ during the 10-month period following the date of the
separation agreement. For such period, he continued to receive his salary and
social and other benefits. In addition, pursuant to the agreement, Mr. Klier
received bonus payments of $65,000 for past services. His Managers Insurance
and further education funds which have an approximate value of $70,000 were
transferred to him as well. In accordance with Israeli law, Mr. Klier was paid
severance pay as if his employment was terminated at the end of the
aforementioned 10month period; approximately $100,000 of such payment was not
covered by his Managers Insurance. The vesting period of 25,000 previously
granted options was accelerated from January 1, 2004 to the date of the
separation agreement. The exercise period with respect to 215,000 options
(including the aforementioned 25,000 options) was extended by 2 months to 14
months. The 215,000 options have exercise prices ranging from $2.25 and $3.15.

|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-36.

For information regarding our export sales see Item 5. Operating and
Financial Review and Prospects.

Legal Proceedings

The legal proceedings which have had or may have significant effects on
the Companys financial position or profitability are as follows:

Proceedings involving a former employee One
of our former employees, who we terminated in September 2003, has made demands
in letters sent to us by his legal counsel, to receive $100,000 and 133,333
options at an exercise price of $0.15, and has claimed damages. On January 29,
2004, the employee filed a claim in court against us in this matter. On March
17, 2004, we filed a counter claim in respect of damages caused by the
employee.

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We believe, based on the advice of our legal counsel, that we have
meritorious defenses, and we intend to vigorously defend ourselves against this
claim. In addition, we do not believe that the outcome of this claim will have
any material adverse effect on our financial position, results of operations or
cash flows.

Proceedings involving W2COM, LLC -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 9 to
our consolidated financial statements attached hereto as pages F-1 to F-36,
which is incorporated herein by reference. 
An Israeli company, generally, 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 are currently traded on the NASDAQ Small Cap
Market, under the symbol ARLC. They had previously been quoted on the NASDAQ
National Market, under the same symbol, however, as of September 3, 2002, our
ordinary shares were delisted from the NASDAQ National Market. Our ordinary
shares are not listed on any other stock exchange and have not been publicly
traded outside the United States.

55

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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:

|Period                |  | High |       | Low |  
|--------------------- |  | ---- | ----- | --- | -
|                      |  |      |       |     |  
|May 2004              |  | $    | 2.86  |     | $
|                      |  |      |       |     |  
|April 2004            |  | $    | 3.04  |     | $
|                      |  |      |       |     |  
|March 2004            |  | $    | 3.74  |     | $
|                      |  |      |       |     |  
|February
  2004       |  | $    | 4.63  |     | $
|                      |  |      |       |     |  
|January 2004          |  | $    | 3.97  |     | $
|                      |  |      |       |     |  
|December
  2003       |  | $    | 3.56  |     | $
|                      |  |      |       |     |  
|Fourth
  quarter 2003 |  | $    | 3.77  |     | $
|                      |  |      |       |     |  
|Third
  quarter 2003  |  | $    | 1.59  |     | $
|                      |  |      |       |     |  
|Second
  quarter 2003 |  | $    | 0.93  |     | $
|                      |  |      |       |     |  
|First
  quarter 2003  |  | $    | 0.33  |     | $
|                      |  |      |       |     |  
|Fourth
  quarter 2002 |  | $    | 0.33  |     | $
|                      |  |      |       |     |  
|Third
  quarter 2002  |  | $    | 0.59  |     | $
|                      |  |      |       |     |  
|Second
  quarter 2002 |  | $    | 0.97  |     | $
|                      |  |      |       |     |  
|First
  quarter 2002  |  | $    | 1.15  |     | $
|                      |  |      |       |     |  
|2003                  |  | $    | 3.77  |     | $
|                      |  |      |       |     |  
|2002                  |  | $    | 1.15  |     | $
|                      |  |      |       |     |  
|2001                  |  | $    | 4.00  |     | $
|                      |  |      |       |     |  
|2000                  |  | $    | 23.94 |     | $
|                      |  |      |       |     |  
|1999                  |  | $    | 11.50 |     | $

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

Our Company was incorporated under the
Companys Ordinance (New Version) -1983 which was replaced by the Companies Law
in February 2000.  Since our articles
were approved before the enactment of the Companies Law, they are not always
consistent with the provisions of the Companies Law.  In all instances in which the Companies Law changes or amends
provisions of the Companies Ordinance, and as such, our articles are
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.

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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. This is supplemented by the NASDAQ requirement
that a minimum quorum of shareholders holding no less than 33.33% of our issued
and outstanding shares be present for the commencement of business.
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;

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| | 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; and                                                                                                                                                                                                  
| | 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.

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; and                                                                                                 
| | 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.

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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.

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 of an
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.

Material Contracts

The following are a list of the material contracts which were entered
into by our company over the course of the last two years or which will be
performed in whole or in part after the date of the filing of this document:

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Settlement and
Release Agreements between Arel Communications Ltd. and W2COM, LLC.Pursuant
to the Settlement and Release Agreement, which was entered into in October
2003,  (i) the parties to the dispute
irrevocably and unconditionally released each other from any and all claims,
(ii) we received $500,000 and 200,000 shares of the 1,049,999 shares which were
deposited in escrow were returned to us, and (iii) 849,999 shares of the
1,049,999 shares which were deposited in escrow were released to Clayton L. Mathile,
as Trustee under an Amended and Restated Agreement of Trust for Clayton L.
Mathile, dated June 18, 2001.

Separation Agreement between Mr. Zvi Klier
and Arel Communications Ltd.In May 2004, our former
President, Mr. Klier, ended a term of thirteen years of dedicated service to
our Company. In July 2003, we entered into a separation agreement with Mr.
Klier under which Mr. Klier continued in our employ during the 10-month period
following the date of the separation agreement.

Separation Agreement between Mr. Izhak Gross
and Arel Communications Ltd. - In May 2002,
we entered into an agreement with Mr. Izhak Gross, whereunder he ceased serving
as our Chief Executive Officer. 
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
continues to receive his monthly salary of $12,500 and other benefits customary
in Israel.  For further information
regarding this agreement see Item 7. Related Party Transactions.

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 is 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.

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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, U.S. shareholders will be subject to any such
currency fluctuations during the period from when such dividend is declared
through the date payment is made in U.S. dollars.

We have never paid any cash dividends on our
ordinary shares and do not 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.

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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.

A company, which qualifies as a
Foreign Investors Company is entitled to further reductions in the tax
rate normally applicable to Approved Enterprises. 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 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 above-mentioned shareholding proportion
will be reached for each subsequent year.

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A company owning an Approved
Enterprise may elect to apply for alternative tax benefits  waiver of grants in
return for tax exemptions on undistributed income. Upon distribution of such exempt
income, the distributing company will be subject to corporate tax at the rate ordinarily
applicable to the Approved Enterprises income. Such tax exemption on undistributed
income is for a period limited to two to ten years, depending upon the location of the
Approved Enterprise. Such company will also be eligible for the regular tax benefits under
the Investment Law for the remainder of the Benefit Period. Several of our investment
programs have been granted the Approved Enterprise status under the alternative tax
benefits election.

Dividends paid by companies owning
Approved Enterprises, the source of which is income derived from an Approved Enterprise
during the Benefit Period, are generally taxed at a rate of 15% (which is withheld and
paid by the company paying the dividend) if such dividends are paid during the Benefit
Period or within a specified period thereafter.

Subject to certain provisions
concerning income subject to the alternative tax benefits election, 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 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.

The Israeli Government has recently
appointed an internal committee to recommend extensive changes to the Investment Law. It
is not yet known when the committees recommendations will be published. Furthermore,
such recommendations should not have an immediate impact, as their implementation would
require legislation. It is anticipated that such recommendations would not impact existing
Approved Enterprises, but only extensions approved after the legislative change because
the Investment Law currently provides that terms and benefits included in any certificate
of approval already granted will remain subject to the provisions of the law as they were
on the date of such approval.

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# 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.
| | --- | -------------------------------------------------------------------------------------------

| | (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.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------

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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 Israeli residents and, in certain cases, by
non-residents. 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 (non-residents may calculate the
Inflationary Amount 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.

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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 generally
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.

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, certain dividends generated by an Approved
Enterprise are taxed at the rate of 15% and such rate is to be withheld at
source.

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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.)

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.

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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.

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. Accordingly, we file annual and current
reports and other information with the SEC. 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.  In addition,
such information concerning our company can be inspected and copied at the
offices of the National Association of Securities Dealers, Inc., 9513 Key West
Avenue, Rockville, Maryland 20850 and at the offices of the Israel Securities
Authority at 22 Kanfei Nesharim St., Jerusalem, Israel.  As a foreign private issuer, all documents
which were filed after November 4, 2002 on the SECs EDGAR system will be
available for retrieval on the SECs website at www.sec.gov. 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. The
documents referred to in this document may be inspected at the Companys
offices, located at 22 Einstein Street, Park Hamadah, Building 22 P.O.B. 4042,
Kiryat Weizmann, Nes Ziona, 74140 Israel.

69

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---

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.
|-------- | ------------------------------------------------------------

Market risk
represents the risk of changes in the value of a financial instrument caused by
fluctuations in interest rates, equity prices and foreign exchange rates.

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 to exchange rate fluctuations 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. We are not a party
to any derivative transactions and do not have any derivative financial
instruments.

The balance of
our NIS monetary assets and monetary liabilities as of December 31, 2003 was
$2,820,000 and $3,335,000, respectively. A portion of our salary expenses is
NIS linked. Market risk was estimated as the potential decrease
in fair value resulting from a hypothetical 10% fluctuation in the year-end
Dollar exchange rate. Assuming such fluctuation in the Dollar exchange rate,
the value of our cash and cash equivalents would decrease by approximately
$50,000.

Interest Rate Risk
Management

We had approximately $5,332,000 in dollar and
dollar-linked fixed rate interest-bearing, short-term deposits as of December
31, 2003.  We are not exposed to any
decrease in the fair value or change in the interest rate of these assets since
the interest rate which applies to these assets is fixed and determinable.

70

---

---

In October 2003, we invested $500,000 in a
long-term structured note bank deposit. The structured note bears total
interest of not less than 10% and not more than 12%, over its life. The exact
duration of the note is a function of the rate of the U.S. Dollar LIBOR at
six-month intervals. The structured note will be discharged at the earlier of:
(1) the point at which total interest on the structured note reaches 12%, and
(2) October 2013. The interest income is recognized over the expected life of
the structured note. Assuming that the rate of the LIBOR does not exceed 4%, we
estimate that the structured note will be discharged on April 30, 2005. However, a significant increase in the rate
of LIBOR may affect the interest income received for a particular period and
whether or not the note is redeemed. Assuming a hypothetical 10% fluctuation in
the rate of LIBOR, the note would still be discharged on April 30, 2005.

Equity-Price
Risk Management

We are exposed to changes in marketable
securities prices held at December 31, 2003. We hold Israeli Government bonds
classified as trading securities and stated at market value. The dollar value
of the bonds at December 31, 2003, was approximately $137,000.   We hold quoted shares classified as
available for sale.  The dollar value
of the quoted shares at December 31, 2003, was approximately $125,000. Equity
risk was estimated as the potential decrease in fair value resulting from a
hypothetical 10% fluctuation in equity price. Assuming such fluctuation, the
fair value of the quoted shares would decrease by approximately $13,000.

As a result of
our limited equity holdings, which are principally in Israeli government bonds,
we do not manage the risks relating to equity price fluctuations.

|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.

71

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

An evaluation was performed under the supervision and with the
participation of our management, including our chief executive officer 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 officer 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.

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

ITEM
16A. AUDIT COMMITTEE FINANCIAL EXPERT.

Our board of directors has determined that Leslie S. Banwart is our
audit committee financial expert.

ITEM 16B. CODE OF ETHICS.

In May 2004, our company adopted a code of ethics, which applies to all
of our employees, officers and directors, including our chief executive
officer, our chief financial officer and our principal accountant.

Our Code of Ethics is included as an exhibit hereto.

ITEM 16C. PRINCIPAL ACCOUNTANT FEES AND
SERVICES.

We paid the following fees for professional services rendered by Kesselman
& Kesselman, for the years ended December 31:

|                        |  | 2003   |  | 2002   | 
|----------------------- |  | ------ |  | ------ | 
|                        |  |        |  |        | 
|Audit
  Fees(1)         |  | 62,000 |  | 64,000 | 
|                        |  |        |  |        | 
|Audit-Related
  Fees(2) |  | 5,000  |  | 5,000  | 
|                        |  |        |  |        | 
|Tax Fees(3)             |  | 17,500 |  | 10,000 | 
|                        |  |        |  |        | 
|                        |  |        |  |        | 
|Total                   |  | 84,500 |  | 79,000 | 

|(1) | The audit fees
  for the years ended December 31, 2003 and 2002, respectively, were for
  professional services rendered for the audits of our annual consolidated
  financial statements, the review of consolidated quarterly financial
  statements and services normally provided by the independent auditor in
  connection with statutory and regulatory filings or engagements.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                                                                                                                                                       
|(2) | The
  audit-related fees for the years ended December 31, 2003 and 2002,
  respectively, were for assurance and related attest services which are not required
  by statute or regulation and consultations concerning financial accounting
  and reporting standards.                                                                                                                
|    |                                                                                                                                                                                                                                                                                                                                                                                       
|(3) | Tax fees for
  the years ended December 31, 2003 and 2002, respectively, were for services
  related to tax compliance, including the preparation of tax returns and
  claims for refund.                                                                                                                                                                                             

ITEM
16D. EXEMPTIONS FROM THE LISTING STANDARDS FROM AUDIT COMMITTEES.

As a foreign private issuer we remain exempt, until July 31, 2005, from
NASDAQ audit committee related listing standards that have come into effect
following December 13, 1999.

72

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---

ITEM 16E. PURCHASES OF EQUITY SECURITIES BY
THE ISSUER AND AFFILIATED PARTIES.

Not Applicable.

PART III

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

Not applicable.

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

See pages F-1 to F-36.

73

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|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  | Summary of the Lease Agreement for premises in Nes Tziona, Israel.                                                                                                                                                                                                                                               
|     |                                                                                                                                                                                                                                                                                                                  
|4.2  | 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.**                                                                                                                                      
|     |                                                                                                                                                                                                                                                                                                                  
|4.3  | 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.***      
|     |                                                                                                                                                                                                                                                                                                                  
|4.4  | 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.
  ***
|     |                                                                                                                                                                                                                                                                                                                  
|4.5  | Chief Executive Officer Employment Agreement dated May 1, 2002
  between Arel Communications and Software, Inc. and Philippe Szwarc. ***                                                                                                                                                                         
|     |                                                                                                                                                                                                                                                                                                                  
|4.6  | Chief Financial Officer Employment Agreement dated July 15, 2002
  between Arel Communications and Software, Ltd. and Daniel Yelin. ***                                                                                                                                                                          
|     |                                                                                                                                                                                                                                                                                                                  
|4.7  | Settlement and Release Agreements between Arel Communications Ltd.
  and W2COM, LLC.                                                                                                                                                                                                                             
|     |                                                                                                                                                                                                                                                                                                                  
|4.8  | Separation
  Agreement between Mr. Zvi Klier and Arel Communications Ltd.                                                                                                                                                                                                                                        
|     |                                                                                                                                                                                                                                                                                                                  
|8.1  | List of subsidiaries.                                                                                                                                                                                                                                                                                            
|     |                                                                                                                                                                                                                                                                                                                  
|10.1 | Consent of Kesselman & Kesselman.                                                                                                                                                                                                                                                                                
|     |                                                                                                                                                                                                                                                                                                                  
|11.1 | Code of Ethics.                                                                                                                                                                                                                                                                                                  
|     |                                                                                                                                                                                                                                                                                                                  
|12.1 | Certification by Chief Executive Officer pursuant to section 302 of
  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                            
|     |                                                                                                                                                                                                                                                                                                                  
|12.2 | Certification by Chief Financial Officer pursuant to section 302 of
  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                            
|     |                                                                                                                                                                                                                                                                                                                  
|13.1 | Certification by Chief Executive Officer pursuant to section 906 of
  the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                            

74

---

---

|13.2 | Certification by Chief Financial Officer pursuant to section 906 of
  the Sarbanes-Oxley Act of 2002.
|---- | -----------------------------------------------------------------------------------------------------

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

| | *   | 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.
| |     |                                                                                                                                                           
| | *** | Incorporated by reference to our Annual Report on Form 20-F for the
  year ended December 31, 2002, filed with the Commission on or about June 30,
  2003.

75

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| | SIGNATURES
| | ----------

Pursuant to
the requirements of Section 12 of the Securities Exchange Act of 1934, the
company 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 24th
day of June, 2004.

|AREL COMMUNICATIONS AND SOFTWARE LTD.
|-------------------------------------
|                                     
|                                     
|                                     
|                                     
|                                     
|                                     

76

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AREL COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)2003 ANNUAL REPORT

---

---

AREL COMMUNICATIONS AND SOFTWARE LTD.(An Israeli
Corporation)2003 ANNUAL REPORT

TABLE OF
CONTENTS

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

---

---

---

---

---

REPORT OF
INDEPENDENT AUDITORS

To the shareholders ofAREL 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, 2003 and 2002 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, 2003. 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, including those prescribed by the
Israeli Auditors (Mode of Performance) Regulations, 1973 and in accordance with the
standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. 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, 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, 2003 and
2002 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,
2003, in conformity with accounting principles generally accepted (GAAP) in
Israel.

Accounting principles generally
accepted in Israel vary in certain significant respects from accounting principles
generally accepted in the United States of America. Information relating to the nature and
effect of such differences is presented in note 15 to the consolidated financial
statements.

|Tel-Aviv, Israel
     February 11, 2004, except for notes 3c and 7c
     for which the date is March 30, 2004 |  | Kesselman & Kesselman
Certified Public Accountants (Isr.)
|------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------

F-2

---

---

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

|                                                   |  | December 31,              |       
|-------------------------------------------------- |  | ------------------------- | ------
|                                                   |  |                           |       
|                                                   |  | 2003                      |       
|                                                   |  |                           |       
|                                                   |  | U.S. dollars in thousands |       
|                                                   |  |                           |       
|Assets                                             |  |                           |       
|CURRENT ASSETS (note 10):                          |  |                           |       
|Cash and cash equivalents
  (note 1i)              |  |                           | 3,897 
|Short-term investments (note 4)                    |  |                           | 4,106 
|Accounts receivable (note 11a):                    |  |                           |       
|Trade                                              |  |                           | 3,098 
|Other                                              |  |                           | 614   
|Inventories (note 1d)                              |  |                           | 534   
|                                                   |  |                           |       
|Total current assets                               |  |                           | 12,249
|                                                   |  |                           |       
|INVESTMENT IN ARELNET LTD. (note 2)                |  |                           | 125   
|                                                   |  |                           |       
|PROPERTY AND
  EQUIPMENT(note 5):                  |  |                           |       
|Cost                                               |  |                           | 2,085 
|Less - accumulated depreciation and
  amortization |  |                           | 1,664 
|                                                   |  |                           |       
|                                                   |  |                           | 421   
|                                                   |  |                           |       
|OTHER ASSETS(note 11b)                             |  |                           | 683   
|                                                   |  |                           |       
|Total assets                                       |  |                           | 13,478
|                                                   |  |                           |       

|                        |  |                 
|----------------------- |  | ----------------
|                        |  |                 
|                        |  | )Izhak Gross    
|                        |  |                 
|Chairman of the Board   |  | )               
|                        |  |                 
|                        |  | )Philippe Szwarc
|                        |  |                 
|Chief Executive Officer |  | )               
|                        |  |                 
|                        |  | )Danny Yelin    
|                        |  |                 
|Chief Financial Officer |  | )               

F-3

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

|                                                                                                                                                                                                                                                                              |  | December 31,              |        
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------- | -------
|                                                                                                                                                                                                                                                                              |  |                           |        
|                                                                                                                                                                                                                                                                              |  | 2003                      |        
|                                                                                                                                                                                                                                                                              |  |                           |        
|                                                                                                                                                                                                                                                                              |  | U.S. dollars in thousands |        
|                                                                                                                                                                                                                                                                              |  |                           |        
|Liabilities and shareholders equity                                                                                                                                                                                                                                          |  |                           |        
|CURRENT
  LIABILITIES (note 10):                                                                                                                                                                                                                                              |  |                           |        
|Short-term bank credit and current
  maturities
            of long-term loan                                                                                                                                                                                                 |  |                           | 52     
|Accounts payable and accruals:                                                                                                                                                                                                                                                |  |                           |        
|Trade                                                                                                                                                                                                                                                                         |  |                           | 489    
|Accrued
  restructuring costs                                                                                                                                                                                                                                                 |  |                           | 22     
|Deferred
  revenues                                                                                                                                                                                                                                                           |  |                           | 294    
|Other
  (note 11c)                                                                                                                                                                                                                                                            |  |                           | 3,718  
|                                                                                                                                                                                                                                                                              |  |                           |        
|Total current liabilities                                                                                                                                                                                                                                                     |  |                           | 4,575  
|                                                                                                                                                                                                                                                                              |  |                           |        
|LONG-TERM
  LIABILITIES:                                                                                                                                                                                                                                                      |  |                           |        
|Liability for employee rights upon
  retirement, net of amount
            funded (note 6)                                                                                                                                                                                    |  |                           | 391    
|Other (note 11d)                                                                                                                                                                                                                                                              |  |                           |        
|                                                                                                                                                                                                                                                                              |  |                           |        
|Total long-term liabilities                                                                                                                                                                                                                                                   |  |                           | 391    
|                                                                                                                                                                                                                                                                              |  |                           |        
|COMMITMENTS
  AND CONTINGENT LIABILITY(note 7)                                                                                                                                                                                                                                |  |                           |        
|                                                                                                                                                                                                                                                                              |  |                           |        
|Total liabilities                                                                                                                                                                                                                                                             |  |                           | 4,966  
|                                                                                                                                                                                                                                                                              |  |                           |        
|SHAREHOLDERS
  EQUITY (note 8):                                                                                                                                                                                                                                              |  |                           |        
|Share capital - ordinary shares of NIS
  0.001 par value
            (authorized -
  December 31, 2003 and December 31, 2002
            30,000,000;
  issued and outstanding: December 31, 2003 -
            13,055,739 shares
  and December 31, 2002 - 12,855,739 shares) |  |                           | 4      
|Capital surplus                                                                                                                                                                                                                                                               |  |                           | 52,760 
|Warrants and options                                                                                                                                                                                                                                                          |  |                           | 1,395  
|Accumulated deficit                                                                                                                                                                                                                                                           |  |                           | (45,647
|                                                                                                                                                                                                                                                                              |  |                           |        
|Total shareholders equity                                                                                                                                                                                                                                                    |  |                           | 8,512  
|                                                                                                                                                                                                                                                                              |  |                           |        
|Total liabilities and shareholders
  equity                                                                                                                                                                                                                                  |  |                           | 13,478 
|                                                                                                                                                                                                                                                                              |  |                           |        

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

F-4

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

|                                                                                    |  | Year ended December 31,                            |       
|----------------------------------------------------------------------------------- |  | -------------------------------------------------- | ------
|                                                                                    |  |                                                    |       
|                                                                                    |  | 2003                                               |       
|                                                                                    |  |                                                    |       
|                                                                                    |  | U.S. dollars in thousands(except per share amount) |       
|                                                                                    |  |                                                    |       
|REVENUES(note 13):                                                                  |  |                                                    |       
|Sales                                                                               |  |                                                    | 6,198 
|Services                                                                            |  |                                                    | 3,920 
|                                                                                    |  |                                                    |       
|                                                                                    |  |                                                    | 10,118
|                                                                                    |  |                                                    |       
|COST OF SALES
  AND SERVICES(note 12a)                                              |  |                                                    | 3,701 
|                                                                                    |  |                                                    |       
|GROSS PROFIT                                                                        |  |                                                    | 6,417 
|RESEARCH AND
  DEVELOPMENT EXPENSES net
       (note 12b)                          |  |                                                    | 1,591 
|                                                                                    |  |                                                    |       
|SELLING,
  GENERAL AND ADMINISTRATIVE
       EXPENSES (note 12c)                    |  |                                                    | 4,195 
|AMORTIZATION
  OF GOODWILL                                                          |  |                                                    |       
|IMPAIRMENT OF
  GOODWILL(note 1m)                                                   |  |                                                    |       
|RESTRUCTURING
  EXPENSES AND IMPAIRMENT
       OF PROPERTY AND EQUIPMENT (note 12d) |  |                                                    |       
|                                                                                    |  |                                                    |       
|OPERATING INCOME
  (LOSS)                                                           |  |                                                    | 631   
|FINANCIAL
  INCOME (EXPENSE)- net                                                   |  |                                                    | (158  
|IMPAIRMENT OF
  INVESTMENT IN
       ARELNET LTD.(note
  2c)                        |  |                                                    |       
|                                                                                    |  |                                                    |       
|NET INCOME (LOSS)FOR THE YEAR                                                       |  |                                                    | 473   
|                                                                                    |  |                                                    |       
|BASIC AND DILUTEDINCOME (LOSS) PER SHARE(note 1l)                                   |  |                                                    | 0.04  
|                                                                                    |  |                                                    |       
|WEIGHTED AVERAGE NUMBER OF SHARES
       (IN THOUSANDS) BASIC AND DILUTED           |  |                                                    | 13,890
|                                                                                    |  |                                                    |       

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

F-5

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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. dollars in thousands | 
|                                    |  |                    |            |                           | 
|                                    |  |                    |            |                           |  |                          |  |                       |  |        | 
|BALANCE AT
  JANUARY 1, 2001        |  |                    | 12,853,739 |                           |  | 4                        |  |                       |  | 52,738 | 
|CHANGES
  DURING 2001:              |  |                    |            |                           |  |                          |  |                       |  |        | 
|Loss                                |  |                    |            |                           |  |                          |  |                       |  |        | 
|Exercise
  of options               |  |                    | 2,000      |                           |  | *                        |  |                       |  | 2      | 
|                                    |  |                    |            |                           |  |                          |  |                       |  |        | 
|BALANCE AT DECEMBER 31, 2001        |  |                    | 12,855,739 |                           |  | 4                        |  |                       |  | 52,740 | 
|CHANGES
  DURING 2002 -             |  |                    |            |                           |  |                          |  |                       |  |        | 
|Loss                                |  |                    |            |                           |  |                          |  |                       |  |        | 
|                                    |  |                    |            |                           |  |                          |  |                       |  |        | 
|BALANCE AT DECEMBER 31, 2002        |  |                    | 12,855,739 |                           |  | 4                        |  |                       |  | 52,740 | 
|CHANGES
  DURING 2003:              |  |                    |            |                           |  |                          |  |                       |  |        | 
|Net
  income                        |  |                    |            |                           |  |                          |  |                       |  |        | 
|Exercise
  of options               |  |                    | 200,000    |                           |  | *                        |  |                       |  |        | 
|Employee
  stock-based compensation |  |                    |            |                           |  |                          |  |                       |  | 20     | 
|                                    |  |                    |            |                           |  |                          |  |                       |  |        | 
|BALANCE AT DECEMBER 31, 2003        |  |                    | 13,055,739 |                           |  | 4                        |  |                       |  | 52,760 | 
|                                    |  |                    |            |                           |  |                          |  |                       |  |        | 

*     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,   |       
|------------------------------------------------------------------------------------------- |  | ------------------------- | ------
|                                                                                            |  |                           |       
|                                                                                            |  | 2003                      |       
|                                                                                            |  |                           |       
|                                                                                            |  | U.S. dollars in thousands |       
|                                                                                            |  |                           |       
|CASH FLOWS
  FROM OPERATING ACTIVITIES:                                                     |  |                           |       
|Net
  income (loss)
  for the year                                                          |  |                           | 473   
|Adjustments required to reconcile
  income (loss) to net cash used in operating activities: |  |                           |       
|Depreciation
  and amortization of property and equipment                                   |  |                           | 318   
|Impairment
  of property and equipment                                                      |  |                           |       
|Amortization
  of goodwill                                                                  |  |                           |       
|Impairment
  of goodwill                                                                    |  |                           |       
|Employee
  stock-based compensation                                                         |  |                           | 20    
|Decline
  in value of investment in Arel Net Ltd.                                           |  |                           |       
|Allowance
  for doubtful accounts                                                           |  |                           | (24   
|Accrued
  employee rights upon retirement - net                                             |  |                           | 20    
|Capital
  loss on disposal of property and equipment                                        |  |                           |       
|Loss
  (gain) on realization and changes in value of marketable securities - net            |  |                           | (10   
|Other 
  net                                                                               |  |                           | (7    
|Changes
  in operating asset and liability items:                                           |  |                           |       
|Decrease
  (increase) in trade receivables (before allowance for doubtful accounts)         |  |                           | (619  
|Decrease
  (increase) in other accounts receivable                                          |  |                           | (180  
|Increase
  (decrease) in accounts payable and accruals (including long-term)                |  |                           | (2,452
|Decrease
  in inventories                                                                   |  |                           | 634   
|                                                                                            |  |                           |       
|Net cash used in operating activities                                                       |  |                           | (1,827
|                                                                                            |  |                           |       
|CASH FLOWS
  FROM INVESTING ACTIVITIES:                                                     |  |                           |       
|Purchase of property and equipment                                                          |  |                           | (78   
|Disposal of property and equipment                                                          |  |                           | 29    
|Proceeds from disposal of property and
  equipment                                          |  |                           |       
|Investment in Arelnet Ltd.                                                                  |  |                           |       
|Long-term bank deposit                                                                      |  |                           | (500  
|Amounts carried to other
  assets                                                           |  |                           | (100  
|Collection of long-term loan to an
  employee                                               |  |                           | 9     
|Short-term bank deposits  net                                                              |  |                           | (3,969
|Acquisition of marketable securities                                                        |  |                           | (6    
|Proceeds from sale of marketable
  securities                                               |  |                           | 8     
|                                                                                            |  |                           |       
|Net cash provided by (used in)
  investing activities                                       |  |                           | (4,607
|                                                                                            |  |                           |       
|CASH FLOWS FROM
  FINANCING ACTIVITIES:                                                     |  |                           |       
|Exercise of warrants and options                                                            |  |                           |       
|Repayment of long-term loan                                                                 |  |                           | (12   
|Short-term bank credit - net                                                                |  |                           | (11   
|                                                                                            |  |                           |       
|Net cash used in financing activities                                                       |  |                           | (23   
|                                                                                            |  |                           |       
|NET INCREASE
  (DECREASE) IN CASH AND CASH EQUIVALENTS                                      |  |                           | (6,457
|BALANCE OF
  CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR                                 |  |                           | 10,354
|                                                                                            |  |                           |       
|BALANCE OF
  CASH AND CASH EQUIVALENTS AT END OF YEAR                                       |  |                           | 3,897 
|                                                                                            |  |                           |       
|SUPPLEMENTAL
  DISCLOSURE OF CASH FLOW INFORMATION -
       CASH PAID DURING THE YEAR FOR:  |  |                           |       
|Interest                                                                                    |  |                           | -,-   
|                                                                                            |  |                           |       
|Income
  taxes                                                                              |  |                           | 30    
|                                                                                            |  |                           |       

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. | Marketable
  securities                                                                                                                                                                                                                                                             
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                     
| |    | These
  securities - are classified as trading securities (except for investment in
  shares constituting permanent investment, as described below) and stated at
  market value. The changes in market value of these securities are carried to
  financial income or expenses.
| |    |                                                                                                                                                                                                                                                                                     
| |    | Investment
  in shares which the Company intends to hold for a long period (permanent
  investment) is stated at cost, net of impairment which is not of a temporary
  nature (see also note 2).                                                                                  
| |    |                                                                                                                                                                                                                                                                                     
| | d. | Inventories -
  raw materials and components                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                     
| |    | Inventories are valued at the lower of cost or market. Cost is
  determined on the first-in, first-out basis.                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                     
| | e. | Property and
  equipment:                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                     
| |    | These assets are stated at cost and are depreciated by the
  straight-line method, over their estimated useful life.                                                                                                                                                                
| |    | Annual rates of depreciation are as follows:                                                                                                                                                                                                                                        

| |                                |  | %    |  |            |  
| | ------------------------------ |  | ---- |  | ---------- | -
| |                                |  |      |  |            |  
| | 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. | 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):

| |    | 2)                                                                                                                                                                                                                                                                                                     | Services rendered                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                        | Revenue from services rendered is recognized rateably over the
  contractual period or as services are performed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                       
| | g. | Research and
  development                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | Research and development expenses are charged to income as incurred.
  Royalty-bearing grants received from government departments for development
  of approved projects are recognized as a reduction of research and
  development expenses as the related cost is incurred, (see also note 7a(1)).
| |    |                                                                                                                                                                                                                                                                                                       
| | h. | Deferred
  taxes:                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | 1)                                                                                                                                                                                                                                                                                                     | Deferred
  income taxes are created for temporary differences between the assets and
  liabilities as measured in the financial statements and for tax purposes.
  Deferred tax balances are computed using the tax rates expected to be in
  effect when these differences reverse. Based upon the weight of available
  evidence, which includes the Companys historical operating performance and
  the reported cumulative net losses in all prior years, management has
  determined that the future realization of the tax benefit is not sufficiently
  assured. Consequently, a full valuation allowance has been provided in
  respect of the net deferred tax assets, see note 9f.
| |    |                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | 2)                                                                                                                                                                                                                                                                                                     | Upon the distribution of dividends from the tax-exempt income of an
  approved enterprise (see also note 9), the amount distributed will be
  subject to tax at the rate that would have been applicable had the Company not
  been exempted from payment thereof. The Company intends to permanently
  reinvest the amounts of tax exempt income and it does not intend to cause
  distribution of such income as cash dividends. Therefore, no deferred income
  taxes have been provided in respect of such tax exempt income.                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | 3)                                                                                                                                                                                                                                                                                                     | The Group may incur additional tax liability in the event of
  intercompany dividend distribution; no account was taken of the additional
  tax, since it is the Groups policy not to cause distribution of dividend which
  would involve additional tax liability to the Group in the foreseeable
  future.                                                                                                                                                                                                                                                                                                                                                                               
| |    |                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | 4)                                                                                                                                                                                                                                                                                                     | Taxes which would apply in the event of disposal of investments in
  subsidiaries have not been taken into account in computing the deferred
  taxes, as it is the Companys policy to hold these investments, not to
  realize them.                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                       
| | i. | Cash
  equivalents                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    | The Group considers all highly liquid investments, which include
  short-term bank deposits (maturing up to three months from date of deposit)
  that are not restricted as to withdrawal or use, to be cash equivalents.                                                                             

F-10

---

---

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

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (continued):

| | j. | Advertising
  expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Advertising
  expenses are charged to income as incurred and amounted to approximately
  $42,000, $34,000 and $194,000 for the years ended December 31, 2003, 2002 and
  2001, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | k. | Concentration
  of credit risks and allowance for doubtful accounts                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | The Groups cash and cash equivalents, short and long-term
  investments as of December 31, 2003 and 2002, were deposited in major
  financial institutions in Israel and in the United States. The Company is at
  the opinion that the credit risk in respect of these balances is remote.                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | A substantial part of the Groups revenues is derived from a limited
  number of customers (see note 13). The Company evaluates the collectibility
  of the trade balances on a regular basis. The allowance in respect of trade
  receivables has been determined for specific debts doubtful of collection.                                                                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | l. | Net income
  (loss) per share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | 1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | 2)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | 3)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | m. | Impairment of long-lived assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | In February 2003, Accounting Standard
  No. 15 of the Israeli Accounting Standards Board - Impairment of
  Assets, became effective. This standard requires a periodic review to
  evaluate the need for a provision for the impairment of the companys
  non-monetary assets - fixed assets and identifiable intangibles, including
  goodwill, as well as investments in associated companies.                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | According to the
  provisions of this standard, commencing 2003 the company assesses - at each
  balance sheet date - whether 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.  When such indicators of impairment are present, the company
  evaluates whether the carrying value of the asset in the companys accounts
  can be recovered from the cash flows anticipated from that asset, and, if
  necessary, records an impairment provision up to the amount needed to adjust
  the carrying amount to the recoverable amount.

F-11

---

---

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

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (continued):

| |    | The recoverable value of
  an asset is determined according to the higher of the net selling price of
  the asset or its value in use to the company.  The 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.                                                                                                                                                                                                                                                                
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    | When it is not possible to
  assess whether an impairment provision is required for a particular asset on
  its own, the need for such a provision is assessed in relation to the recoverable value of the cash generating
  unit to which that asset belongs.  A
  cash-generating unit includes goodwill allocated to that unit, and any
  impairment loss relating to that unit is initially allocated to the goodwill
  and then to the other assets.                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    | The impairment loss is
  carried directly to income.  Where
  indicators are present that beneficial events have occurred or beneficial
  changes in circumstances have taken place, the impairment provision in
  respect of the asset (other than goodwill) may be cancelled or reduced in the
  future, so long as the recoverable value of the asset has increased, as a result
  of changes in the estimates previously employed in determining such value.                                                                                                                                                                   
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    | The adoption of this
  standard has not had any effect on the company or its subsidiaries, since
  through December 31, 2002, the company and its subsidiaries applied provisions
  for assessing and recording impairment of assets, based on the U.S. standard,
  FAS 121.                                                                                                                                                                                                                                                                                                                                                       
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | n. | Stock-based
  compensation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    | The Company applies Accounting Principles Board Opinion No. 25,
  Accounting for Stock Issued to Employees (APB 25) and the related
  interpretations in accounting for its stock option plan grants to employees
  and directors. Under APB 25, compensation expense is computed under the
  intrinsic value method of accounting to the extent that the fair value of the
  underlying shares on the date of grant exceeds the exercise price of the
  stock option. It is the Companys policy to grant options to employees at an
  exercise price equal to the fair value of the underlying shares on the date
  of grant.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    | The Company applies Statement of Financial Accounting Standards
  (SFAS) No. 123 SFAS 123 in accounting for stock options granted to
  non-employees. Under SFAS 123, these equity transactions are accounted for
  based on the fair value of the consideration received or the fair value of the
  equity instruments issued, whichever is more reliably measurable. The fair
  value of the equity instruments is calculated under a fair value based method
  of accounting, using the Black-Scholes option-pricing model.                                                                                                 

F-12

---

---

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

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES (continued):

| | o. | Recently issued accounting pronouncement                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    | In October 2001, the
  Israel Accounting Standards Board (the IASB) issued Israel Accounting
  Standard No. 12 - Discontinuance of Adjusting Financial Statements for
  Inflation, which provided for the discontinuance of adjusting financial
  statements for the effects of inflation, as of January 1, 2003.  In December 2002, Accounting Standard
  No. 17 was issued that postponed the date from which Accounting Standard
  No. 12 is to be applied until January 1, 2004.                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    | Upon implementation of
  Standard No. 12, Clarifications Nos. 8 and 9 to Opinion 36 of the Institute
  of Certified Public Accountants in Israel will be canceled and will be
  replaced with effect from January 1, 2004 by Israel Accounting Standard No.
  13  Effect of Changes in Foreign Currency Exchange Rates, which was issued
  at the same time as Standard No. 12. Most of the
  provisions of Standard No. 13 correspond to the provisions, which appeared in
  the above-mentioned clarifications.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    | Since the companys
  financial statements are drawn up in U.S. dollar and based on the provisions
  in paragraph 4 to Israeli Accounting Standard No. 13, at this stage, it is
  expected that the implementation of these standards will have no effect on
  the companys reporting of its operating results, and the company will
  continue using the U.S. dollar  the primary currency in which the Company
  conducts its operations  to measure its operations.                                           
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | p. | Reclassifications                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    | Certain comparative
  figures have been reclassified to conform to the current year presentation.                                                                                                                                                                                                                                                                                                                                                                                                                   

F-13

---

---

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

NOTE 2 -
INVESTMENT IN ARELNET LTD. (Arelnet):

| | a. | On June 8, 2000, the Company distributed 2,900,040 ordinary shares,
  out of 4,824,000 ordinary shares held by the Company, of Arelnet, a
  subsidiary of the Company, to its shareholders (the spin-off).                                                                             
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                          
| | b. | In May 2001, the Company 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 the Company paid approximately $829,000 at such time.
| |    | On June 30, 2003, all options received in Arelnets offering expired.
  In addition, in September 2001 the Company acquired 600,978 shares of Arelnet
  at approximately $82,000.                                                                                                        
| |    |                                                                                                                                                                                                                                                                                          
| | c. | Following
  the spin-off and the above transaction, the Company holds approximately 17.9%
  of the outstanding share capital of Arelnet and has no significant influence
  over Arelnet. Accordingly, such investment is stated at cost, net of
  impairment.                            
| |    |                                                                                                                                                                                                                                                                                          
| | d. | In 2002 and
  2001, the Company recorded an impairment charge of $279,000 and $2,890,000
  with respect to the investment in Arelnet, respectively, as a result of
  decrease in the value of the shares of Arelnet.                                                                     

NOTE 3 - INVESTMENT IN W2COM LLC(W2COM):

| | a. | On
  August 8, 2000, the Company acquired certain of the assets and liabilities,
  and the activities of W2COM, which was engaged in interactive video, network
  integration, network services, and distance learning services, for an
  aggregate cash consideration of $2,250,000, and for 3,681,818 ordinary shares
  of NIS 0.001 par value of the Company. Of the 3,681,818 shares, 272,727
  shares (the guarantee shares)were placed in escrow for the purpose of
  indemnifying the Company if the acquired business did not achieve the
  specified revenue and earning levels determined in the agreement.  In
  addition, 777,272 of the 3,681,818 shares were placed in escrow for the
  purpose of indemnifying the Company in the event of misrepresentation made by
  W2COM, and for adjustments to be made to the working capital and the failure
  to collect pre-existing accounts receivables following the closing. For
  accounting purposes, in accordance with APB 16 the guarantee shares were held
  back from the Purchase Consideration and were not recorded as a liability nor
  presented as outstanding shares.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | b. | The
  acquisition of W2COM was accounted for under the purchase method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The Company has allocated the
  purchase price as follows: Approximately $2.5 million was
  attributed to defined assets net of defined liabilities, the remainder of the
  purchase price - approximately $21 million, was attributed to goodwill, which
  was amortized over a period of 10 years. 
  Approximately $1.1 million of expenses related to the acquisition of
  the business was considered part of the purchase price, of which a portion
  was attributed to the goodwill.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |    | On
  September 30, 2002 and September 30, 2001, due to the Companys 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, the Company
  evaluated the carrying amount of the goodwill acquired in this transaction.
  Accordingly and following estimates of discounted future cash flows, impairment loss of approximately
  $14.6 million was recorded in 2001 and the balance of the goodwill -
  $4.6 million, was written off in 2002. Goodwill
  amortization expenses were approximately $283,000 and $1,795,000 in 2002 and
  2001, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                      

F-14

---

---

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

NOTE 3  INVESTMENT IN W2COM LLC(continued):

| | c. | In
  June 2002, the Company filed a claim against W2COM for non-compliance
  with the conditions determined in the agreement, demanding that the shares
  deposited with the trustee (both the Guarantee Shares and the 777,272 shares)
   be returned to the Company with the
  addition of damages in the amount of $4 million.  W2COM has filed a counter claim against the Company for damages
  in the amount of $4 million.                                                                                                                                                                                                                                                                                                                 
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    | In
  2003, the parties have reached an arrangement. According to this arrangement,
  W2COM is to pay the Company $500,000 and give back to the Company 200,000 of
  the Guarantee Shares; the remaining shares (72,727 of the Guarantee Shares
  and the 777,272 shares) would be kept by W2COM. The arrangement was approved
  by the court in March 2004, and will be reflected in the accounts in the
  first quarter of 2004, as follows: 72,727 of the Guarantee Shares (previously
  considered for accounting purposes as contingent consideration) will be
  recorded as issuance of shares and the balance of the cash payment, net of the value of the shares issued,
  will be recorded as other income in the statement of operations.

NOTE 4 - SHORT-TERM INVESTMENTS:

| |                                                |  | Interest rates
  at December 31, |       | December 31               | 
| | ---------------------------------------------- |  | -------------------------------- | ----- | ------------------------- | 
| |                                                |  |                                  |       |                           | 
| |                                                |  | 2003                             |       | 2003                      | 
| |                                                |  |                                  |       |                           | 
| |                                                |  | %                                |       | U.S. dollars in thousands | 
| |                                                |  |                                  |       |                           | 
| | Short-term bank deposits:                      |  |                                  |       |                           | 
| | Linked to the dollar                           |  |                                  | 1-1.2 |                           | 
| | Linked to the NIS                              |  |                                  | 6.1   |                           | 
| | Marketable securities -                        |  |                                  |       |                           | 
| | Israeli Government bonds - linked to
  the NIS |  |                                  |       |                           | 
| |                                                |  |                                  |       |                           | 
| |                                                |  |                                  |       |                           | 
| |                                                |  |                                  |       |                           | 

NOTE 5 - PROPERTY AND
EQUIPMENT:

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

| |                                              |  | December 31               |      
| | -------------------------------------------- |  | ------------------------- | -----
| |                                              |  |                           |      
| |                                              |  | 2003                      |      
| |                                              |  |                           |      
| |                                              |  | U.S. dollars in thousands |      
| |                                              |  |                           |      
| | Cost:                                        |  |                           |      
| | Vehicles                                     |  |                           | 175  
| | Computer
  equipment                         |  |                           | 1,204
| | Office
  furniture and equipment             |  |                           | 363  
| | Leasehold
  improvements                     |  |                           | 343  
| |                                              |  |                           |      
| |                                              |  |                           | 2,085
| |                                              |  |                           |      
| | Accumulated depreciation and
  amortization: |  |                           |      
| | Vehicles                                     |  |                           | 68   
| | Computer
  equipment                         |  |                           | 1,057
| | Office
  furniture and equipment             |  |                           | 247  
| | Leasehold
  improvements                     |  |                           | 292  
| |                                              |  |                           |      
| |                                              |  |                           | 1,664
| |                                              |  |                           |      

F-15

---

---

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

NOTE 5 - PROPERTY AND
EQUIPMENT(continued):

| | b. | Depreciation and amortization of property and
  equipment totalled approximately $318,000, $588,000, and $801,000 in 2003,
  2002, and 2001 respectively.                                    
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                              
| | c. | In 2002, the Company recorded $750,000 as
  impairment of property and equipment expenses in the consolidated statements
  of operations in connection with restructuring plan, see note 12d.
| |    |                                                                                                                                                                                              
| | d. | As to lease commitments in respect of the Groups
  premises, see note 7b.                                                                                                                   
| |    |                                                                                                                                                                                              
| | e. | As to long-term loan and related pledge in respect
  of a vehicle, see note 11c.                                                                                                             

NOTE 6 - ACCRUED SEVERANCE PAY LIABILITY

| | Israeli law
  generally requires payment of severance pay upon dismissal of an employee or
  upon termination of employment in certain other circumstances. The severance
  pay liability of the Company to its Israeli employees, based upon the number
  of years of service and the latest monthly salary, is partly covered by
  regular deposits with severance pay funds and pension funds, and by purchase
  of insurance policies; under labor agreements, the deposits with recognized
  pension funds and the insurance policies, as above, are in the employees
  names and are, subject to certain limitations, the property of the employees.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | The
  severance pay liabilities covered by the 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               |    
|----------------------------------------------------------- |  | ------------------------- | ---
|                                                            |  |                           |    
|                                                            |  | 2003                      |    
|                                                            |  |                           |    
|                                                            |  | U.S. dollars in thousands |    
|                                                            |  |                           |    
|Amount accrued                                              |  |                           | 874
|Less - amount funded                                        |  |                           | 483
|                                                            |  |                           |    
|Unfunded balance, as presented in
       the balance sheets |  |                           | 391
|                                                            |  |                           |    

| | 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. The Company records the obligation as if it was payable at
  each balance sheet date on an undiscounted basis.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                
| | The Group may only make withdrawals from the severance pay funds for
  the purpose of paying severance pay.                                                                                                                                                                                                                                                    
| |                                                                                                                                                                                                                                                                                                                                                                
| | Severance pay expenses for the years ended December 31, 2003,
  2002, and 2001, totalled approximately $207,000, $100,000, and $109,000,
  respectively.                                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                
| | The Company expects to contribute in 2004,
  approximately $126,000 to the insurance companies in respect of its severance
  pay obligation.                                                                                                                                                                                                                   

F-16

---

---

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

NOTE7 COMMITMENTS AND CONTINGENT LIABILITY:

| | a. | Royalty
  commitments:        
| | -- | ------------------------------
| |    |                               
| |    | 1)                            
| |    |                               
| |    |                               
| |    |                               
| |    |                               
| |    |                               
| |    | 2)                            
| |    |                               
| |    |                               
| |    |                               
| | b. | Operating
  lease commitments:
| |    |                               
| |    | 1)                            
| |    |                               
| |    |                               
| |    |                               
| |    | 2)                            
| |    |                               
| |    | 3)                            
| |    |                               
| |    | 4)                            

F-17

---

---

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

NOTE7- COMMITMENTS AND CONTINGENT LIABILITY (continued):

| | 5) | The
  projected rental payments for the next five years, at rates in effect at
  December 31, 2003, are as follows:
| | -- | -------------------------------------------------------------------------------------------------------------------

| |      |  | U.S. dollars
  in thousands |    
| | ---- |  | --------------------------- | ---
| |      |  |                             |    
| | 2004 |  |                             | 254
| | 2005 |  |                             | 179
| | 2006 |  |                             | 176
| | 2007 |  |                             | 184
| | 2008 |  |                             | 195
| |      |  |                             |    
| |      |  |                             | 988
| |      |  |                             |    

| | c. | Contingent
  liability:                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | Employee of the Company, who was terminated in September 2003, has
  made demands in letters sent to the Company by his legal counsel, to receive
  $100,000 and 133,333 options at an exercise price of $0.15, and has claimed
  damages. On January 29, 2004, the employee filed a claim in court against the
  Company in that respect. On March 17, 2004, the Company filed a counter claim
  in respect of damages caused by the employee.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    | The Company believes, based on the advice of its legal counsel, it has meritorious defenses and intends
  to defend vigorously against this claim. In addition, the Company does not
  believe that the outcome of such claim will have a material adverse effect on
  its financial position, results of operations and cash flows. No provision for
  this matter has been included in the accounts.                                         

NOTE 8 - SHAREHOLDERS EQUITY:

| | a. | Share
  capital:             
| | -- | -----------------------------
| |    |                              
| |    | 1)                           
| |    |                              
| |    |                              
| |    |                              
| |    | 2)                           
| |    |                              
| | b. | Share options
  and warrants:
| |    |                              
| |    | 1)                           
| |    |                              
| |    |                              
| |    |                              
| |    |                              

F-18

---

---

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

NOTE 8 - SHAREHOLDERS EQUITY (continued):

| | Through December 31,
  2002, the amount that the company will be allowed to claim as an expense for
  tax purposes will be the amount of the benefit chargeable to tax in the hands
  of the employee.                                                                                                                                                                                                                                                                                                                                               
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | As from January 1,
  2003, the amount that the company will be allowed to claim as an expense for
  tax purposes, will be the amount of the benefit chargeable to tax as ordinary
  income in the hands of the employee, while that part of the benefit that is
  chargeable to capital gains tax in the hands of the employee shall not be
  allowable.  All being subject to the
  restrictions specified in Section 102 of the Income Tax Ordinance.                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | The aforementioned expense
  will be recognized in the tax year that the benefit is credited to the
  employee.                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | From
  the effective date of grant, options usually vest over 4 years so that 25%
  vest one year from the date of grant, and an additional 25% vest in each of
  the following 3 years. Any option not exercised within 10 years from grant
  date, will expire, unless extended by the board of directors.                                                                                                                                                                                                                                         
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | During 1998, the Board of Directors of the Company resolved to grant
  senior officers of the Company (related parties) an aggregate of 330,000
  options at an exercise price of $3.16 per option. Each option can be
  exercised to purchase one ordinary share of NIS 0.001 par value. Through
  December 31, 2003, 90,000 options expired. The remaining options are fully
  vested.  150,000 options will expire
  on June 1, 2004 and 90,000 options will expire on July 9, 2005.                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | In 2000, the Company granted 120,000 options to a senior officer of
  the Company exercisable at the earlier of 5 years from the date of vesting or
  60 days after termination of his employment. Each option can be exercised to
  purchase one ordinary share of the Company at an exercise price of $11.00. In
  September 2001, the senior officer tendered his resignation from his
  position. Pursuant to the terms of a separation agreement, all of the options
  granted to the senior officer to purchase 120,000 ordinary shares vested.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | In March 2001, the Company granted 150,000 options to a senior
  officer of the Company, exercisable until 5 years from the grant date. Each
  option can be exercised to purchase one ordinary share of the Company, at an
  exercise price of $2.25.                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | In May 2002, the Company granted 500,000 options to a senior officer
  of the Company. The options are vested over 4 years from the grant date and
  exercisable until 5 years from the date of vesting or 60 days after
  termination of his employment. Each option can be exercised to purchase one
  ordinary share of the Company, at an exercise price of $0.93.                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | In July 2002, the Company granted 125,000 options to a senior officer
  of the Company. The options are vested over 4 years from the grant date and
  exercisable until 5 years from the date of vesting or 60 days after
  termination of his employment. Each option can be exercised to purchase one
  ordinary share of the Company, at an exercise price of $0.60.                                                                                                                                                                              

F-19

---

---

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

NOTE 8 - SHAREHOLDERS EQUITY (continued):

| | b) | A
  summary of the status of the Plans as of December 31, 2003, 2002 and 2001 and
  changes during the years ended on those dates, is presented below (also
  includes the options granted to senior officers of the Company, see above):
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                       |  | Year ended December 31 |          
|------------------------------------------------------ |  | ---------------------- | ---------
|                                                       |  |                        |          
|                                                       |  | 2003                   |          
|                                                       |  |                        |          
|                                                       |  | Number                 |          
|                                                       |  |                        |          
|                                                       |  |                        |          
|                                                       |  |                        |          
|Options outstanding
       at beginning of year        |  |                        | 1,727,360
|Changes during the year:                               |  |                        |          
|Granted - at market value                              |  |                        | 525,791  
|Exercised                                              |  |                        | (200,000 
|Forfeited/ Expired                                     |  |                        | (167,000 
|                                                       |  |                        |          
|Options outstanding at end of year                     |  |                        | 1,886,151
|                                                       |  |                        |          
|Options exercisable at year end                        |  |                        | 1,191,790
|                                                       |  |                        |          
|Weighted average fair value of
       options granted* |  |                        |          
|                                                       |  |                        |          

| | * | The fair value of each option 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 162%,
  152% and 157% for 2003, 2002 and 2001, respectively; Risk-free interest rate of 2.7%,
  4.5% and 2.5% for 2003, 2002, and 2001, respectively and expected life of 5
  years for 2003, 2002 and 2001, respectively.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | c) | The following table summarizes information about options outstanding
  at December 31, 2003 (including options granted to the Companys senior
  officers):
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------

| | Options outstanding |  | Options
  exercisable | 
| | ------------------- |  | --------------------- | 
| |                     |  |                       | 
| | Exercise
  prices   |  | Number
  of
  options | 
| |                     |  |                       | 
| | $                   |  |                       | 
| |                     |  |                       | 
| | 0.30                |  | 100,000               | 
| | 0.60                |  | 190,000               | 
| | 0.80                |  | 120,000               | 
| | 0.90-0.93           |  | 530,800               | 
| | 1.11
  - 1.88*      |  | 42,651                | 
| | 2.25                |  | 150,000               | 
| | 2.33                |  | 175,000               | 
| | 2.63                |  | 202,700               | 
| | 151,172             |  | 240,000               | 
| | 4.44                |  | 5,000                 | 
| | 8.77                |  | 10,000                | 
| | 11.00               |  | 120,000               | 
| |                     |  |                       | 
| |                     |  | 1,886,151             | 
| |                     |  |                       | 

| | * | Weighted
  average exercise price is $1.56 for options outstanding and exercisable at
  December 31, 2003.
| | - | ----------------------------------------------------------------------------------------------------------

F-20

---

---

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

NOTE 8 - SHAREHOLDERS EQUITY (continued):

| | 2) | Warrants:                                                                                                                                                                                                                                                                                       
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                 
| |    | Under an agreement between the Company, Arelnet and Keppel
  Communications Pte. (Keppel) dated September 14, 1999, and under an
  additional understanding between the parties, following the above agreement,
  Keppel has been granted a warrant to purchase 700,000 shares of the Company.
| |    |                                                                                                                                                                                                                                                                                                 
| |    | The exercise prices are to be determined by Keppel according to one
  of the following options:                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                 
| |    | (a)                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                 
| |    | (b)                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                 
| |    | In June 2000, Keppel exercised the first portion of the warrant to
  purchase 175,000ordinary shares of the Company for $10 per share.                                                                                                                                                          

NOTE 9 - TAXES ON INCOME:

| | a. | Tax benefits
  under the Law for Encouragement of Capital Investments, 1959 (the law)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    | Most of the Israeli production facilities of the Company have been
  granted approved enterprise status under this law. Since the Company has
  elected to receive alternative benefits under this law (i.e., waiver of
  grants in exchange for a tax exemption), the income from the
  Companys approved enterprise, which was approved in 1996, is tax exempt
  during the first four years, commencing the first year in which the
  enterprise earns taxable income, and will be subject to a reduced tax rate of
  25% during the following three years (restricted to year 2010). The income from the
  Companys approved enterprise, which was approved in 2000, is tax exempt
  during the first two years, commencing the first year in which the enterprise
  earns taxable income, and will be subject to a reduced tax rate of 25% during
  the following five years (restricted to year 2012). Since the Company has not
  derived taxable income from the time it was granted the approved enterprise
  status the abovementioned periods of benefits have not yet commenced.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    | In
  the event of distribution of cash dividends from income which is tax exempt
  as above, the Company will have to pay tax at the rate of 25% on the amount
  distributed, see also note 1h(2).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| |    | The
  entitlement to the above benefits is conditional upon the Company fulfilling
  the conditions stipulated by the law, regulations published thereunder and
  the instruments of approval for the specific investments in approved
  enterprises. In the event of failure to comply with these conditions, the
  benefits may be cancelled and the Company may be required to refund the
  amount of the benefits, in whole or in part, with the addition of linkage
  differences to the Israeli CPI and interest.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

F-21

---

---

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

NOTE 9 - TAXES ON INCOME:

| | b. | Measurement
  of results for tax purposes under the Income Tax (Inflationary Adjustments)
  Law, 1985 (the Inflationary Adjustments Law)                                                                                                                                                                                                                                                                 
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| |    | Under the Inflationary Adjustments Law, results for tax purposes are
  measured in real terms, in accordance with the changes in the Israeli
  CPI.  The Company is taxed under this
  law. Under the Inflationary Adjustments Law, Carryforward tax losses in
  Israel are linked to the Israeli CPI and can be utilized indefinitely.                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| |    | As explained in note 1a, the financial statements are measured in
  dollars.  The difference between the
  change in the Israeli CPI and in the exchange rate of the dollar relative to
  the Israeli currency, both on an annual and cumulative basis, causes
  differences between taxable results and results reflected in these financial
  statements.                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| | c. | Tax benefits
  under the Law for the Encouragement of Industry (Taxes), 1969                                                                                                                                                                                                                                                                                                                               
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| |    | The Company is an industrial company as defined by this law and as
  such is entitled to certain tax benefits, consisting mainly of accelerated
  depreciation as prescribed by regulations published under the Inflationary
  Adjustments Law, the right to claim public issuance expenses as a deduction
  for tax purposes and amortization of patents and certain other intangible
  property rights.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| | d. | Tax rates
  applicable to income from other sources in Israel                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| |    | Income
  not eligible for approved enterprise benefits mentioned in a. above is
  taxed at the regular rate of 36%.                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| | e. | Tax rates
  applicable to income of the U.S. subsidiaries                                                                                                                                                                                                                                                                                                                                                  
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| |    | The
  subsidiaries are taxed on the basis of federal, state and local tax laws in
  their place of residence at a regular rate of 38%.                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| | f. | Deferred income
  taxes:                                                                                                                                                                                                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                                                                                                                                                                                                                            
| |    | 1)                                                                                                                                                                                                                                                                                                                                                                                                         

| |                                           |                                      | December 31               |  
| | ----------------------------------------- | ------------------------------------ | ------------------------- | -
| |                                           |                                      |                           |  
| |                                           |                                      | 2003                      |  
| |                                           |                                      |                           |  
| |                                           |                                      | U.S. dollars in thousands |  
| |                                           |                                      |                           |  
| | In respect of:                            |                                      |                           |  
| | Severance pay                             |                                      | 98                        |  
| | Vacation pay                              |                                      | 103                       |  
| | Amortization and impairment of
  goodwill |                                      | 6,534                     |  
| | U.S. operating loss carryforwards         |                                      | 5,595                     |  
| | Israeli operating loss carryforwards      |                                      | 1,185                     |  
| | Other                                     |                                      | 314                       |  
| |                                           |                                      |                           |  
| |                                           |                                      | 13,829                    |  
| |                                           |                                      |                           |  
| | Valuation allowance**                     |                                      | (13,829                   | )
| |                                           |                                      |                           |  
| |                                           |                                      | -,-                       |  
| |                                           |                                      |                           |  
| |                                           |                                      |                           |  
| |                                           | *   Reclassified.
  **  See note 1h.
| |                                           |                                      |                           |  

F-22

---

---

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

NOTE 9 - TAXES ON INCOME (continued):

| | g. | Tax assessments and
  carryforward tax losses                                                                                                                                                                      
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                    
| |    | Tax
  assessments filed by the company through the year ended December 31,
  1999 are considered to be final.                                                                                                      
| |    | Carryforward
  tax losses of the Company amounted to approximately $4.5 million at December
  31, 2003, with no expiration date.                                                                                   
| |    |                                                                                                                                                                                                                    
| |    | The subsidiaries have not been assessed for tax purposes since
  incorporation.                                                                                                                                    
| |    | At
  December 31, 2003, the subsidiaries have federal net operating losses
  carryforward of approximately $14.5 million, available to reduce future
  taxable income, which expires at various dates through 2022.
| |    |                                                                                                                                                                                                                    
| | h. | Income (loss) before taxes
  on income:                                                                                                                                                                            

| |               |  | Year ended December 31    | 
| | ------------- |  | ------------------------- | 
| |               |  |                           | 
| |               |  | 2003                      | 
| |               |  |                           | 
| |               |  | U.S. dollars in thousands | 
| |               |  |                           | 
| | Israel        |  | 133                       | 
| | United States |  | 340                       | 
| |               |  |                           | 
| |               |  | 473                       | 
| |               |  |                           | 

NOTE 10- MONETARY
BALANCES IN NON-DOLLAR CURRENCIES:

| | a. | Comprised at December 31, 2003 as follows:
| | -- | ------------------------------------------

| |                                         |  | Israeli currency (1)     |      
| | --------------------------------------- |  | ------------------------ | -----
| |                                         |  |                          |      
| |                                         |  | Unlinked                 |      
| |                                         |  |                          |      
| |                                         |  | U.S. dollarsin thousands |      
| |                                         |  |                          |      
| | Assets:                                 |  |                          |      
| | Current assets:                         |  |                          |      
| | Cash and
  cash equivalents             |  |                          | 175  
| | Short-term
  investments                |  |                          | 2,496
| | Accounts
  receivable:                  |  |                          |      
| | Trade                                   |  |                          | 15   
| | Other                                   |  |                          | 19   
| | Other assets                            |  |                          |      
| |                                         |  |                          |      
| |                                         |  |                          | 2,705
| |                                         |  |                          |      
| | Liabilities:                            |  |                          |      
| | Current liabilities:                    |  |                          |      
| | Current
  maturities of long-term loan  |  |                          | 52   
| | Trade                                   |  |                          | 123  
| | Accounts
  payable and accruals - other |  |                          | 864  
| |                                         |  |                          |      
| |                                         |  |                          | 1,039
| |                                         |  |                          |      

| | (1) | Not including balances in Israeli currency linked to the dollar.
| | --- | ----------------------------------------------------------------
| | (2) | To the Israeli CPI.                                             

F-23

---

---

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

NOTE 10- MONETARY
BALANCES IN NON-DOLLAR CURRENCIES(continued):

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

| |                                        |  | Exchange
  rate of one
  U.S. dollar |    | CPI*         |   
| | -------------------------------------- |  | ------------------------------------ | -- | ------------ | --
| |                                        |  |                                      |    |              |   
| |                                        |  | NIS                                  |    | Points       |   
| |                                        |  |                                      |    |              |   
| | At
  end of year:                      |  |                                      |    |              |   
| | 2003                                   |  | NIS 4.379                            |    | 178.6 points |   
| | 2002                                   |  | NIS 4.737                            |    | 182.0 points |   
| | 2001                                   |  | NIS 4.416                            |    | 170.9 points |   
| | Increase
  (decrease) during the year: |  |                                      |    |              |   
| | 2003                                   |  | (7.6                                 | )% | (1.9         | )%
| | 2002                                   |  | 7.3                                  | %  | 6.5          | % 
| | 2001                                   |  | 9.3                                  | %  | 1.4          | % 

NOTE 11- SUPPLEMENTARY
BALANCE SHEET INFORMATION:

| |                                                                                             |  | December 31               |    
| | ------------------------------------------------------------------------------------------- |  | ------------------------- | ---
| |                                                                                             |  |                           |    
| |                                                                                             |  | 2003                      |    
| |                                                                                             |  |                           |    
| |                                                                                             |  | U.S. dollars in thousands |    
| |                                                                                             |  |                           |    
| | a.      Accounts
  receivable:                                                              |  |                           |    
| | 1) Trade - net of allowance for
  doubtful
                     accounts
  in the amount of |  |                           | 209
| |                                                                                             |  |                           |    
| | 2) Other:                                                                                   |  |                           |    
| | Israeli
  Government departments and agencies                                               |  |                           | 86 
| | Employees                                                                                   |  |                           | 23 
| | Prepaid
  expenses                                                                          |  |                           | 123
| | Advances
  to suppliers                                                                     |  |                           |    
| | Income
  receivable                                                                         |  |                           | 382
| | Sundry                                                                                      |  |                           |    
| |                                                                                             |  |                           |    
| |                                                                                             |  |                           | 614
| |                                                                                             |  |                           |    

| | b. | Other assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    | Other assets consist mainly of structure note bank deposit (the
  Structure) and other long-term deposits. The Structure in the amount of
  $500,000 bears total interest of not less than 10% and not more than 12%,
  over its life, depends upon the rate of the six months U.S. dollar LIBOR
  (LIBOR). The Structure will be discharge at the earlier of: (1) total
  interest on the Structure will reach 12%, or (2) 10 years from date of
  deposit. The interest income is recognized, in accordance with the provisions
  of EITF 96-12, Recognition of Interest income and Balance sheet
  Classification of Structured Notes, over the expected life of the Structure.
  Assuming the rate of the LIBOR will not exceed 4%, the Structure will be
  discharged at April 30, 2005.

F-24

---

---

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

NOTE 11- SUPPLEMENTARY
BALANCE SHEET INFORMATION(continued):

| | c. | Accounts payable and accruals  other:
| | -- | --------------------------------------

| |                                       |  | December 31               |      
| | ------------------------------------- |  | ------------------------- | -----
| |                                       |  |                           |      
| |                                       |  | 2003                      |      
| |                                       |  |                           |      
| |                                       |  | U.S. dollars in thousands |      
| |                                       |  |                           |      
| | Employees
  and employee institutions |  |                           | 252  
| | Provision
  for vacation pay          |  |                           | 354  
| | Income
  tax payable                  |  |                           | 2,296
| | Accrued
  expenses                    |  |                           | 790  
| | Advances
  from customers             |  |                           | 23   
| | Related
  parties                     |  |                           | 3    
| |                                       |  |                           |      
| |                                       |  |                           | 3,718
| |                                       |  |                           |      
| |                                       |  |                           |      

| | d. | Long-term loan:
| | -- | ---------------

| | Principal
  amount          |  |  | 52  |  |  | 64 | 
| | --------------------------- |  |  | --- |  |  | -- | 
| | Less
  - current maturities |  |  | 52  |  |  | 16 | 
| |                             |  |  |     |  |  |    | 
| |                             |  |  | -,- |  |  | 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 an annual rate of 22%. 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.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | e. | Fair value of
  financial instruments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The
  financial instruments of the Group consist of non-derivative assets and
  liabilities (items included in working capital and long-term loan to
  employee).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | In
  view of their nature, the fair value of the financial instruments included in
  working capital of the Group is usually identical to their carrying value.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

F-25

---

---

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

NOTE 12- SELECTED INCOME
STATEMENT DATA:

| |                                                                                   |  | Year ended December 31,   |      
| | --------------------------------------------------------------------------------- |  | ------------------------- | -----
| |                                                                                   |  |                           |      
| |                                                                                   |  | 2003                      |      
| |                                                                                   |  |                           |      
| |                                                                                   |  | U.S. dollars in thousands |      
| |                                                                                   |  |                           |      
| | a.       Cost of
  sales and services*:                                           |  |                           |      
| | Materials and components
                   consumed                              |  |                           | 1,797
| | Payroll and related expenses                                                      |  |                           | 632  
| | Subcontractors                                                                    |  |                           | 941  
| | Depreciation and amortization                                                     |  |                           | 116  
| | Other                                                                             |  |                           | 215  
| |                                                                                   |  |                           |      
| |                                                                                   |  |                           | 3,701
| |                                                                                   |  |                           |      
| | *  Including cost of services                                                     |  |                           | 1,500
| |                                                                                   |  |                           |      
| | b.       Research
  and development
                   expenses - net:            |  |                           |      
| | Total expenses                                                                    |  |                           | 2,107
| | Less - grants and participations
                    (see note 7a(1))             |  |                           | 516  
| |                                                                                   |  |                           |      
| |                                                                                   |  |                           | 1,591
| |                                                                                   |  |                           |      
| | c.       Selling,
  general and
                  administrative
  expenses:      |  |                           |      
| | Selling,
  net*                                                                   |  |                           | 1,936
| | General
  and administrative                                                      |  |                           | 2,259
| |                                                                                   |  |                           |      
| |                                                                                   |  |                           | 4,195
| |                                                                                   |  |                           |      
| | *  Net
  of Government
                           participation,
  see note 7a(2) |  |                           |      

F-26

---

---

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

|NOTE 12- SELECTED
 INCOME STATEMENT DATA (continued):
|-----------------------------------------------------
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|NOTE 13 - SEGMENT INFORMATION:                       
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     
|                                                     

F-27

---

---

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

NOTE 13- SEGMENT
INFORMATION (continued):

| | b. | Information about reported segment profit
 or loss and assets:
| | -- | --------------------------------------------------------------

|                                         |  | Segment A                 |        | Segment B |  | Elimination of intersegment
 balances |   | Consolidated |       
|---------------------------------------- |  | ------------------------- | ------ | --------- |  | ------------------------------------- | - | ------------ | ------
|                                         |  |                           |        |           |  |                                       |   |              |       
|                                         |  | 2003                      |        | 2002      |  | 2001                                  |   | 2003         |       
|                                         |  |                           |        |           |  |                                       |   |              |       
|                                         |  | U.S. dollars in thousands |        |           |  |                                       |   |              |       
|                                         |  |                           |        |           |  |                                       |   |              |       
|                                         |  |                           |        |           |  |                                       |   |              |       
|Revenues
 from external customers        |  |                           | 8,169  |           |  | 3,429                                 |   |              | 5,336 
|                                         |  |                           |        |           |  |                                       |   |              |       
|Depreciation
 and amortization           |  |                           | 280    |           |  | 269                                   |   |              | 252   
|                                         |  |                           |        |           |  |                                       |   |              |       
|Amortization
 and impairment of goodwill |  |                           |        |           |  |                                       |   |              |       
|                                         |  |                           |        |           |  |                                       |   |              |       
|Impairment
 of property and equipment    |  |                           |        |           |  |                                       |   |              |       
|                                         |  |                           |        |           |  |                                       |   |              |       
|Operating
 income (loss)                 |  |                           | 406    |           |  | (5,551                                | ) |              | (2,307
|                                         |  |                           |        |           |  |                                       |   |              |       
|Financial
 income (expense)              |  |                           | (135   | )         |  | 123                                   |   |              | 889   
|                                         |  |                           |        |           |  |                                       |   |              |       
|Segment
 profits (loss)                  |  |                           | 508    |           |  | (5,707                                | ) |              | (4,308
|                                         |  |                           |        |           |  |                                       |   |              |       
|Segment
 assets                          |  |                           | 16,932 |           |  | 40,962                                |   |              | 43,221
|                                         |  |                           |        |           |  |                                       |   |              |       
|Segment
 liabilities                     |  |                           | 8,295  |           |  | 6,351                                 |   |              | 3,872 
|                                         |  |                           |        |           |  |                                       |   |              |       
|Goodwill                                 |  |                           |        |           |  |                                       |   |              |       
|                                         |  |                           |        |           |  |                                       |   |              |       
|Capital
 expenditures                    |  |                           | 70     |           |  | 172                                   |   |              | 69    
|                                         |  |                           |        |           |  |                                       |   |              |       

F-28

---

---

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

|NOTE 13- SEGMENT
 INFORMATION(continued):
|-----------------------------------------
|                                         
|                                         

| |                          |  | Year ended December 31     |       
| | ------------------------ |  | -------------------------- | ------
| |                          |  |                            |       
| |                          |  | 2003                       |       
| |                          |  |                            |       
| |                          |  | U.S. dollars
 in thousands |       
| |                          |  |                            |       
| | IDEAL                    |  |                            | 8,283 
| | IVC and network services |  |                            | 1,835 
| |                          |  |                            |       
| |                          |  |                            | 10,118
| |                          |  |                            |       

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

| |            |  | Year ended December 31    |      
| | ---------- |  | ------------------------- | -----
| |            |  |                           |      
| |            |  | 2003                      |      
| |            |  |                           |      
| |            |  | U.S. dollars in thousands |      
| |            |  |                           |      
| | Customer A |  |                           | 3,104
| | Customer B |  |                           | 2,394
| | Customer C |  |                           | 47   
| | Customer D |  |                           |      
| |            |  |                           |      
| |            |  |                           | 5,545
| |            |  |                           |      

*  All
principal customers relate to segment A.

|NOTE 14 - TRANSACTIONS WITH RELATED
 PARTIES:
|---------------------------------------------
|                                             
|                                             
|                                             
|                                             
|                                             
|                                             

F-29

---

---

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

|NOTE 15 - EFFECT OF MATERIAL DIFFERENCES
 BETWEEN ISRAELI GAAP AND U.S. GAAP
|----------------------------------------------------------------------------
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            
|                                                                            

F-30

---

---

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

|NOTE 15 - EFFECT OF MATERIAL DIFFERENCES
 BETWEEN ISRAELI GAAP AND U.S. GAAP(continued):
|----------------------------------------------------------------------------------------
|                                                                                        
|                                                                                        
|                                                                                        
|                                                                                        

| |                                                         |  | Year ended December 31,   |       
| | ------------------------------------------------------- |  | ------------------------- | ------
| |                                                         |  |                           |       
| |                                                         |  | 2003                      |       
| |                                                         |  |                           |       
| |                                                         |  | U.S. dollars in thousands |       
| |                                                         |  |                           |       
| | Net cash used in operating activities                   |  |                           | (1,825
| |                                                         |  |                           |       
| | Net cash provided by (used in) investing
    activities |  |                           | (4,609
| |                                                         |  |                           |       

| |  | 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 such
 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.
| |  |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| |  |    | The effect on Operating Loss:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

| |                                                                                                      |  | 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
| |                                                                                                      |  |                            |        

F-31

---

---

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

|NOTE 15 - EFFECT OF MATERIAL DIFFERENCES BETWEEN ISRAELI GAAP AND
 U.S. GAAP (continued):
|-----------------------------------------------------------------------------------------
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         

F-32

---

---

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

|NOTE 15 - EFFECT OF MATERIAL DIFFERENCES
 BETWEEN ISRAELI GAAP AND U.S. GAAP (continued):
|-----------------------------------------------------------------------------------------
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         

F-33

---

---

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

|NOTE 15 - EFFECT OF MATERIAL DIFFERENCES
 BETWEEN ISRAELI GAAP AND U.S. GAAP (continued):
|-----------------------------------------------------------------------------------------
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         
|                                                                                         

|                                              |  | Year ended December 31     |     
|--------------------------------------------- |  | -------------------------- | ----
|                                              |  |                            |     
|                                              |  | 2003                       |     
|                                              |  |                            |     
|                                              |  | As reported                |     
|                                              |  |                            |     
|                                              |  | U.S.
 dollars in thousands |     
|                                              |  |                            |     
|Income (loss)                                 |  |                            | 473 
|                                              |  |                            |     
|Income (loss) per share
    basic and diluted |  |                            | 0.04
|                                              |  |                            |     

F-34

---

---

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

|NOTE 15 - EFFECT OF MATERIAL DIFFERENCES
 BETWEEN ISRAELI GAAP AND U.S. GAAP (continued):
|-----------------------------------------------------------------------------------------
|                                                                                         
|                                                                                         

| |                                                                                                                                      |                                                                                     | Year ended
 December 31    | 
| | ------------------------------------------------------------------------------------------------------------------------------------ | ----------------------------------------------------------------------------------- | -------------------------- | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     | 2003                       | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     | U.S. dollars
 in thousands | 
| |                                                                                                                                      |                                                                                     |                            | 
| | 1)  The effect on comprehensive income
 (loss):                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      | Income (loss) as reported in these financial
         statements under Israeli GAAP |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      | Other comprehensive loss:                                                           |                            | 
| |                                                                                                                                      | Unrealized income (loss) on investment in
         Arelnet                          |                            | 
| |                                                                                                                                      | Less- reclassification adjustment for losses
         included in net loss          |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      | Other comprehensive income (loss)                                                   |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      | Comprehensive
 income (loss)                                                        |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| | 2)  The effect on income (loss) per share:                                                                                           |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     | Year ended December 31     | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     | 2003                       | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      | Under U.S. GAAP - in
 dollars:                                                      |                            | 
| |                                                                                                                                      | Basic                                                                               |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      | Diluted                                                                             |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| | Weighted average number of
 shares
               issued and outstanding (in thousands) -
               used in computation of EPS: |                                                                                     |                            | 
| |                                                                                                                                      | Basic                                                                               |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      | Diluted                                                                             |                            | 
| |                                                                                                                                      |                                                                                     |                            | 
| |                                                                                                                                      |                                                                                     |                            | 

F-35

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

|NOTE 15 - EFFECT OF MATERIAL DIFFERENCES
 BETWEEN ISRAELI GAAP AND U.S. GAAP (continued):
|-----------------------------------------------------------------------------------------

| | 3)  The effect on shareholders equity:                                                                                |  |                         |      
| | ---------------------------------------------------------------------------------------------------------------------- |  | ----------------------- | -----
| |                                                                                                                        |  |                         |      
| |                                                                                                                        |  | Year ended
 December 31 |      
| |                                                                                                                        |  |                         |      
| |                                                                                                                        |  | 2003                    |      
| |                                                                                                                        |  |                         |      
| | Shareholders equity as reported in these
         financial statements under Israeli GAAP                              |  |                         | 8,512
| | 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                                                                               |  |                         | 505  
| | Less - reclassification
 adjustment for losses
         included in net loss                                           |  |                         |      
| |                                                                                                                        |  |                         |      
| | Shareholders equity under
 U.S. GAAP                                                                                   |  |                         | 9,017
| |                                                                                                                        |  |                         |      

| | k. | Recently issued accounting pronouncements in the United
 States                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | FAS 132 (revised 2003)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | In December
 2003, the FASB issued SFAS No. 132 (revised 2003), Employers Disclosures
 about Pensions and Other Postretirement Benefits, an amendment of FASB
 Statements No. 87, 88 and 106, and a revision of FASB Statement No. 132 (FAS
 132 (revised 2003)) . This Statement revises employers disclosures about
 pension plans and other postretirement benefit plans. It does not change the
 measurement or recognition of those plans. The new rules require additional
 disclosures about the assets, obligations, cash flows, and net periodic
 benefit cost of defined benefit pension plans and other postretirement
 benefit plans.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |    | Part of the
 new disclosures provisions are effective for 2003 calendar year-end financial
 statements, and accordingly have been applied by the company in these
 consolidated financial statements. The rest of the provisions of this
 Statement, which have a later effective date, are currently being evaluated
 by the company.                                                                                                                                                                                                                                                                                                                 

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F-36



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