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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON,
DC 20549

FORM 20-F

|           |                                                                                                   
|---------- | --------------------------------------------------------------------------------------------------
|(Mark One)
|           |                                                                                                   
|o          | Registration
  statement pursuant to Section 12(b) or (g) of the Securities Exchange Act of
  1934
|or        
|x          | Annual
  report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934            

For the fiscal year ended December 31, 2004orFor the transition period from ________ to ________

Commission file number 0-30348

ECtel
Ltd.(Exact name of registrant as
specified in its charter)

Israel(Jurisdiction of incorporation
or organization)

43 Hasivim Street, Petah Tikva 49130, Israel(Address of
principal executive offices)

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

Securities registered or to be registered pursuant to
Section 12(g) of the Act:
Ordinary Shares, Nominal Value NIS 0.04 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)

Indicate the number of outstanding shares of each of the
Issuers classes of capital or common stock as of December 31, 2004:

18,151,172 Ordinary Shares, nominal value NIS 0.04 per
share

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.

YesxNo
o

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

Item 17 o   Item
18 x



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TABLE OF CONTENTS

|       |         |                                                         |  |   
|------ | ------- | ------------------------------------------------------- |  | --
|PART I |         |                                                         |  | 5 
|       |         |                                                         |  |   
|       | Item 1. | Identity
  Of Directors, Senior Management And Advisers |  | 5 
|       |         |                                                         |  |   
|       | Item 2. | Offer
  Statistics and Expected Timetable               |  | 5 
|       |         |                                                         |  |   
|       | Item 3. | Key
  Information                                       |  | 5 
|       |         |                                                         |  |   
|       |         | A.
  Selected Financial Data                            |  | 5 
|       |         |                                                         |  |   
|       |         | B. Capitalization
  and Indebtedness                    |  | 7 
|       |         |                                                         |  |   
|       |         | C. Reasons
  for the Offer and Use of Proceeds          |  | 7 
|       |         |                                                         |  |   
|       |         | D. Risk
  Factors                                       |  | 7 
|       |         |                                                         |  |   
|       | Item 4. | Information
  on the Company                            |  | 18
|       |         |                                                         |  |   
|       |         | A. History
  and Development of the Company             |  | 18
|       |         |                                                         |  |   
|       |         | B.
  Business Overview                                  |  | 18
|       |         |                                                         |  |   
|       |         | C.
  Organizational Structure                           |  | 26
|       |         |                                                         |  |   
|       |         | D.
  Property, Plants and Equipment                     |  | 26
|       |         |                                                         |  |   
|       | Item 5. | Operating
  and Financial Review and Prospects          |  | 26
|       |         |                                                         |  |   
|       |         | A.
  Operating Results                                  |  | 26
|       |         |                                                         |  |   
|       |         | B.
  Liquidity and Capital Resources                    |  | 35
|       |         |                                                         |  |   
|       |         | C.
  Research and Development, Patents and Licenses     |  | 38
|       |         |                                                         |  |   
|       |         | D. Trend
  Information                                  |  | 39
|       |         |                                                         |  |   
|       |         | E.
  Off-Balance Sheet Arrangements                     |  | 39
|       |         |                                                         |  |   
|       |         | F. Tabular
  Disclosure of Contractual Obligations      |  | 39
|       |         |                                                         |  |   
|       | Item 6. | Directors,
  Senior Management and Employees            |  | 40
|       |         |                                                         |  |   
|       |         | A.
  Directors and Senior Management                    |  | 40
|       |         |                                                         |  |   
|       |         | B.
  Compensation                                       |  | 42
|       |         |                                                         |  |   
|       |         | C. Board
  Practices                                    |  | 42
|       |         |                                                         |  |   
|       |         | D.
  Employees                                          |  | 45
|       |         |                                                         |  |   
|       |         | E. Share  Ownership                                     |  | 46
|       |         |                                                         |  |   
|       | Item 7. | Major
  Shareholders and Related Party Transactions     |  | 47
|       |         |                                                         |  |   
|       |         | A. Major
  Shareholders                                 |  | 47



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|        |           |                                                                                |  |   
|------- | --------- | ------------------------------------------------------------------------------ |  | --
|        |           | B. Related
  Party Transactions                                                |  | 48
|        |           |                                                                                |  |   
|        |           | C.
  Interests of Experts and Counsel                                          |  | 49
|        |           |                                                                                |  |   
|        | Item 8.   | Financial
  Information                                                        |  | 49
|        |           |                                                                                |  |   
|        |           | A.
  Consolidated Statements and Other Financial Information                   |  | 49
|        |           |                                                                                |  |   
|        |           | B.
  Significant Changes                                                       |  | 50
|        |           |                                                                                |  |   
|        | Item 9.   | The Offer
  and Listing                                                        |  | 50
|        |           |                                                                                |  |   
|        |           | A. Offer
  and Listing Details                                                 |  | 50
|        |           |                                                                                |  |   
|        |           | B. Plan of
  Distribution                                                      |  | 51
|        |           |                                                                                |  |   
|        |           | C. Markets                                                                     |  | 51
|        |           |                                                                                |  |   
|        |           | D. Selling
  Shareholders                                                      |  | 51
|        |           |                                                                                |  |   
|        |           | E.
  Dilution                                                                  |  | 51
|        |           |                                                                                |  |   
|        |           | F.
  Expenses of the Issue                                                     |  | 51
|        |           |                                                                                |  |   
|        | Item 10.  | Additional
  Information                                                       |  | 51
|        |           |                                                                                |  |   
|        |           | A. Share
  Capital                                                             |  | 51
|        |           |                                                                                |  |   
|        |           | B.
  Memorandum and Articles of Association                                    |  | 51
|        |           |                                                                                |  |   
|        |           | C.
  Material Contracts                                                        |  | 56
|        |           |                                                                                |  |   
|        |           | D.
  Exchange Controls                                                         |  | 58
|        |           |                                                                                |  |   
|        |           | E.
  Taxation                                                                  |  | 58
|        |           |                                                                                |  |   
|        |           | F.
  Dividends and Paying Agents                                               |  | 66
|        |           |                                                                                |  |   
|        |           | G.
  Statement by Experts                                                      |  | 66
|        |           |                                                                                |  |   
|        |           | H.
  Documents on Display                                                      |  | 66
|        |           |                                                                                |  |   
|        |           | I.
  Subsidiary Information                                                    |  | 66
|        |           |                                                                                |  |   
|        | Item 11.  | Quantitative
  and Qualitative Disclosures about Market Risk                   |  | 66
|        |           |                                                                                |  |   
|        | Item 12.  | Description
  of Securities other than Equity Securities                       |  | 69
|        |           |                                                                                |  |   
|PART II |           |                                                                                |  | 69
|        |           |                                                                                |  |   
|        | Item 13.  | Defaults,
  Dividend Averages and Delinquencies                                |  | 69
|        |           |                                                                                |  |   
|        | Item 14.  | Material
  Modifications to the Rights of Security Holders and Use of Proceeds |  | 69
|        |           |                                                                                |  |   
|        | Item 15.  | Controls
  and Procedures                                                      |  | 69
|        |           |                                                                                |  |   
|        | Item 16A. | Audit
  Committee Financial Expert                                             |  | 69
|        |           |                                                                                |  |   
|        | Item 16B. | Code of
  Ethics                                                               |  | 69



3

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|         |           |                                                          |  |   
|-------- | --------- | -------------------------------------------------------- |  | --
|         | Item 16C. | Principal
  Accountant Fees and Services                 |  | 69
|         |           |                                                          |  |   
|         | Item 16D. | Exemptions
  from Listing Standards for Audit Committees |  | 70
|         |           |                                                          |  |   
|         | Item 16E. | Repurchase
  of Securities                               |  | 70
|         |           |                                                          |  |   
|PART III |           |                                                          |  | 70
|         |           |                                                          |  |   
|         | Item 17.  | Financial
  Statements                                   |  | 70
|         |           |                                                          |  |   
|         | Item 18.  | Financial
  Statements                                   |  | 70
|         |           |                                                          |  |   
|         | Item 19.  | Exhibits                                                 |  | 71



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PART   I

Unless
the context otherwise requires, all references in this annual report to ECtel,
us, we, our and the Company refer to ECtel Ltd. and its subsidiaries,
and all references to ECI refer to ECI Telecom Ltd. References to dollars
or $ are to United States Dollars. References to NIS are to New Israeli
Shekels.

On
March 31, 2004, we sold our government surveillance business to Verint
Systems. Accordingly, our statements of operations, including those of
prior periods, reflect the results of operations of this business in the line
item called income (loss) from discontinued operations. All data in this
Annual Report derived from our statements of operations, unless otherwise
specified, exclude our government surveillance business.

Statements
in this annual report concerning our business outlook or future economic
performance; anticipated revenues, expenses or other financial items;
introductions and advancements in development of products, and plans and
objectives related thereto; and statements concerning assumptions made or
expectations as to any future events, conditions, performance or other matters,
are forward-looking statements as that term is defined under the United
States Federal Securities Laws. In some cases, you can identify forward-looking
statements by our use of words such as expect, anticipate, believe, intend,
plan, seek, and estimate and similar expressions. Forward-looking
statements are subject to risks, uncertainties and other factors which could
cause actual results to differ materially from those in such statements.
Factors that could cause or contribute to these differences include, but are
not limited to, those set forth under Item 3D - Risk Factors in this annual
report and elsewhere in this annual report as well as our reports on Form 6-K
submitted to the Securities and Exchange Commission.

Item 1.
Identity of Directors, Senior Management and Advisers

Not
Applicable.

Item 2.
Offer Statistics and Expected Timetable

Not
Applicable.

Item 3.
Key Information

A.        Selected
Financial Data

The
selected consolidated balance sheet data as of December 31, 2003 and 2004
and the selected consolidated statements of operations data for each of the
three years in the period ended December 31, 2004 have been derived from
our audited consolidated financial statements included elsewhere in this annual
report, which have been prepared in accordance with accounting principles
generally accepted in the United States, or U.S. GAAP, and audited by Somekh
Chaikin, Registered Public Accountants, a member of KPMG International,
independent public accountants in Israel. 
Their report appears elsewhere in this annual report.  The selected consolidated balance sheet data
as of December 31, 2000, 2001, and 2002 and the selected consolidated
statements of operations data for the years ended December 31, 2000 and
2001 have been derived from our audited consolidated financial statements which
are not included in this annual report. The following selected financial data should be read in conjunction
with Item 5 - Operating and Financial Review and Prospects and the
consolidated financial statements and the notes thereto included elsewhere in
this annual report. These data should not be construed as indicative of our
future operating results or financial position.

In
March 2004, we sold our government surveillance business to Verint Systems
pursuant to an asset purchase agreement, which is described below under Item
10.C Additional InformationMaterial Agreements.  The results of
operations of this business for each of the five years ended December 31, 2004
are reflected in our statements of income in the line item called income
(loss) from discontinued operations, and the assets and liabilities of this
business as of December 31, 2003 are reflected in our balance sheet in separate
line items, as well.



5

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|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|--------------------------------------------------------------------------------------------------- |  | ----------------------------------------------- | ---------- | ---- | - | ---------- | - | ---- | ---------- | ---- | - | ---------- | - | - | ---------- | -
|                                                                                                    |  | Year ended December 31,                         |           
|                                                                                                    |  |                                                 |           
|                                                                                                    |  | 2000                                            |            | 2001 |   | 2002       |   | 2003 |            | 2004 |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |  
|                                                                                                    |  | (in thousands, except share and per share data) |           
|                                                                                                    |  |                                                 |           
|Statements of Income Data:                                                                          |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Revenues                                                                                            |  | $                                               | 47,431     |      | $ | 60,951     |   | $    | 52,426     |      | $ | 28,857     |   | $ | 12,605     |  
|Cost of revenues                                                                                    |  |                                                 | 18,480     |      |   | 24,051     |   |      | 22,364     |      |   | 17,454     |   |   | 10,271     |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Gross profit                                                                                        |  |                                                 | 28,951     |      |   | 36,900     |   |      | 30,062     |      |   | 11,403     |   |   | 2,334      |  
|Research and development costs, net                                                                 |  |                                                 | 7,836      |      |   | 8,541      |   |      | 9,152      |      |   | 10,078     |   |   | 5,439      |  
|Selling and marketing expenses                                                                      |  |                                                 | 9,562      |      |   | 12,201     |   |      | 13,687     |      |   | 14,297     |   |   | 9,071      |  
|General and administrative expenses                                                                 |  |                                                 | 4,515      |      |   | 6,982      |   |      | 8,903      |      |   | 16,974     |   |   | 8,500      |  
|In process research and development costs                                                           |  |                                                 |            |      |   | 916        |   |      |           |      |   |           |   |   |           |  
|Amortization of goodwill                                                                            |  |                                                 | 142        |      |   |           |   |      |           |      |   |           |   |   |           |  
|Restructuring and related impairment costs                                                          |  |                                                 |           |      |   |           |   |      |           |      |   |           |   |   | 3,358      |  
|Goodwill impairment                                                                                 |  |                                                 |           |      |   |           |   |      |           |      |   | 6,019      |   |   | 2,186      |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Total operating expenses                                                                            |  |                                                 | 22,055     |      |   | 28,640     |   |      | 31,742     |      |   | 47,368     |   |   | 28,554     |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Operating income (loss)                                                                             |  |                                                 | 6,896      |      |   | 8,260      |   |      | (1,680     | )    |   | (35,965    | ) |   | (26,220    | )
|Financial income, net                                                                               |  |                                                 | (1,478     | )    |   | (774       | ) |      | (269       | )    |   | (192       | ) |   | (438       | )
|Other income (expenses), net                                                                        |  |                                                 | 150        |      |   | (27        | ) |      | (13        | )    |   | 3          |   |   | (3         | )
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Income (loss) before taxes on income                                                                |  |                                                 | 8,224      |      |   | 9,007      |   |      | (1,424     | )    |   | (35,770    | ) |   | (25,785    | )
|Taxes on income (tax benefit)                                                                       |  |                                                 | 1,040      |      |   | (78        | ) |      | (29        | )    |   | 38         |   |   | (30        | )
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Net income from continuing operations before cumulative effect of
  change in accounting principles |  |                                                 | 7,184      |      |   | 9,085      |   |      | (1,395     | )    |   | (35,808    | ) |   | (25,755    | )
|Cumulative effect of change in accounting principles                                                |  |                                                 |           |      |   | (27        | ) |      |           |      |   |           |   |   |           |  
|Income (loss) from discontinued operations                                                          |  |                                                 | 1,361      |      |   | 2,878      |   |      | 18,715     |      |   | (4,867     | ) |   | 12,260     |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Net income (loss) for the year                                                                      |  | $                                               | 8,545      |      | $ | 11,936     |   | $    | 17,320     |      | $ | (40,675    | ) | $ | (13,495    | )
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Earnings (loss) per share                                                                           |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Basic earnings per share:                                                                           |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Continuing operations                                                                               |  | $                                               | 0.45       |      | $ | 0.55       |   | $    | (0.08      | )    | $ | (1.99      | ) | $ | (1.42      | )
|Cumulative effect of change in accounting principles                                                |  |                                                 |            |      |   |            |   |      |           |      |   |           |   |   |            |  
|Discontinued operations                                                                             |  |                                                 | 0.08       |      |   | 0.17       |   |      | 1.05       |      |   | (0.27      | ) |   | 0.68       |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|                                                                                                    |  | $                                               | 0.53       |      | $ | 0.72       |   | $    | 0.97       |      | $ | (2.26      | ) | $ | (0.74      | )
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Weighted average number of shares outstanding                                                       |  |                                                 | 16,144,473 |      |   | 16,652,509 |   |      | 17,802,492 |      |   | 17,967,082 |   |   | 18,112,216 |  
|Diluted earnings per share:                                                                         |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Continuing operations                                                                               |  | $                                               | 0.41       |      | $ | 0.51       |   | $    | (0.08      | )    | $ | (1.99      | ) | $ | (1.42      | )
|Cumulative effect of change in accounting principles                                                |  |                                                 |           |      |   | (*         | ) |      |           |      |   |           |   |   |           |  
|Discontinued operations                                                                             |  |                                                 | 0.08       |      |   | 0.16       |   |      | 1.01       |      |   | (0.27      | ) |   | 0.68       |  
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|                                                                                                    |  | $                                               | 0.49       |      | $ | 0.67       |   | $    | 0.93       |      | $ | (2.26      | ) | $ | (0.74      | )
|                                                                                                    |  |                                                 |            |      |   |            |   |      |            |      |   |            |   |   |            |  
|Weighted average number of shares outstanding                                                       |  |                                                 | 17,291,382 |      |   | 17,838,633 |   |      | 18,551,836 |      |   | 17,967,082 |   |   | 18,112,216 |  

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|    |                                         
|--- | ----------------------------------------
|(*) | Represent an amount of
  less than $0.01



6

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|                                                            |  |                |        |      |   |         |  |      |         |      |   |         |  |   |        |  
|----------------------------------------------------------- |  | -------------- | ------ | ---- | - | ------- |  | ---- | ------- | ---- | - | ------- |  | - | ------ | -
|                                                            |  | December 31,   |       
|                                                            |  |                |       
|                                                            |  | 2000           |        | 2001 |   | 2002    |  | 2003 |         | 2004 |  
|                                                            |  |                |        |      |   |         |  |      |         |      |  
|                                                            |  | (in thousands) |       
|                                                            |  |                |       
|                                                           
|Balance
  Sheet Data:                                       |  |                |        |      |   |         |  |      |         |      |   |         |  |   |        |  
|                                                            |  |                |        |      |   |         |  |      |         |      |   |         |  |   |        |  
|Cash and cash equivalents                                   |  | $              | 41,735 |      | $ | 40,525  |  | $    | 52,786  |      | $ | 27,964  |  | $ | 34,436 |  
|Working capital                                             |  |                | 60,985 |      |   | 72,246  |  |      | 88,600  |      |   | 52,961  |  |   | 41,986 |  
|Assets - held for sale                                      |  |                | -      |      |   | -       |  |      | -       |      |   | 2,337   |  |   | -      |  
|Total assets                                                |  |                | 85,882 |      |   | 124,173 |  |      | 151,868 |      |   | 101,507 |  |   | 81,268 |  
|Due to (from) parent and
  fellow subsidiary companies, net |  |                | (1,597 | )    |   | 2,246   |  |      | 284     |      |   | 614     |  |   | (225   | )
|Shareholders equity                                        |  |                | 67,351 |      |   | 97,681  |  |      | 116,529 |      |   | 76,023  |  |   | 62,689 |  



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B.        Capitalization
and Indebtedness

Not applicable.

C.     Reasons for the Offer and Use of
Proceeds

Not applicable.

D.
     Risk Factors

We believe that the occurrence of any one or some
combination of the following factors could have a material adverse effect on
our business, financial condition and results of operations.

Risks Related to Our Business and Our Industry

The recovery plan we implemented in response to a
deterioration in our business in the second half of 2003 and the beginning of
2004 may not succeed.

During
a portion of 2003, we were engaged in negotiations with Verint Systems, to whom
we sold our government surveillance business on March 31, 2004. This
complex, protracted transaction diverted management attention and distracted
our employees, further harming our operations. Moreover, we believe that
rumors of a pending transaction with Verint System caused potential customers
to award contracts to our competitors. Finally, our chief executive
officer resigned in January 2004 and this was followed by the resignation of
six vice presidents during the balance of the first half of 2004, either in
connection with the transaction with Verint Systems or for their own personal
or professional reasons. This further harmed our business and results of
operations.



7

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In
mid-February 2004, Eitan Naor assumed the position of president and chief
executive officer, assembled a new management team and led our efforts in
formulating a comprehensive recovery plan. 
We implemented this recovery plan during the second half 2004.  The plan involves increasing our focus on
sales execution, project delivery and customer support, with an emphasis on
improving existing customer relationships, expanding the sales pipeline and
closing pending deals. As part of these efforts, we established, in June 2004,
a new department we refer to as the PSO (Professional Services Organization
& Operations). The PSO is responsible for project development, field
engineering, customer support, expert guidance and training. There can be no
guarantee that the appointment of a new management team, the PSOs activities
or that other aspects of our recovery plan will result in sales to new or
existing customers.

We are dependent upon Verint Systems to complete the
implementation of certain government projects and provide warranty services to
our government customers, and we could be exposed to liability if Verint
Systems fails to do so satisfactorily.

In
connection with the sale to Verint Systems of our government surveillance
business, we retained substantially all our then existing government
surveillance projects and warranty obligations and agreed to subcontract the
performance thereof to Verint Systems upon agreed terms. Following the sale of
our government surveillance business, Verint Systems owns the relevant
technologies that are necessary for the performance of these projects. Since
we remain legally bound to the applicable government customers, we could have
difficulties collecting payments from these customers and be exposed to claims
by them if Verint Systems fails for any reason to perform in a manner that
these customers consider to be satisfactory. In addition, with respect to
some of these obligations, we are still obligated to pay Verint Systems for
their services even if we have not received payment from the customers. In the
past we have experienced disputes with Verint with respect to the scope of the
parties respective obligations under these subcontracting arrangements; while
such disputes have been eventually resolved, we may experience similar disputes
in the future. We are subject to these obligations during 2005 and will
possibly be so obligated subsequently as well. 
Therefore, our financial condition and results of operations would
suffer if these customers do not pay us on a timely basis. If we would be
required for any reason to seek a new subcontractor to provide these services,
a new subcontractor may not be available at all and, in any event, switching to
a new subcontractor would involve significant delay and expense, which could
further expose us to claims by these government customers.

A significant portion of our products is based on a single
technology platform, and our business will suffer if we cannot develop new
products based on this platform to meet the needs of our customers.

A
portion of our software applications is based on a single technology
platform. If we are unable to develop new products that meet the needs of
our customers because of our reliance on this single technology platform, sales
of our products could decline. Any significant decrease in the sales of
our products could seriously harm our results of operations.

Our
customers generally operate their networks using a wide variety of software
applications, network equipment and software and hardware platforms. If
our products fail to integrate properly with our customers equipment, our
ability to generate future sales will be harmed. For example, our
FraudView® application platform uses the Windows NT operating system.
Most companies in the telecommunications industry currently use UNIX and may
not be willing to implement a solution based on Windows NT. If service
providers are unwilling to accept a Windows NT-based solution, our business
will be harmed.

We could be subject to warranty claims and product recalls,
which could be very expensive and harm our financial condition.

We
typically provide one-year warranty programs with respect to our
products. Our warranty generally provides that we will repair or replace
products with defects in materials or workmanship or that fail to meet
agreed-upon specifications. Any significant product returns or warranty
claims under our purchase orders could adversely affect our results of
operations. We offer sophisticated products that may contain software
with undetected errors. In addition, new products may experience failures
when first introduced, and both current and future products may experience
failures as new versions are released. We rely to a large extent on our
reputation among industry leaders in conducting our sales efforts. As a
result, any product recall as a result of errors or failures, and the
associated negative publicity, could result in the loss of, or delay in, market
acceptance of our products and hurt our business.

We depend on single suppliers for some of our product
components, including key product components in our legacy probing devices, and
we cannot control the manufacturing and delivery of these components. Our
business will be interrupted if these suppliers are unable or unwilling to
provide these components.

We
utilize single suppliers for some of our product components, including critical
components needed for our X-ellence® platform. We cannot control the delivery schedule for these
components. Any problems that may occur with respect to the delivery,
quality or cost of these components could result in product shortages or
quality assurance problems. Our supplier of the critical component for our X-ellence® platform has special expertise
in engineering these components. If it is unable or unwilling to provide
these components, we will experience substantial delays in the manufacturing of
certain of our products, and our business will suffer. In addition, in
connection with our sale to Verint Systems of our government surveillance
business, we agreed to sell some of these components to Verint Systems for a
period of seven years. Any problems with our supplier that cause us to
breach our obligations to Verint Systems, which problems may not be under our
control, could expose us to claims by Verint Systems. Such claims could
materially harm our financial condition.



8

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Volatility experienced by telecommunications service
providers may adversely affect our sales and operating results.

The
telecommunications service provider market to which we sell historically has
been volatile.  From time to time this
industry has experienced significant downturns.  For instance, beginning in late 2000 and continuing into 2003,
the deterioration of the global economy in general and economic uncertainty in
the telecommunications market in particular resulted in a decline of capital
investment by telecommunications service providers. This decline in capital
expenditures significantly reduced our sales and also resulted in pressure on
the prices we charge for our products. While recovery of the
telecommunication market was evident in 2004, the two principal markets in
which we compete, the fraud prevention solution market and the revenue
assurance market both continued to suffer the lasting impact of the changes to
the market between 2000 and 2003.  If
the recovery in our principal markets continues to progress at a  slow pace such that current and potential
customers postpone or decrease further capital investment, our revenues may
fail to grow significantly or may decline, either of which would have a
continued material adverse effect on our operating results.

The increased focus of telecommunications service providers and
cellular operators on revenue-generating projects may reduce the investment in
our markets.

Telecommunication companies are increasingly
focused on capital expenditures that are designed to increase ARPU, or average
revenue per user, such as various new features and services for users.  To the extent that these companies decide to
allocate their capital expenditure budgets to these types of products, instead
of to products that increase the prevention of fraudulent acts and provide
revenue assurance, such as our products, our sales may decrease.

Increased expense levels will harm
our business if our revenues do not grow.

Our
revenues for 2004 were $12.6 million, compared to $28.9 million for 2003.
Our net loss from continuing operations for 2004 was $ 25.7 million, compared
with a net loss from continuing operations of $ 35.9 million for 2003. Our net
loss for 2004 was $13.5 million, including $12.2 million in income, which was
attributable to our discontinued government surveillance business, compared
with a net loss of $ 40.7 million for 2003. 
We implemented a comprehensive recovery plan in 2004 aimed at rebuilding
our business in response to the significant decrease in our revenues.  Although the plan involved significant
expense reductions in 2004 in order to bring expenses more into line with
revenues, it also involves increasing our focus on sales execution, project
delivery and customer support.  
Accordingly, we expect our operating expenses to increase in 2005 due
primarily to planned increases in sales and marketing and research and
development activities to support our recovery plan in order to increase
revenues. If our revenues do not increase proportionately to our operating
expenses, or if revenues decrease or do not meet expectations for a particular
period, and we are not able to reduce our expenses in the short term, or at
all, our business, financial condition and results of operations will be
materially adversely affected.

Developments affecting telecommunication service providers,
such as mergers, can adversely affect us.

Developments
in the telecommunications industry, such as the impact of general global
economic conditions, continued industry consolidation, the formation of
alliances among network operators and service providers, and changes in the
regulatory environment have had, and could continue to have, a material adverse
effect on our existing or potential customers. These conditions have reduced
the high growth rates that the telecommunications industry had previously
experienced, and have caused the market value, financial results and prospects,
and capital spending levels of many telecommunications companies to decline or
degrade. In recent years, the telecommunications industry has experienced
significant financial pressures that have caused many in the industry to cut
expenses and limit investment in capital-intensive projects and have led to
numerous restructurings and bankruptcies. Recent telecommunications company
mergers may have a material adverse effect on our results of operations, as
existing or potential customers may be purchased or two customers may combine
and combine operations in a manner that results in a decline in repeat sales by
us, reduces the number of licenses we can sell to the combined entity or cause
us to have to repeat significant pre-sale efforts in respect of one or more of
the merger parties.



9

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Many of our customers require a lengthy, detailed and
comprehensive evaluation process before they order our products. Our
sales process has been subject to delays that have significantly decreased our
revenues and which could result in the eventual cancellations of some projects.

We
derive substantially all of our revenues from the sale of products and related
services for telecommunications service providers. The purchase of our
products represents a relatively significant capital expenditure for our
customers. As a result, our products generally undergo a lengthy
evaluation and purchase process before we can sell them. In recent years,
our customers are conducting a more stringent and detailed evaluation of our products,
and decisions are subject to additional levels of internal review. As a
result, the evaluation process has significantly lengthened. This
evaluation process is currently taking between six and 18 months.
The following factors, among others, affect the length of the approval process:

| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | the time involved for our
  customers to determine and announce their specifications;   
| |  | the time required for our
  customers to process approvals for purchasing decisions;    
| |  | the complexity of the
  products involved;                                              
| |  | the technological
  priorities and budgets of our customers; and                        
| |  | the need for our customers
  to obtain or comply with any required regulatory approvals.

Delays in project approval
have significantly decreased our revenues. If customers continue to
subject our products to lengthy evaluation processes, if they continue to delay
project approval, if delays lengthen further, or if such continued delays
result in the eventual cancellation of any projects, it would continue to
seriously harm our business and results of operations.

In previous years, we experienced fluctuations in our annual
and quarterly results of operations, which resulted, and may continue to result
in the future, in volatility in our share
price.

In
recent years we have experienced, and may continue to experience, significant
fluctuations in our quarterly results of operations, and we may likewise
experience significant fluctuations in our annual results of operations.
Factors which have contributed and may in the future contribute to fluctuations
in our results of operations include:

| |   |                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------
| |  | general economic
  conditions;                                                                                                
| |  | the capital spending
  patterns of our customers;                                                                             
| |  | the size and timing of
  orders, including order deferrals, and subsequent shipments;                                         
| |  | market acceptance of new
  products;                                                                                          
| |  | the timing of our product
  introductions or enhancements or that of our competitors or providers of
  complementary products;
| |  | the timing of approval of
  Israeli government research and development grants;                                               
| |  | the percentage of sales
  for which we pay sales commissions;                                                                 
| |  | disruptions in our sources
  of supply; and                                                                                   
| |  | increasing delays between
  the receipt of awards and the formal issuances of purchase orders.                                

The
results of past periods should not be relied upon as an indication of our
future performance. It is likely that in some future periods, our
operating results may again be below expectations of public market analysts or
investors, which may cause our share price to drop.

We must maintain sufficient inventory levels to meet
anticipated demand. If we cannot predict orders accurately, our inventory
may become obsolete and our financial performance may be harmed.

The
timing and volume of our customers orders are generally difficult to forecast
for each quarter, as a substantial majority of our sales are booked and shipped
in the same quarter pursuant to purchase orders. We must therefore
maintain or have available sufficient inventory levels to satisfy anticipated
demand on a timely basis. Maintaining sufficient inventory levels to assure
prompt delivery of our products increases the risk of inventory obsolescence
and associated write-offs. A shift in demand could also result in
inventory write-offs, which could harm our financial performance. For example,
during the first half of 2004, we recorded an inventory write-off of
approximately $915 thousand in connection with inventory that became obsolete
or that we estimated that we would not be able to sell.



10

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We depend on several relatively large
customers and the loss of one or more of these customers, or a significant
decrease in revenue from any of these customers, could have a disproportionate
impact on our revenue and income.

A
substantial portion of our revenue has come from relatively large purchases by
a small number of customers. Sales to our top ten customers accounted for
74.8% of our revenues in 2004, with sales to three customers in Eastern Europe
accounting for 39.7% of our revenues and sales to a customer in Latin
America accounting for 10.4% of our revenues. Sales to our top ten
customers accounted for 75.1% of our revenues in 2003, with sales to one
customer in Europe accounting for 13.9% of our revenues. We expect to continue
to depend on sales to a small number of customers. However, we do
not have long-term commitments from any of our top customers to purchase any
specific quantities of products. We expect that our largest customers
will vary from period to period. If we lose one or more large customers
and fail to add new customers our results of operations could be seriously
harmed.

We recently entered into a Distribution
Agreement with ECI Telecom Ltd. under which we appointed ECI as our exclusive
distributor in significant portions of the former Soviet Union, which we expect
to be important markets for us. 
Accordingly we are dependent upon ECI for the achievement of sales in
those markets.

In June 2005
we entered into a distribution agreement with ECI under which we appointed ECI
as our exclusive distributor in the Russian Federation, Ukraine and Kazakhstan,
territories from which we expect, in the aggregate, to derive a significant
portion of our revenues in the near future. 
Under this agreement, ECI will, among other things, maintain a business
and sales organization in these territories to promote and effect the sale of
those of our products and services covered by the agreement.  In addition, we agreed to provide services
to those customers who purchase our products from ECI and ECI will resell our
products subject to a standard warranty. 
The agreement expires on December 31, 2005, provided that subsequent to
that date, it continues in full force and effect until such time as either
party gives the other party three months notice.  In addition, either party may terminate the agreement at any time
upon a material breach by the other party or in the event of liquidation or
similar consequences of the other party. If ECI were to terminate this
agreement or if it does not succeed in obtaining orders for our products and
services, for whatever reason, our business may be harmed.

The payment cycle for our receivables may
reduce the cash we have available to operate and expand our business.

As
is typical in the telecommunications industry, our contracts may provide for
payments under a variety of payment schedules. For example, we may
receive a deposit prior to shipment, a partial payment upon delivery and final
payment after 180 or 360 days from delivery. Such payment cycles may
adversely affect the cash resources available to operate and expand our
business.

Because the telecommunications market is
characterized by rapid technological and other changes, our success depends on
our ability to continually develop technologically advanced products and
product enhancements that achieve market acceptance.

The
telecommunications market is characterized by rapid technological advances and
frequent product introductions and enhancements. We believe that our
future success will largely depend upon our ability to continue to enhance our
existing products and to successfully develop and market products on a
cost-effective and timely basis. The technologies applicable to our
products include applications capable of analyzing and processing data based on
accepted telephony standards and protocols. If other technological
standards and protocols gain broad market acceptance, we will be required to
redesign our existing products or design new products that are able to view and
analyze networks based on these new standards and protocols. For example,
the types of fraudulent schemes to which service providers are subject change
with the emergence of new technologies, networks and other developments.
We cannot assure you that we will be successful in developing and marketing new
applications or systems that will respond to technological change.



11

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The market for our products is highly
competitive. Because many of our competitors have much greater
resources than we have, it may be difficult for us to return to, and maintain,
profitability.

Competition
in our industry is intense, and we expect it to continue. To compete
effectively, we have, at times, been required to grant substantial discounts on
our products, especially as some of our competitors utilize aggressive pricing
strategies. In addition, we could lose sales to our competitors.
Lower prices and reduced demand for our products would reduce our ability to
generate revenue, which would harm our business.

Many
of the companies that compete with us have greater name recognition, longer
operating histories, larger customer bases and significantly greater financial,
marketing, public relations, sales, distribution and other resources.
Some of our competitors and potential competitors are among the largest and
most capitalized software and hardware companies in the world. Also, some
of our competitors have located their research and development facilities in
countries where labor costs for engineers and other experienced personnel are
far lower than in Israel, where our research and development facilities are
located.

We
may also face competition from our customers. Some of our customers are
developing their own solutions internally or through strategic alliances.
Also, the internal information technology departments of some service providers
are acting as our competitors for the provision of various revenue assurance
solutions within their own companies. As a result, solutions developed by
our customers may replace and/or compete with products that we currently sell
to them or that we may seek to sell to them in the future.

Our business and its future growth depend on
increased market acceptance of services based on packet-switched technology and
third generation wireless networks. If these services are not fully
developed and accepted in the marketplace, our growth plans will be materially
adversely affected.

Several
of our newer products are designed to meet the specific requirements of new
value-added services being made available by packet-switched technology (VoIP)
and third generation wireless networks (3G). The markets for VoIP and 3G
are currently developing.  We cannot be
sure that the delivery of telephone, other communication or new value-added
services through VoIP or 3G networks rather than over traditional telephone
networks will expand.  If third
generation networks and VoIP services are not fully developed and accepted in the
marketplace, the market for some of our newer products may not develop or be
sustainable. In that case, our business would be materially adversely
affected.

Implementation of certain new technologies by
telecom carriers may result in a decline in demand for our products.

New
technologies, such as VoIP, are facilitating the use of cheaper communications
media and new pricing schemes, such as flat rates, by some telecom service
providers. Such service providers may be less inclined to invest in
high-end solutions like ours. Moreover, since these technologies enable the
service providers to offer relatively low calling rates to subscribers, this
may reduce the incentive to commit telecom fraud and thereby reduce the demand
for anti-fraud solutions like ours. This trend may harm our revenues and
results of operation.

We do business with companies located in
countries around the world, which subjects us to additional risks. If
these risks materialize, our business will be materially adversely affected.

Because
of the global nature of our business, we are exposed to the risk of economic or
political instability in countries where our customers are located,
particularly in developing countries. In addition, there are often longer
sales and payment cycles in developing countries, as well as greater
difficulties in collecting accounts receivable.

We
face additional risks from our international operations including:

| |   |                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------
| |  | difficulties
  of obtaining licenses, the imposition of tariffs and the effects of other
  trade barriers;
| |  | difficulties
  in staffing and managing foreign operations;                                               
| |  | potentially
  adverse tax consequences;                                                                   
| |  | laws and
  business practices favoring local competitors;                                                 
| |  | costs and
  difficulties of customizing products for foreign countries;                                   
| |  | compliance
  with a wide variety of complex foreign laws and treaties; and                                
| |  | variance and
  unexpected changes in local laws and regulations.                                          

If
we fail to overcome the challenges we encounter in our international operations,
our business will be materially adversely affected.



12

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Currency fluctuations could cause customers
to decrease or cancel orders or default on payment.

Currently
our international sales are denominated primarily in U.S. dollars.
Accordingly, devaluation in the local currencies of our customers relative to
the U.S. dollar could cause customers to decrease or cancel orders or default
on payment. An increasing portion of our international sales is now
denominated in Euros, and in the future additional sales may be denominated in
currencies other than U.S. dollars, thereby exposing us to gains and losses on
non-U.S. currency transactions. We may choose to limit this exposure by entering
into hedging transactions. However, hedging transactions may not prevent
exchange-related losses, and our business may be harmed by exchange rate
fluctuations. Furthermore, as we seek to expand our sales to regions
throughout the world, we might be exposed to risks of customers located in
countries suffering from uncertain economic environments such as high inflation
and solvency problems.

Our proprietary technology is difficult to
protect and unauthorized use of our proprietary technology by third parties may
impair our ability to compete effectively.

Our
success and ability to compete depend in large part upon our protection of our
proprietary technology, including both hardware and software components of our X-ellence® platform. We currently
rely on a combination of patents, trade secret and copyright laws, nondisclosure
and other contractual agreements and technical measures to protect our
proprietary rights. We have filed several patent and trademark applications
covering some of our technology and are in the process of preparing and filing
additional patent and trademark applications. We cannot assure you that
any of these applications will be granted. These agreements and measures
may not be sufficient to protect our technology from third-party infringement,
or to protect us from the claims of others. Additionally, our products
may be sold in foreign countries that provide less protection to intellectual
property than that provided under U.S. or Israeli laws. Moreover,
competitors and potential competitors may attempt to copy or reverse engineer
aspects of our product line or to obtain and use information that we regard as
proprietary. If we are unable to maintain the security of our proprietary
technology for these or any other reasons, our business may suffer.

Because our products may infringe on the
intellectual property rights of third parties, our business will suffer if we
are sued for infringement or cannot obtain licenses to these rights on
commercially acceptable terms.

We
are subject to the risk of adverse claims and litigation alleging infringement
by us of the intellectual property rights of others. Many participants in
the telecommunications industry have an increasing number of patents and patent
applications and have frequently demonstrated a readiness to pursue litigation
based on allegations of patent and other intellectual property
infringement. All of our products rely on technology that could be the
subject of existing patents or patent applications of third parties. We
have agreed to indemnify our customers with respect to infringement by our
products of the proprietary rights of third parties. Third parties may
assert infringement claims in the future with respect to our current or future
products. These claims may require us to enter into license arrangements
or result in protracted and costly litigation, regardless of the merits of
these claims. Any necessary licenses may not be available or, if
available, may not be obtainable on commercially reasonable terms. If we
cannot obtain all necessary licenses on commercially reasonable terms, we may
be forced to stop selling our products in some or all countries, and our
business would be seriously harmed.

Because we currently depend on licensed
software as part of some of our products, our results of operations will suffer
if we are unable to maintain these licenses on commercially reasonable terms or
if the vendors are unable to provide the necessary support and maintenance.

We
currently rely upon software that we license from third parties as part of some
of our products, including software that is integrated with our internally
developed software and used in our products to perform key functions. For
example, we utilize a software package of i2 Technologies in our fraud
management solution. We may be unable to maintain these software licenses
from third parties on commercially reasonable terms, if at all. This could
result in shipment delays or reductions until equivalent replacement software
could be developed or licensed and integrated into our products. Any
inability to maintain these licenses could harm our business.
Furthermore, some software is licensed from relatively small vendors, who may
not be able to survive if the current difficult economic climate
continues. If any of these vendors cease their operations, we may face
difficulties in obtaining the necessary support and maintenance for the
software originally provided by them.

Breaches in the security of the data
collected by systems that we have sold and still support could adversely affect
our reputation and results of operations.

Our
customers rely on third-party security features to protect the privacy and
integrity of customer data. Our products may be vulnerable to breaches in
security due to defects in the security mechanisms, the operating system, the
hardware platform or the networks linked to the platform. Our QualiWeb® product, which we ceased to
produce and to actively market in 2004, but which will still support, provides
information using Web access, presents additional security issues for our
customers. Exploitation of any vulnerability could jeopardize the
security of information stored in and transmitted through the computer systems
of our customers. If the security of our products were compromised, our reputation
would be significantly harmed, which would cause our business to suffer.
In addition, we may be liable to our customers for any breach in
security. We may be required to expend significant capital and other
resources to further protect against security breaches or to correct problems
caused by any breach.



13

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We depend on a limited number of key
personnel who would be difficult to replace. If we lose the services of
these individuals or cannot hire additional qualified personnel, our business
will be harmed.

Our
business and future growth and success largely depend on the managerial and
technical skills of Eitan Naor, our President and Chief Executive Officer, and
other members of senior management. If either Mr. Naor or other members
of the senior management team are unable or unwilling to continue in our
employ, our results of operations could be materially and adversely
affected.

Our
success also depends to a substantial degree upon our ability to attract,
motivate, and retain other highly-qualified personnel. There is
competition in Israel for the services of highly-qualified technical and
engineering personnel. There is also considerable competition for the services
of experienced sales and marketing personnel. We may not be able either
to retain our current personnel or hire additional qualified personnel if and
when needed.

We may seek to expand our business through
mergers and acquisitions that could result in diversion of resources and extra
expenses, which could disrupt our business and harm our financial condition.

We
may pursue mergers and acquisitions of businesses, products and technologies,
or the establishment of joint venture arrangements, that could expand our
business. The negotiation of potential acquisitions or joint ventures as
well as the integration of an acquired or jointly developed business,
technology or product could cause a diversion of managements time and our
resources. Future acquisitions could also result in:

| |   |                                                      
| | - | -----------------------------------------------------
| |  | dilutive issuances
  of equity securities;           
| |  | the
  incurrence of debt and contingent liabilities; 
| |  | impairment
  of goodwill and other intangible assets;
| |  | research and
  development write-offs; and           
| |  | other
  acquisition-related expenses.                

We
cannot be sure that we will successfully integrate the business of any acquired
companies or joint ventures with our operations. We may not receive the
intended benefits of any future acquisition or joint venture. In
addition, we have limited experience with respect to operating acquired
businesses. If the operation of the business of any future acquisitions
disrupts our operations, our business may suffer.

We may be classified as a passive foreign
investment company and, as a result, our U.S. shareholders may suffer adverse
tax consequences.

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

Our costs may increase as a result of ECIs
cessation of the control of us.

In
May 2004, ECI distributed 7.6 million of our ordinary shares to its shareholders,
causing its holdings of our outstanding ordinary shares to decrease from 57.9%
to 15.9%. In the past we benefited from certain cost savings as a result of
discounts afforded by third parties to members of the ECI group. Following the
share distribution, we may lose some of these benefits, which would increase
our expenses.



14

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Risks Related to Operations in Israel

Potential political, economic and military
instability in Israel may adversely affect our results of operations.

Our
principal offices and manufacturing facilities and many of our suppliers are
located in Israel. Accordingly, political, economic and military
conditions in Israel directly affect our operations. Since the
establishment of the State of Israel in 1948, a number of armed conflicts have
taken place between Israel and its Arab neighbors. A state of hostility,
varying in degree and intensity, has led to security and economic problems for
Israel. From October 2000 until recently, there was a high level of violence
between Israel and the Palestinians, which led to a breakdown of the entire
peace process and has affected Israels relationship with its Arab citizens and
several Arab countries. There can be no assurance that the recent relative calm
and renewed discussions with Palestinian representatives will continue.
Furthermore, several countries restrict business with Israel and Israeli
companies, and additional companies may restrict doing business with Israel and
Israeli companies as the result of the recent increase in hostilities. These
restrictive policies have had and may continue to have an adverse impact on our
business. We could be adversely affected by any major hostilities
involving Israel, the interruption or curtailment of trade between Israel and
its trading partners or a significant downturn in the economic conditions in
Israel.

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

Some
of our executive officers and employees in Israel are obligated to perform
military reserve duty annually. They may also be further subject to being
called to active duty at any time under emergency circumstances.
Our operations could be disrupted by the absence for a significant period of
one or more of our executive officers or key employees due to military service,
and any disruption in our operations would harm our business. The full
impact on our workforce or business if some of our executive officers and
employees will be called upon to perform military service, especially in times
of national emergency, is difficult to predict.

Because most of our revenues are generated in
U.S. dollars but a significant portion of our expenses are incurred in New
Israeli Shekels, our results of operations may be seriously harmed by inflation
and currency fluctuations.

We
generate most of our revenues in U.S. dollars but incur a significant portion
of our expenses in New Israeli Shekels, commonly referred to as NIS. As a
result, we are exposed to risk to the extent that the rate of inflation in
Israel exceeds the rate of devaluation of the NIS in relation to the dollar or
if the timing of such devaluation lags behind inflation in Israel. In
either event, the dollar cost of our operations in Israel will increase and our
dollar-measured results of operations will be adversely affected. Our
operations also could be adversely affected if we are unable to guard against
currency fluctuations in the future. Accordingly, we may enter into
currency hedging transactions to decrease the risk of financial exposure from
fluctuations in the exchange rate of the dollar against the NIS. These
measures, however, may not adequately protect us from material adverse effects
due to the impact of inflation in Israel.

The tax benefits that we currently receive
from the Investment Center of the Israeli Ministry of Industry, Trade and Labor
require us to meet several conditions and may be terminated or reduced in the
future, which would increase our taxes.

We
receive tax benefits under Israeli law for capital investments that are
designated as approved enterprises. To maintain our eligibility for these
tax benefits, we must continue to meet conditions stipulated in applicable law
and in our specific approvals, including making specified investments in fixed
assets. If we fail to comply with these conditions, in whole or in part,
with respect to any approved enterprise program we establish, we may be
required to pay additional taxes for the period in which we benefited from the
tax exemption or reduced tax rates and we would likely be denied these benefits
in the future.   From time to time, we submit requests for expansion of
our approved enterprise programs or for new programs to be designated as
approved enterprises. These requests might not be approved, particularly
in light of difficult economic conditions in Israel. In addition, in March
2005, the law governing these tax benefits was amended to revise the
criteria for investments that qualify for tax benefits as an approved
enterprise.  We cannot assure
you that we will, in the future, be eligible to receive additional tax
benefits under this law.  We received an
approval in principle from the Investment Center with respect to the sale of
our government surveillance business to Verint Systems in March 2004. If the
Investment Center declines, for any reason, to grant us the final approval, our
tax benefits under Israeli law will be materially reduced. The
termination or reduction of these tax benefits could seriously harm our
financial condition and results of operations.

Because we receive grants from the Office of
the Chief Scientist, we are subject to ongoing restrictions, and certain of our
large shareholders are required to undertake to observe such restrictions.
Our grant programs may be terminated or reduced in the future, which would
increase our costs.



15

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We
receive royalty-bearing grants from the Office of the Chief Scientist of the
Israeli Ministry of Industry Trade and Labor, or the OCS, for research and
development programs that meet specified criteria. According to Israeli law,
any products developed with grants from the OCS are required to be manufactured
in Israel, unless we obtain prior approval of a governmental committee.
As a condition to obtaining this approval, we may be required to pay the Office
of the Chief Scientist up to 300% of the grants we received and to repay such
grants at a quicker rate. Furthermore, the transfer to a non-Israeli
entity of technology developed with OCS funding, including pursuant to a merger
or similar transaction, and the transfer of rights related to the manufacture
of more than ten percent of a product developed with OCS funding are subject to
approval by an OCS committee and to various conditions, including payment by us
to the OCS of a percentage of the consideration paid to us or our shareholders
in the transaction in which the technology is transferred.  In connection with a merger or similar
transaction, the amount payable would be a fraction of the consideration equal
to the relative amount invested by the OCS in the development of the relevant
technology compared to the total investment in our company, net of financial
assets that we have at the time of the transaction, but in no event less than
the amount of the grant.  In addition,
in the event that the committee believes that the consideration to be paid in a
transaction requiring payment to the OCS pursuant to the provisions of the law
described above does not reflect the true value of the technology or the
company being acquired, it may determine an alternate value to be used as the
basis for calculating the requisite payments. 
These restrictions may impair our ability to enter
into agreements for those products or technologies, without OCS approval.

We
recorded grant participations of an aggregate of $1.4 million in 2004 and
approximately $0.8 million in 2003. As of December 31, 2004, our
contingent liability to the Office of the Chief Scientist with respect to
grants received was approximately $3.3 million. The Israeli government has
reduced the benefits available under these programs in recent years and has
indicated that it may reduce or eliminate these benefits in the future.
These programs may not continue in the future at their current levels or at any
level. From time to time, we submit requests for new grants from the
Office of the Chief Scientist. These requests might not be approved,
particularly in light of the difficult economic conditions in Israel. The
termination or reduction of these grants could seriously harm financial
condition and results of operations.

It may be difficult to enforce a U.S.
judgment against us, our officers or directors or to assert U.S. securities law
claims in Israel.

Service
of process upon us, since we are incorporated and headquartered in Israel 
and upon our directors and officers, substantially all of whom reside outside
the United States, may be difficult to obtain within the United States.
Furthermore, because substantially all of our assets and ECIs assets, and
substantially all of our directors and officers are located outside the United
States, any judgment obtained in the United States against us or any of them
may not be collectible within the United States.

There
is doubt as to the enforceability of civil liabilities under the Securities Act
of 1933 and the Securities Exchange Act of 1934 in original actions instituted
in Israel. However, subject to specified time limitations, Israeli courts
may enforce a U.S. final executory judgment in a civil matter, provided that:

| |   |                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | adequate
  service of process has been effected and the defendant has had a reasonable
  opportunity to be heard;                                                 
| |  | the judgment
  and its enforcement are not contrary to the law, public policy, security or
  sovereignty of the State of Israel;                                  
| |  | the judgment
  was obtained after due process before a court of competent jurisdiction
  according to the rules of private international law prevailing in Israel;
| |  | the judgment
  was not obtained by fraudulent means and does not conflict with any other
  valid judgment in the same matter between the same parties;            
| |  | 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 U.S. court; and        
| |  | the U.S.
  court is not prohibited from enforcing judgments of Israeli courts.                                                                                    

If
a foreign judgment is enforced by an Israeli court, it generally will be
payable in NIS, which can then be converted into non-Israeli currency and
transferred out of Israel. The usual practice in an action to recover an
amount in non-Israeli currency is for the Israeli court to render judgment for
the equivalent amount in NIS at the rate of exchange on the date of payment, but
the judgment debtor also may make payment in non-Israeli currency.
Pending collection, the amount of the judgment of an Israeli court stated in
NIS ordinarily will be linked to the Israel Consumer Price Index plus interest
at the annual rate (set by Israeli law) prevailing at that time. Judgment
creditors bear the risk of unfavorable exchange rates.

Provisions of Israeli law may delay, prevent
or make more difficult a merger or other business combination, and therefore
depress the price of our stock.



16

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The
Israeli Companies Law  1999 includes restrictions on mergers, such as special
voting requirements, the ability of creditors to seek court intervention to
delay or prevent a merger and mandatory waiting periods. In addition,
under certain circumstances, the Companies Law requires that acquisitions be
performed via tender offer. For more information, see Item 10B 
Memorandum and Articles of Association -- Mergers and Acquisitions Under
Israeli Law.

Risks Related to the Market for Our Ordinary
Shares

We are currently a party to a securities
litigation class action lawsuit, which, if determined adversely, could
negatively affect our business and results of operations.

In
January 2005, a class action complaint was filed against us, certain persons
who served as our officers and directors in the years 2001-2003, as well as ECI
Telecom Ltd. (a major shareholder of ours during that period), in the District
Court of the State of Maryland. The complaint alleges violation of U.S. Federal
securities laws and breach of fiduciary duties in connection with disclosure of
our financial results between April 2001 and April 2003. An unfavorable
resolution of these matters could materially affect our results of operations
and financial condition. We have stated that we believe that the allegations
made in the complaint are without merit and that we intend to vigorously defend
against such complaint. In doing so, we may incur substantial costs. In
addition, the litigation has been, and may continue to be, time-consuming and
costly and could divert the attention of our senior management. These lawsuits
or any future lawsuits filed against us could seriously harm our business.

Substantial future sales of our ordinary
shares may depress our share price.

On
May 10, 2004, ECI distributed 7,600,000 ordinary shares to its shareholders,
which constituted approximately 42% of our outstanding shares at that time. As
a result, ECI currently holds 2,890,325, or 15.9%, of our outstanding ordinary
shares. In June 2004, ECI placed into an irrevocable trust 544,054 of our
ordinary shares, which it withheld from its shareholders pursuant to Israeli
tax law, with instructions to sell on the Nasdaq Stock Market to reimburse the
tax payable by ECI to the Israeli government, subject to the terms of the trust
and applicable securities laws. As of January 31, 2005, there were 195,321
shares still held in the trust.  The
trust is the record owner of the withheld shares, and ECI is the sole
beneficiary with respect to the proceeds of the sale of shares held by the
trust.  An additional 369,035 shares are
held by Telrad Networks Ltd. ECI and Telrad both have rights to require
us to register their ordinary shares with the Securities and Exchange
Commission.If our shareholders
sell substantial amounts of our ordinary shares, including shares distributed
by ECI to its shareholders and shares issued upon the exercise of outstanding
employee options, or if the perception exists that our shareholders may sell a
substantial number of our ordinary shares, the market price of our ordinary
shares may fall. Any substantial sales of our shares in the public market
also might make it more difficult for us to sell equity or equity related
securities in the future at a time we deem appropriate.

Our stock price has decreased significantly
and could continue to fluctuate significantly.

The
market price for our ordinary shares, as well as the prices of shares of other
technology companies, has been volatile. Our share price has decreased
significantly since the first quarter of 2003. Even though our share
price increased during the last half of 2004, numerous factors, many of
which are beyond our control, have caused and may continue to cause the market
price of our ordinary shares to fluctuate significantly, such as:

| |   |                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------
| |  | shortfalls
  in our operating results from levels forecast by securities analysts.                 
| |  | fluctuations
  in our quarterly revenues and earnings and those of our publicly held
  competitors;
| |  | announcements
  concerning us, our affiliates, or our competitors;                                 
| |  | the
  introduction of new telecommunications services;                                             
| |  | changes in
  pricing policies by us or our competitors;                                            
| |  | market
  conditions in our industry and the global economy in general; and                         
| |  | the general
  state of the securities market (particularly the technology sector).                 

In
addition, trading in shares of companies listed on the Nasdaq National Market
in general and trading in shares of technology companies in particular have
experienced extreme price and volume fluctuations that have often been
unrelated or disproportionate to operating performance. These broad
market and industry factors may depress our share price, regardless of our
actual operating results.



17

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Item 4.
Information on the Company

A.        History
and Development of the Company

ECtel
Ltd. is our legal and commercial name.  Until April 1998, we operated
under the name ECI Telesystems Ltd. We were incorporated as a
wholly-owned subsidiary of ECI Telecom Ltd. on April 4, 1990, under the laws of
the State of Israel. Our principal executive offices are located at 43 Hasivim
Street, Petah Tikva 49130, Israel and our telephone number is (972-3)
926-6102. Our agent in the United States, ECtel Inc., is located at 8211
W. Broward Blvd., Suite 460,  Fort
Lauderdale, FL

In
March 2004, we sold our government surveillance business to Verint Systems
pursuant to an asset purchase agreement, which is described below under Item
10.C Additional InformationMaterial Agreements.  Our chief executive
officer resigned in January 2004 and this was followed by the resignation of
six vice presidents during the balance of the first half of 2004, either in
connection with the transaction with Verint Systems or for their own personal
or professional reasons. In mid-February 2004, Eitan Naor assumed the
position of president and chief executive officer. Mr. Naor assembled a
new management team which has led our efforts in formulating a comprehensive recovery
plan and is leading its implementation.

The
plan, which was launched during the second quarter of 2004 and whose
implementation continued through the balance of 2004, was aimed at rebuilding
our core telecom business.  To this end,
the plan involved increasing our focus on sales execution, project delivery and
customer support, with an emphasis on improving existing customer
relationships, expanding the sales pipeline and closing pending deals. As part
of these efforts, we established, in June 2004, a new department we refer to as
the PSO (Professional Services Organization & Operations). The PSO is
responsible for project development, field engineering, customer support,
expert guidance and training. We believe that the establishment of the PSO will
improve our capability to provide prompt responses to market needs, thereby
both strengthening sales and improving customer retentions.

The
recovery plan also included measures to further reduce our cost
structure. Specifically, it included steps intended to align our costs
and revenues, including a material reduction of our global workforce and the
consolidation of several of our activities, such as the closing of our main
U.S. office and the elimination of our quality assurance product research and
development team located in that office. 
In connection with the implementation of the plan, we recorded $3.4 million in reorganization expenses
associated with payroll expenses, disposal of fixed assets and rent contracts,
termination penalty expenses and other costs. See Note 17 to our consolidated
financial statements for the year ended December 31, 2004, included elsewhere
in this annual report.

Principal Capital Expenditures

Our
principal capital expenditures in the past three years have been the purchase
of equipment and other fixed assets used in our business (mainly in
Israel). These purchases totaled approximately $2.1million in 2002,
approximately $1.8 million in 2003 and approximately $ 0.9 million in 2004.
Our capital expenditures in 2004 were spent primarily for the procurement of
test and production equipment computers. We used internal working capital
to finance these capital expenditures.

B.        Business
Overview

The
following description does not include our government surveillance business.
Our surveillance solutions enabled governmental agencies to perform real-time,
comprehensive surveillance on telecommunications networks. We sold this
business to Verint Systems in March 2004.

General

We
develop and market fraud prevention and revenue assurance solutions for
circuit-switched and packet-switched wireline and wireless networks. Our
solutions equip telecommunications service providers with comprehensive data
gathering and analysis capabilities to improve their operational efficiency and
profitability by:

| |   |                                                                  
| | - | -----------------------------------------------------------------
| |  | detecting
  and preventing fraud;                                
| |  | supporting
  revenue assurance, including call leakage detection;



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| |   |                                                                 
| | - | ----------------------------------------------------------------
| |  | helping to
  settle interconnect disputes between operators; and
| |  | monitoring
  network usage and providing traffic-trends reports.

Industry Overview

Changes
in the Telecommunications Industry

The
telecommunications industry is characterized by, among others, the following
factors:

Convergence
of Circuit-Switched and Packet-Switched Networks.Telecommunications
networks of the early 1990s were not designed to handle the dramatic increases
in data traffic which have been fueled by the growing use of the
Internet. This led to the development of a new generation of
data-oriented communications networks, often based on Internet Protocol, that
use packet-networking technology, as an alternative to traditional,
circuit-switched telephone networks. These packet-based, or next-generation,
networks, however, are not expected to immediately replace circuit-switched
networks. As a result, packet-switched and circuit-switched networks are
expected to coexist and interconnect with each other for the foreseeable
future, creating what is known as converged networks.

Development
of Value-Added Services. Greater competition and
advances in technology have led service providers to seek to differentiate
themselves by offering advanced, value-added services. The increased connectivity
to the Internet is making Internet-based communications, such as multimedia
content, including video and audio, and e-commerce services, an integral part
of these value-added services. Service providers are also expanding the
range of wireless services to include data services such as e-mail, Short
Message Service (SMS) and limited Internet access. The emerging third
generation wireless (3G) technology will enable the wireless provisioning of an
even broader range of services, including full Internet access, downloading
music and video, video conferencing and mobile banking, trading and online
games.

Increased
Network Interconnectivity.  Advanced technologies
and expanded product offerings have caused telecommunications networks of multiple
service providers to be increasingly interconnected. For example, the
value-added services offered by service providers are often obtained from a
number of different content providers, requiring interconnections among their
networks to provide the services to customers. In addition, although recently
there has been a trend of consolidation among service providers in response to
deteriorating conditions in the industry, deregulation and privatization have
led to a large increase in the number of service providers operating
worldwide. These service providers must interconnect their networks with
those of other providers to enable their respective subscribers to communicate
with each other.

Increased
Focus on Revenue Assurance. Recently, in response
to deteriorating industry conditions, service providers have often been forced
to lower the prices they charge for value added services.  In turn, lower
prices have resulted in lower profit margins for the service providers with
respect to these value-added services. As a result, there is an increased
need for service providers to ensure that they capture as much of the revenues
associated with these value added services as possible. In addition, the recent
increase in regulatory scrutiny by securities law and other regulators serve as
an incentive for our potential customers to implement advanced revenue
assurance systems, thereby improving the quality of their internal controls.

Service
Provider Challenges

As
service providers increase their focus on fraud prevention and revenue
assurance, they face challenges in the following areas:

Fraud
Prevention. Fraud typically represents a
significant loss of revenues for service providers. Due to the following
factors, there are greater opportunities for fraud, and acts of fraud are
potentially significantly more damaging:

| |   |                                                                                                                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Value-added
  service offerings create vulnerabilities in telecommunications networks,
  making fraud schemes easier. Service offerings include high value
  transactions such as on-line banking, mobile commerce, and content, which has
  significantly increased the potential losses caused by acts of fraud;
| |   |                                                                                                                                                                                                                                                                                                                   
| |  | The growth
  of interconnected networks makes it more difficult for any provider in the
  chain to detect fraud and hold a defrauder responsible;                                                                                                                                                                 



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Under their
  interconnection agreements, service providers are often committed to make
  partial payments to each other relating to fraudulent sessions that they may
  not be able to recoup from their customers. This has increased the
  out-of-pocket costs incurred by service providers as a result of fraud; and                                                                                                                                                                                                                                                                                                                                                                                                                              
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |  | In some
  countries, pirate service providers have begun providing international
  voice service on data lines that the pirate providers lease on PABX exchanges
  in the local country network. These leased data lines are generally not
  permitted by various laws governing data and voice traffic in these countries
  to carry voice traffic. By using these data lines, the pirate providers
  bypass the high international toll tariffs that traditional service providers
  are required to pay when providing international voice service. As a result,
  the pirate providers can charge less to customers than traditional service
  providers can, which in turns results in the loss of customers by traditional
  service providers.

Service
providers require increasingly sophisticated fraud prevention solutions in
order to overcome these challenges and effectively detect and prevent fraud in
modern telecommunications networks.

Interconnect
Billing. The number of interconnections among
service providers is continually increasing, making it more important to verify
the accuracy of inter-carrier billing under interconnection arrangements.
In addition, the current flat rate billing solutions do not enable service
providers to bill other providers based on usage of new value-added services,
such as SMS or cellular roaming, over their networks. In order to
maximize potential revenues, service providers require usage-based billing
solutions.

In
order for service providers to effectively address these challenges and remain
competitive, they require comprehensive revenue assurance solutions to prevent
fraud and accurately bill for interconnected transmissions. These
solutions must be capable of processing tens of millions of sessions per day
from an objective source, operating with hardware and software provided by
multiple vendors and supporting the multiple technologies that exist in
converged networks. In addition, solutions must be flexible in order to
adapt easily to rapidly changing technologies.  Finally, service providers
seek revenue assurance solutions that meet all of these objectives and provide
a demonstrable and rapid return on investment.

The ECtel Solution

We
develop and market fraud prevention and revenue assurance solutions for
circuit-switched and packet-switched wireline and wireless networks. Our
products consist of proprietary software and hardware components, as well as off-the-shelf
hardware and software components. We believe that our solutions provide
our customers with the following benefits:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Comprehensive View of the Network. Modern
  international communications networks function on a variety of transmission
  protocols. For example, transmission protocols for circuit-switched networks
  are different from those used in packet-switched networks. Our solutions have
  the capability to view and analyze many of the transmission protocols used in
  converged networks. In addition, our solutions are capable of viewing and
  analyzing not only the signaling information, but also the embedded session
  information. Signaling information consists of basic information, such as
  time and place of origin and destination of the message. Embedded session
  information includes the classification of message type (e.g., voice, fax or
  data) and information regarding the message content, such as touch tones
  initiated during a call. Most alternative solutions provided by our
  competitors only analyze the signaling information. Moreover, our solutions
  perform the crucial mediation function, which is necessary in order to
  analyze and correlate data from a wide variety of information sources in a
  packet-switched network. These information sources include specialized probes
  that provide value-added services and other applications. As a result, our
  solutions are generally able to provide a more comprehensive view of modern,
  interconnected networks than those of our competitors.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Real-Time Functionality. Our system platform
  is designed to collect, process and present data about the network in
  real-time. This allows our customers to react to network conditions and
  events generally as they occur. For example, using our fraud prevention
  product, a service provider can detect and interrupt fraudulent activity as
  it occurs or even before it begins, thereby reducing losses. This real-time
  functionality is of increasing importance with respect to data services that
  support high value transactions, such as on-line banking or securities
  trading, in which both the network provider and the subscriber bear the risk
  of substantial losses as a result of acts of fraud. In addition, using our
  quality-of-service monitoring products, a service provider can monitor network
  quality and detect service problems in its network. Based on this
  information, the provider can reroute traffic and initiate maintenance on its
  network within minutes.                                                                                                                                                                                                                                                                                                                                                                                                                                          



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Flexible,
  Scalable, Multi-Application Platform. Our system platform has been designed to
  meet the continually evolving requirements of service providers. Our
  platform is based on a modular architecture, which enables our customers to
  easily and cost-effectively add capacity and network coverage. In
  addition, because all of our applications run on the same platform, our
  customers can easily add new functionalities to their installed
  solution. Our solutions can also be easily upgraded to keep up with the
  rapid introduction of new technologies and services.                                                                                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  | Vendor
  Independent Solutions. 
  Our probing solutions analyze raw signaling information and embedded session
  information, each captured directly from the network. These solutions
  do not rely on information provided in vendor-specific format such as data
  that is processed and formatted for billing systems. By analyzing raw
  information, our fraud prevention system enables our customers to detect
  types of fraud that would not be detected by analyzing only processed
  data. For example, our solutions capture and analyze information about
  unsuccessful call attempts, which is not usually registered with billing
  systems, and which is important in detecting some types of fraud and
  implementing a proactive approach for fraud prevention.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  | Sophisticated
  Algorithms. We
  have developed sophisticated proprietary algorithms to enable our products to
  perform comprehensive session analyses. Using these algorithms and
  supporting hardware, our solutions can analyze signaling information and
  embedded session information on multiple channels simultaneously. For
  example, our powerful data-mining algorithm uses neural networks and decision
  tree techniques that enable our fraud prevention solutions to detect types of
  fraud that the rule-based solutions of many of our competitors are unable to
  detect. We have also developed proprietary digital signal processing
  algorithms to enable our products to perform comprehensive session signal
  analysis.                                
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  | User-Defined
  Operational Parameters. Our system platform and applications provide service providers with
  the flexibility to have their personnel define the scope of the data they
  require and the preferred method of viewing this data. For example, a
  service providers quality assurance professional may use our
  quality-of-service products to view a bar graph showing the ratio of
  successful call connections to various destinations. At the same time,
  its marketing professional may use the same product to view usage
  information. Using a standard personal computer, each user can generate
  customized reports and easily select, organize and analyze the data relevant
  to the user.                                                          

Business Strategy

Our
objective is to be the leading provider of fraud prevention solutions and a
significant player in revenue
assurance software solutions worldwide. The following are key elements of
our strategy:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Offer
  Comprehensive Fraud Prevention and Revenue Assurance Solutions. We offer our service provider customers
  comprehensive fraud prevention and revenue assurance solutions to meet their
  fraud prevention and revenue assurance needs. We also seek to regularly
  add new applications to our products to enable our customers to meet the full
  range of fraud prevention and revenue assurance challenges that exist in
  converged networks. We continually seek to adapt our existing fraud
  prevention and revenue assurance solutions to be compatible with emerging
  technologies and services.                                                                             
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Maintain
  and Enhance Our Technological Leadership. We believe that our technology platform
  provides us with a competitive advantage in developing revenue assurance
  solutions to meet the rapidly changing needs of service providers. We
  have invested significant resources over a number of years for both internal
  development and selective acquisitions. We intend to continue to invest
  in our technology, through internal development and selective acquisitions,
  to maintain our position as a technological leader in revenue assurance solutions.                                                                                                                    
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Focus on
  Leading Worldwide Service Providers. We focus our marketing efforts on leading
  worldwide service providers of wireline, wireless and next-generation
  communication services, many of whom have global affiliations. We have
  sold our solutions to many of the worlds largest telecommunications service
  providers, including Austria Telekom, Belgacom, Cable & Wireless Group,
  Hutchison H3G, MMO2, Portugal Telecom, MCI, Vodafone Sweden, Kievstar, Qwest
  Communications International, Swisscom, the Telefonica Group, Serbia Telecom
  and Rostelecom. We believe that sales to market leaders will assist our
  marketing efforts to other industry participants.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |  | Maintain
  Direct and Interactive Relationships With Our Customers. We work closely with our existing
  customers, both to support the solutions already sold to them, and to provide
  additional consulting services to help them refine and upgrade their
  solutions. This enables us to market complementary products to our
  customers to meet their changing needs and to stay abreast of the evolving
  needs of the marketplace.                                                                                                                                                                                                                                                     



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Products

Revenue
Assurance Solutions

All
of our revenue assurance solutions are based on our X-ellence® platform, which consists of:

| |   |                              
| | - | -----------------------------
| |  | Probes;                      
| |   |                              
| |  | Mediation software; and      
| |   |                              
| |  | Data analysis
  applications.

Probes.  Our application-specific probes are
attached to the service providers network. Our probes for
circuit-switched networks are a combination of our proprietary software and
hardware components. Our probes for next generation networks are a
combination of our proprietary software and off-the-shelf probe hardware.
The probes capture, filter, aggregate, correlate and merge data collected from
network links, such as E-1/T-1 links, and Internet, fast Internet and gigabit
Internet links. Our probes gather information from all layers of the
network, from the physical layer to the application layer, without disrupting
the operation of the network service.

Mediation
Software. Our
software solutions perform the crucial mediation function. Mediation
consists of extracting, collecting, re-formatting and filtering raw information
from various network elements, including routers, firewalls, authentication
servers, domain name servers, Web servers, e-mail servers, video servers, and
VoIP gateways. This information can be combined with information obtained
from probes to create complete data records relating to sessions passing
through the network.

Data
Analysis Applications. Our solutions analyze the data records created by the probes and
mediation software and create the reports used for the revenue assurance needs
of our clients. Our solutions are capable of collecting and analyzing
reports in real-time for tens of millions of sessions per day.

Our
platforms flexible, scalable architecture is designed to evolve and grow with
emerging technologies and the changing needs of our customers. It enables
our customers to:

| |   |                                                                           
| | - | --------------------------------------------------------------------------
| |  | Scale the capacity and
  processing power of our products;                
| |   |                                                                           
| |  | Add new applications to an
  installed system; and                        
| |   |                                                                           
| |  | Assimilate new and
  emerging network standards, devices and applications.

We
have the following revenue assurance solutions that operate on our platform:

Fraud
Prevention Solutions

Our
fraud prevention solutions gather information about calls both in real-time and
offline and compare it to fraudulent scenarios established within
user-specified filter parameters, subscriber profiles and thresholds.
When defined thresholds are reached, an alert is automatically generated and
appropriate intervention can take place according to the users chosen
parameters. Our FraudView® system
provides comprehensive fraud detection and prevention solution for wireline,
circuit-switched and next generation networks.

Revenue
Assistance Solutions

Our
revenue assurance solutions are designed to support service providers that
offer multiple services and interconnect with numerous other providers on circuit-switched
or packet-switched networks.

Sales and Marketing

As
of April 1, 2005, our direct sales force and marketing staff consisted of 26
employees. We market our fraud prevention and revenue assurance solutions
to service providers worldwide, primarily through a direct sales force.
Our sales staff operates out of our offices in Israel, the United States and
Germany, and in addition we engage local sales representatives,
distributors and sales consultants.  In Brazil and Singapore we engage
full time sales consultants for management of sales activities in adjacent
territories.



22

---

---



Sales
of our fraud prevention and revenue assurance solutions are made predominantly
to large service providers and involve lengthy evaluation processes before the
customers issue purchase orders. Because the purchase of our products is
a relatively significant capital expenditure, prospective customers generally
commit substantial resources to an evaluation of our solutions and require us
to expend significant time, effort and money educating them about the value of
our solutions. This sales cycle for our revenue assurance solutions is an
average of between six and 18 months. Our primary marketing activities include
raising awareness among existing and potential customers of the benefits
provided by the features of our products. We utilize the sales and
marketing services of local sales representatives for such activities. We also
participate in exhibitions and industry trade shows in an effort to promote our
products.

We
have sold our solutions to miscellaneous worldwide customers, including the
following:

|                       |                 
|---------------------- | ----------------
|Belgacom               |                 
|                       |                 
|BellSouth group        | MCI             
|                       |                 
|Cable & Wireless Group | MM02            
|                       |                 
|Cellcom                | Portugal Telecom
|                       |                 
|Embratel               | Qwest           
|                       |                 
|Hutchison H3G          | Swisscom        
|                       |                 
|Kievstar               | Telefonica Group
|                       |                 
|Serbia Telecom         | Vodafone Sweden 
|                       |                 
|Iusacell               | CTBC            

In
2004, our top ten customers accounted for 74.8% of our revenues, with sales to
three customers in Eastern Europe region accounting for 39.7% of our revenues
and sales to one customer in Latin America accounting for 10.4% of our
revenues.  In 2003, our top ten
customers accounted for 75.1% of our revenues, with sales to one customer in
the Europe accounting for 13.9% of our revenues and sales to one customer in
Latin and North America accounting for 11.4% of our revenues.



23

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The
following table shows a breakdown of our sales of products by geographical
region during 2002, 2003 and 2004 (in thousands):

| |                |  |                         |        |      |   |        |  |   |        | 
| | -------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |                |  | Year ended December 31, |       
| |                |  |                         |       
| |                |  | 2002                    |        | 2003 |   | 2004   | 
| |                |  |                         |        |      |   |        |  |   |        | 
| | Israel         |  | $                       | 997    |      | $ | 1,095  |  | $ | 852    | 
| | Asia Pacific   |  |                         | 21,110 |      |   | 2,234  |  |   | 1,117  | 
| | North America  |  |                         | 634    |      |   | 1,877  |  |   | 779    | 
| | Europe         |  |                         | 10,668 |      |   | 14,549 |  |   | 7,244  | 
| | Other          |  |                         | 2,100  |      |   | 1,369  |  |   | 68     | 
| | South America  |  |                         | 16,917 |      |   | 7,733  |  |   | 2,545  | 
| |                |  |                         |        |      |   |        |  |   |        | 
| |                |  |                         |        |      |   |        |  |   |        | 
| | Total Revenues |  | $                       | 52,426 |      | $ | 28,857 |  | $ | 12,605 | 
| |                |  |                         |        |      |   |        |  |   |        | 

PSO (Professional Services Organization)

In
the summer of 2004 we formed a professional services organization (PSO). This
organization consists of technical personnel possessing an in-depth
understanding of customers business environments.  The PSO provides comprehensive consulting services, project
management, training and on-going support, thereby maximizing the value of our
Fraud Prevention (FraudView) and Revenue Assurance (CashView) solutions to our
customers.

We
offer ongoing support services for our customers worldwide through our
facilities in Israel, the United States and Germany.

Manufacturing

We
purchase some hardware, such as servers and storage devices, from third party
vendors such as IBM and Hewlett Packard. Our manufacturing operations
consist primarily of final assembly and testing, involving the application of
extensive testing and quality control procedures to materials, modules,
subassemblies and systems. Although we generally use standard parts and
modules in our products, certain modules are presently available only from a
limited number of sources. In addition, we purchase various customized
components from ECI, such as digital signaling processing boards and mechanical
wiring.

We
maintain organization-wide quality assurance procedures, coordinating the
quality control activities of our research and development and manufacturing
departments. Our primary manufacturing and research and development
facilities have received certification to Quality Standard ISO 9001:2000.
ISO 9001:2000 is an international standard of quality assurance for companies
involved in the design, development, manufacturing, installation and servicing
of products or services. This standard is set by the International
Organization for Standardization (ISO), an international federation of national
standards bodies. To be recommended for ISO 9001:2000 certification, a
company must be audited by an ISO-accredited auditing company and must meet or
surpass the ISO standards. We believe that our customers value the
process, control and traceability that are required to achieve ISO 9001:2000
certification.

Research and Development

In
order to accommodate the rapidly changing needs of our markets, we place
considerable emphasis on research and development projects designed to improve
our existing product lines, develop new product lines and customize our
products to meet our customers needs. As of March 31, 2005, 22 of our
employees were engaged primarily in product development activities. We expect
that we will continue to commit substantial resources to product development in
the future.



24

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As
a recipient of grants from the Office of the Chief Scientist, we are obligated
to perform, in Israel, all development activities related to products under
these grants, unless we receive an exemption. Know-how from the research and
development which is used to produce these products may not be transferred to
third parties without the approval of the Office of the Chief Scientist.
Approval is not required for the export of any products resulting from the
research and development based on these grants. For further information
regarding the Office of the Chief Scientist of the Israeli Ministry of
Industry, Trade and Labor, see Item 5C - Research and Development, Patents and
Licenses  Grants from the Office of the Chief Scientist.

Competition

The
telecommunications industry is characterized by intense competition. Many
of the companies that compete with us have greater name recognition, longer
operating histories, larger customer bases and significantly greater financial,
marketing, public relations, sales, distribution and other resources.
Some of our competitors and potential competitors are among the largest and
most well capitalized software and hardware companies in the world.

We
also face competition from our customers and new vendors, and we expect this
trend to continue in the future. Some of our customers are developing
their own solutions internally or through strategic alliances.

Our
competitors in the fraud prevention market are HP, Neural Technologies,
FairIsaac, Azure and Subex. Our competitors in the sale of revenue
assurance solutions include Azure, ConnexN, Subex, Elron Telesoft, Cape, WeDo
and HP

We
believe that the principal competitive factors in the markets in which we
compete are product functionality, the ability to provide effective and
comprehensive solutions, pricing, timely introduction of new products,
especially products of next generation networks, and responsive customer
support.

Intellectual Property and Proprietary Rights

The
telecommunications industry is characterized to a great extent by its reliance
on proprietary technology. We believe that we own or have the license to
use the technologies used in our products. We depend on a combination of
technical innovations, trade secrets, and non-disclosure agreements for the
protection of this technology. Also, we are filing patent applications to
protect our technology and trademark applications to register our
trademarks. Various trademarks have already been registered in certain
countries.

Although
we intend to protect our rights in technology vigorously, we cannot be sure
that these measures will be successful. It may be possible for
unauthorized third parties to misappropriate or reverse engineer aspects of our
products or technology, independently develop technology of substantially
similar functionality or performance, or obtain information that we regard as
proprietary. Moreover, the laws of some foreign countries in which we
sell or may sell our products may not fully protect, or may not protect at all,
our proprietary rights in products.

Third
parties may, from time to time, claim that our current or future products
infringe their intellectual property rights. Intellectual property litigation
is complex and we cannot assure you of the outcome of any such
litigation. Any future intellectual property litigation, regardless of
outcome, could result in substantial expense and significant diversion of the
efforts of our technical and management personnel and disrupt or otherwise
severely impact our relationships with current and potential customers. 
An adverse determination in any such proceeding could subject us to significant
liabilities to third parties, require disputed rights to be licensed from those
parties, assuming licenses to the rights could be obtained, or require us to
cease using the technology and expend significant resources to develop
non-infringing technology. We may not be able to obtain a license at an
acceptable price.

CashView®, 
FraudView®, IC-Guard®,  I-Probe®, NeTrace®, NGN FraudView®, ProfEdge®,
PreView®, X-ellence®, ValueRoute®, BillGuard®, FllowGuard®, ServeGuard®andX-pertView®are among our trademarks.

Government Regulations

We
receive grants from the Office of the Chief Scientist of the Israeli Ministry
of Industry, Trade and Labor for research and development programs. We
also receive tax benefits under Israeli law for capital investments that are
designated as approved enterprises. Our participation in these programs
is subject to our compliance with certain conditions and imposes certain
restrictions upon us.



25

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Demand
for products by service providers is affected by various types of laws and
regulations in the areas of use of communications customer records, network
service standards, billing for use of interconnected networks, certification of
and charges paid by VoIP service providers and opening markets to
competition. For more information regarding the Office of the Chief
Scientist and tax benefits for approved enterprises, see Item 5C  Research
and Development, Patents and Licenses  Grants from the Office of the Chief
Scientist and Item 10E  Taxation  Israeli Taxation  Tax Benefits under the
Law for the Encouragement of Capital Investments, 1959, respectively.

C.        Organizational
Structure

Prior
to May 10, 2004, ECI held of record 10,490,325, or approximately 57.9%, of our
outstanding ordinary shares. On May 10, 2004 ECI distributed 7,600,000 ordinary
shares to its shareholders. As a result, ECI holds 2,890,325, or 15.9%, of our
outstanding ordinary shares. ECI is a provider of integrated network
solutions which designs, develops, manufactures and markets digital
telecommunications and data transmission systems, enabling network operators to
deliver cost-effective services.

We
own all the outstanding shares of:

| |   |                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------
| |  | ECtel Inc., a Maryland
  corporation;                                                               
| |   |                                                                                                     
| |  | ECtel (2000) U.K. Ltd., a
  U.K. company; and                                                       
| |   |                                                                                                     
| |  | ECtel BV, a Dutch company
  which, in turn, holds all of the shares of ECtel GmbH, a German company.

D.        Property,
Plants and Equipment

We
have recently entered into a lease agreement for our new headquarters and main
facilities in Rosh Haayin, Israel.  The
facilities  occupy approximately 37,232
square feet.  The lease period commences
on July 10, 2005 and runs through June 30, 2015. We are entitled to shorten the
term of the lease at any time following its fifth or sixth anniversary, subject
to making certain penalty payments. We are further entitled to discontinue the
lease on the seventh, eight, or ninth anniversaries, upon providing six months
written notice, without any penalty payments.

ECtel
Inc., our U.S. subsidiary, leases approximately 1,500 square feet of office
space in Florida. The term of the Florida lease is through June 30, 2006. Our
U.K. subsidiary, ECtel (2000) U.K. Ltd., leased approximately 2000 square feet
of office space in London, England until February 2005.

ECtel
GmbH leases approximately 970 square feet of office space from ECI Telecom GmbH
in Frankfurt, Germany. The term of this lease is one year from October 1,
2002, with an automatic one year renewal, unless either party notifies the
other party, no later than 180 days prior to the termination of the initial
term, of its wish not to renew.

Item 5. Operating and Financial Review and
Prospects

A.        Operating
Results

You
should read this discussion in conjunction with the consolidated financial
statements and the other financial information appearing elsewhere in this
annual report.

On
March 31, 2004, we sold our government surveillance business to Verint
Systems. Accordingly, our statements of operations, including those of
prior periods, reflect the results of operations of this business in the line
item called income (loss) from discontinued operations. All data in this
Annual Report derived from statements from our statements of operations, unless
otherwise specified, exclude our government surveillance business.



26

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Overview

We
develop and market fraud prevention and revenue assurance solutions for
circuit-switched and packet-switched wireline and wireless networks. Our
solutions equip telecommunications service providers with comprehensive data
gathering and analysis capabilities to improve their operational efficiency and
profitability by:

| |   |                                                                  
| | - | -----------------------------------------------------------------
| |  | detecting and preventing
  fraud;                                
|
| |  | supporting revenue
  assurance, including call leakage detection;
|
| |  | helping to settle
  interconnect disputes between operators; and 
|
| |  | monitoring network usage
  and providing traffic trend reports.  

Our
business deteriorated in the first quarter of 2003, in which we experienced a
sharp decline in revenues and recorded a net loss. Until then, we had
maintained strong revenues and remained profitable despite the slowdown in the
worldwide telecommunications industry, which resulted in decreases and delays
in the procurement and deployment of new telecommunications equipment. We
believe that the war in Iraq, including the lead-up thereto, contributed to the
hesitancy of customers to commit to large technology investments. Our
sales continued to decline in 2003 and during the first nine months of
2004.   During this period, we also experienced intensifying
competition, causing us to lose potential contracts due to aggressive pricing
on the part of some of our competitors. This reduction in revenues and
prices resulted in worsening gross margins and increasing net losses. In
response to this decline in revenues, we implemented cost-cutting measures in
the second quarter of 2003.

During
much of 2003, we were engaged in negotiations with Verint Systems, to whom we
sold our government surveillance business on March 31, 2004. This
complex, protracted transaction diverted management attention and distracted
our employees, further harming our operations. Moreover, we believe that
rumors of a pending transaction with Verint System caused potential customers
to award contracts to our competitors. Finally, our chief executive
officer resigned in January 2004 and this was followed by the resignation of
six vice presidents during the balance of the first half of 2004, either in
connection with the transaction with Verint Systems or for their own personal
or professional reasons. This further harmed our business and results of
operations.

In
mid-February 2004, Eitan Naor assumed the position of president and chief
executive officer. Utilizing his extensive experience in, and knowledge
of, the telecom market, Mr. Naor assembled a new management team and led our
efforts in formulating a comprehensive recovery plan.

The
plan, which was launched during the second quarter of 2004 and whose implementation
continued through the balance of 2004, was aimed at rebuilding our core telecom
business.  It also included measures to
further reduce our cost structure. Specifically, it included steps
intended to align our costs and revenues, including a material reduction of our
global workforce and the consolidation of several of our activities, such as
the closing of our main U.S. office in Maryland and the elimination of our
quality assurance product research and development team located in that office.  In connection with the implementation of the
plan, we recorded $3.4 million in
reorganization and related expenses associated with payroll expenses, disposal
of fixed assets and rent contracts termination penalty expenses and other
costs.

The
sale of our government surveillance business generated proceeds of
approximately $35 million, leaving us in a strong cash position that will
enable our full implementation of the recovery plan. At March 31, 2005,
we had cash and cash equivalents, short-term deposits and long-term investments
of approximately $50 million.

We
believe that our results for the first quarter of 2005, in which we recorded
revenues of $ 4.8 million and a net loss of $ 0.8 million, reflect increased
revenues and decreased net loss in comparison with last three quarters of 2004. We believe that those results, along with maintenance renewals and extensions received from our installed
base, indicate that our plan has started to take effect.  However, as detailed in Item 3.D - Risk
Factors, there are still significant challenges to the success of our plan and
there can be no assurance that it will succeed.

Results of Operations

The
following table sets forth the percentage relationships of certain items from
our consolidated statements of operations, as a percentage of revenues for the
periods indicated:



27

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| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | --------------------------------------------------------------- |  | ----------------------- | ----- | ---- |  | ------ | --- |  | ------ | ---
| |                                                                 |  | Year ended December 31, |      
| |                                                                 |  |                         |      
| |                                                                 |  | 2002                    |       | 2003 |  | 2004   |    
| |                                                                 |  |                         |       |      |  |        |    
| | Revenues                                                        |  |                         | 100.0 | %    |  | 100.0  | %   |  | 100.0  | %  
| | Cost of revenues                                                |  |                         | 42.7  |      |  | 60.5   |     |  | 81.5   |    
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | Gross profit                                                    |  |                         | 57.3  |      |  | 39.5   |     |  | 18.5   |    
| | Research and development costs, net                             |  |                         | 17.4  |      |  | 34.9   |     |  | 43.2   |    
| | Selling and marketing expenses                                  |  |                         | 26.1  |      |  | 49.6   |     |  | 72.0   |    
| | General and administrative expenses                             |  |                         | 17.0  |      |  | 58.8   |     |  | 67.4   |    
| | Restructuring and related impairment costs                      |  |                         |      |      |  |       |     |  | 26.6   |    
| | Goodwill impairment                                             |  |                         |      |      |  | 20.9   |     |  | 17.3   |    
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | Total operating expenses                                        |  |                         | 60.5  |      |  | 164.2  |     |  | 226.5  |    
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | Operating income (loss)                                         |  |                         | (3.2  | )    |  | (124.7 | )   |  | (208.0 | )  
| | Financial income, net                                           |  |                         | (0.5  | )    |  | (0.7   | )   |  | (3.4   | )  
| | Other income (expenses), net                                    |  |                         | (*    | )    |  | (*     | )   |  | (*     | )  
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | Income (loss) from continuing operations before taxes on
income |  |                         | (2.7  | )    |  | (124.0 | )   |  | (204.6 | )  
| | Taxes on income (tax benefit)                                   |  |                         | (*    | )    |  | (0.1   | )   |  | (0.2   | )  
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | Net income (loss) from continuing operations                    |  |                         | (2.7  | )    |  | (124.1 | )   |  | (204.4 | )  
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | Net income (loss) from discontinued operations                  |  |                         | 35.7  |      |  | (16.9  | )   |  | (97.3  | )  
| |                                                                 |  |                         |       |      |  |        |     |  |        |    
| | Net income (loss)                                               |  |                         | 33.0  | %    |  | (141.0 | ) % |  | (107.1 | ) %

|    |                                         
|--- | ----------------------------------------
|   
|(*) | Represent a percentage
  less than 0.1%.

Comparison of 2004, 2003 and 2002

Revenues

Revenues
consist primarily of the sale of our hardware and software solutions, as well
as hardware and software licenses of third parties, to telecommunications
service providers. A small portion of our revenues comes from fees for
maintenance and other services. 
However, we expect service revenues to increase, both on an aggregate
basis and as a percentage of revenues, due to the introduction of our PSO,
whose activities we expect to generate service revenues.



28

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2004
vs. 2003

Total
revenues decreased by 56% from $28.9 million in 2003 to $12.6 million in 2004
due to the continued effects of extended negotiations with Verint Systems
during the first quarter of 2004, the heavy turnover in senior management and
the resultant transition as well as the costs and effects of implementing our
recovery plan. These were slightly offset by an increase in revenues in the
fourth quarter due to our recovery plan starting to take effect. Revenues were also
slightly impacted by continued industry-wide price erosion resulting from an
enhanced competitive environment and global economic conditions.

2003
vs. 2002

Total
revenues decreased 45% from $52.4 million in 2002 to $28.9 million in 2003 due
mainly to the general slowdown in the telecommunications market, exacerbated by
the war in Iraq, which contributed to the hesitancy of customers to commit to
large technology investments, and intensifying competition. Our revenues were
also adversely affected by the extended negotiations with Verint Systems,
reorganization activities and management transition. Revenues were also
impacted by industry-wide price erosion resulting from an enhanced competitive
environment and global economic conditions.

The
following is the breakdown of our revenues by geographical distribution and as
a percentage of total revenues for the years indicated (continuing operations
only):

| |                |  |      |      |      |  |       |   |   |      |  |  |       |   |   |      |  |  |       |  
| | -------------- |  | ---- | ---- | ---- |  | ----- | - | - | ---- |  |  | ----- | - | - | ---- |  |  | ----- | -
| | (in millions)  |  | 2002 |      | 2003 |  | 2004  |  
| |                |  |      |      |      |  |       |  
|
| | Israel         |  | $    | 1.0  |      |  | 1.9   | % | $ | 1.1  |  |  | 3.8   | % | $ | 0.9  |  |  | 6.8   | %
| | Asia Pacific   |  |      | 21.1 |      |  | 40.3  | % |   | 2.2  |  |  | 7.8   | % |   | 1.1  |  |  | 8.9   | %
| | North America  |  |      | 0.6  |      |  | 1.2   | % |   | 1.9  |  |  | 6.5   | % |   | 0.8  |  |  | 6.2   | %
| | Europe         |  |      | 10.7 |      |  | 20.3  | % |   | 14.6 |  |  | 50.4  | % |   | 7.2  |  |  | 57.5  | %
| | Other          |  |      | 2.1  |      |  | 4.0   | % |   | 1.4  |  |  | 4.7   | % |   | 0.1  |  |  | 0.4   | %
| | South America  |  |      | 16.9 |      |  | 32.3  | % |   | 7.7  |  |  | 26.8  | % |   | 2.5  |  |  | 20.2  | %
| |                |  |      |      |      |  |       |   |   |      |  |  |       |   |   |      |  |  |       |  
| | Total Revenues |  | $    | 52.4 |      |  | 100.0 | % | $ | 28.9 |  |  | 100.0 | % | $ | 12.6 |  |  | 100.0 | %

Cost of Revenues

Cost
of revenues consists primarily of the direct cost of materials, employee
compensation expenses, payments to sub-contractors and outsourcing, payments to
consultants, depreciation related to manufacturing, allocated overhead,
installation and support of our products, changes in inventory and royalties to
the Office of the Chief Scientist in Israel.

2004
vs. 2003

Gross
profit decreased by 79.5% from $11.4 million in 2003 to $2.3 million in
2004. Our gross profit margin decreased from 39.5% in 2003 to 18.5% in 2004. 
This decrease derives primarily from the following:

| |                                                                                                                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1)          Our
  low volume of revenues in 2004 compared with 2003, together with high fixed
  costs, reduced gross margins significantly, especially in the first half of
  2004, which was prior to our implementation of the cost cutting measures of
  our recovery plan.                               
| | (2)          As
  a part of the sale of our governmental surveillance business to Verint
  Systems and the recovery plan we subsequently implemented, we made a
  one-time write-off in the amount of $915,000 relating to inventory of certain
  components which we believed could not be used in the future



29

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2003
vs. 2002

Gross
profit decreased 62.1% from $30.1 million in 2002 to $11.4 million in
2003. Gross profit margin decreased from 57.3% in 2002 to 39.5% in
2003. This decrease derives primarily from the following:

| |                                                                                                                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1)          Our
  cost of revenues includes both fixed and variable costs. The
  decrease in our revenues in 2003 compared to 2002 combined with our fixed
  costs remaining at similar levels in 2003 as they were in 2002 reduced gross
  margins significantly.
| | (2)          The
  industry-wide price erosion resulting from an enhanced competitive
  environment and global economic conditions.                                                                                                                                

Operating Expenses

|                                             |  |                           |      |                          |  |                          |  |  |      |  |  |      |  |  |       |  
|-------------------------------------------- |  | ------------------------- | ---- | ------------------------ |  | ------------------------ |  |  | ---- |  |  | ---- |  |  | ----- | -
|($ in millions)                              |  | Year ended
  December 31, |      | % Change
  2003 vs. 2002 |  | % Change
  2004 vs. 2003 | 
|                                             |  |                           |     
|                                             |  | 2002                      |      | 2003                     |  | 2004                     | 
|                                             |  |                           |      |                          |  |                          |  |  |      |  | 
|                                             |  |                           |      |                          |  |                          |  |  |      |  |  |      |  |  |       |  
|Research and development
  costs, net        |  |                           | 9.1  |                          |  | 10.1                     |  |  | 5.4  |  |  | 10.1 |  |  | (46.5 | )
|Selling and marketing
  expenses             |  |                           | 13.7 |                          |  | 14.3                     |  |  | 9.1  |  |  | 4.5  |  |  | (36.4 | )
|General and administrative
  expenses        |  |                           | 8.9  |                          |  | 17.0                     |  |  | 8.5  |  |  | 90.7 |  |  | (50.0 | )
|Restructuring and related
  impairment costs |  |                           |     |                          |  |                         |  |  | 3.4  |  |  | N/A  |  |  | N/A   |  
|Goodwill impairment                          |  |                           |     |                          |  | 6.0                      |  |  | 2.2  |  |  | N/A  |  |  | (63.3 | )
|Total operating expenses                     |  |                           | 31.7 |                          |  | 47.4                     |  |  | 28.6 |  |  | 49.2 |  |  | (39.7 | )

Research and Development Costs, Net

Research
and development costs consist primarily of employee compensation expenses,
payments to sub-contractors and consultants and allocated overhead, costs of
materials and software and amortization of purchased technologies associated
with our research and development activities. Grants received from the Office
of the Chief Scientist in Israel are deducted from gross research and development
expenses to determine net research and development expenses.

2004
vs. 2003

Research
and development costs, net decreased by 46% from $10.0 million in 2003 to $5.4
million in 2004. This decrease reflected a decrease in gross research and
development costs from $10.9 million in 2003 to $6.8 million in 2004, which
decrease was primarily due to a reduction in headcount due to implementation of
our recovery plan. Research and development grants from the Office of the Chief
Scientist increased by 61.9% from approximately $0.8 million in 2003 to $1.4
million in 2004.

2003
vs. 2002

Research
and development costs, net increased 10.1% from $9.1 million in 2002 to $10.1
million in 2003. This increase reflected an increase in gross research and
development costs from $10.0 million in 2002 to $10.9 million in 2003, which
was primarily due to an increase in materials and subcontracting expenses in
2003 as well as an increase in purchased technology amortization partially offset
by a decrease in labor expenses due to the cost-cutting measures that we took
in the second quarter of 2003. Research and development grants from the Office
of the Chief Scientist decreased 5.3% from approximately $0.9 million in 2002
to $0.8 million in 2003.

Selling and Marketing Expenses

Selling
and marketing expenses consist primarily of employee compensation expenses,
payments to consultants, agents commissions and costs associated with
advertising, exhibitions, market research, industry trade shows, travel and
allocated overheads.



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2004
vs. 2003

Selling
and marketing expenses decreased 36.6% from $14.3 million in 2003 to $9.1
million in 2004.  The decrease was due
to reduced headcount, reductions in related expenses during 2004 and the
decrease in agent commissions due to the reduction in revenues.

2003
vs. 2002

Selling
and marketing expenses increased 4.5% from $13.7 million in 2002 to $14.3
million in 2003.  The increase was due
primarily to the continuing expansion of our worldwide sales and marketing
organization, and due to an increase in the rates of agent commissions.

General and Administrative Expenses

General
and administrative expenses consist primarily of employee compensation
expenses, professional fees, including legal and accounting fees, recruiting
costs, allocated overheads and the provision for doubtful debt.

2004 vs.2003

General
and administrative expenses decreased 49.9% from $17.0 million in 2003 to $8.5
million in 2004.  The decrease was
primarily due to decrease in expenses for doubtful debts from $13.2 million in
2003 to $4.7 million in 2004 due both to reduced sales in the second half of
2003 and during 2004 and due to 
improved credit worthiness in the telecommunication industry.

2003 vs. 2002

General
and administrative expenses increased 90.7% from $8.9 million in 2002 to $17.0
million in 2003.  This increase was
primarily due to an increase in expenses for doubtful and bad debts from $5.5
million in 2002 to $13.2 million in 2003 due to worsening of credit worthiness
in the telecommunication industry.

Restructuring and related impairment costs

As
a part of our boards June 2004 decision to focus on our core products and to
abandon certain products as well as engage in overall cost reductions, in 2004 we
recorded $3.4 million in reorganization expenses associated with
payroll expenses, disposal of fixed assets, rental contract termination
penalties and related expenses.

Goodwill impairment

On
October 1, 2001, we acquired all of the outstanding shares of Telrad Hawk Net-I
Ltd., or Net-I. As a result of the purchase of Net-I, goodwill in the
amount of $16.3 million was created as at the date of purchase. Goodwill is
subject to SFAS No. 142, which provides that goodwill and other intangible
assets with indefinite lives are no longer amortized, but instead are to be
tested for impairment at least annually in accordance with the provisions of
SFAS No. 142. During 2002, a third party expert examined the value of the
reporting unit to which the goodwill was attributed. We concluded then
that, in accordance with SFAS No. 142, there was no impairment in the value of
the goodwill.

In
June 2003 and 2004, due to significant reduction in our revenues, goodwill was
impaired. We obtained an independent appraisal to assess whether the goodwill
carried on our books needed to be written down. We impaired the goodwill by
$2.2 million in 2004 and $6.0 million in 2003 to its fair value in the amount
of $8.1 million as at December 31, 2004.

Please
see Note 7 to our consolidated financial statements appearing elsewhere in this
annual report.

Operating profit (loss)

2004
vs.2003

Operating
loss decreased from $36.0 million in 2003 to $26.2 million in 2004. This
decrease was primarily due to a decrease in all components of operating
expenses as a result of the implementation of our recovery plan. In addition,
while  goodwill impairment expenses  amounted 
to $6.0 million in 2003, in 2004 we had goodwill impairment expenses of
$2.2 million and restructuring expense of $3.4 million.



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2003
vs. 2002

Operating
loss increased from $1.7 million in 2002 to $36.0 million in 2003. This
increase was primarily due to a decrease in revenues, as well as a decrease in
gross profit margins, an increase in research and development costs, net, and
in general and administrative expenses and the goodwill impairment expenses of
$6.0 million recorded in 2003.

Financial
income, net

2004
vs. 2003

Financial
income, net increased 128.1% from $192,000 in 2003 to $438,000 in 2004. 
This increase was primarily due to our increased investments in marketable
securities enabled by receipt of the proceeds from the sale of our government
surveillance business.

2003
vs. 2002

Financial
income, net decreased 28.6% from $269,000 in 2002 to $192,000 in 2003. 
This decrease was primarily due to the reduction in cash and cash equivalents
as well as a reduction in interest rates we received on our cash and cash
equivalents and currency revaluations.

Taxes on
Income (Tax Benefit)

2004
vs. 2003

We
incurred a tax expense of $38,000 in 2003, compared with a tax benefit of
$30,000 that we received in 2004, which benefit was primarily related to a
revised estimation based on our discussion regarding our tax assessment.  For more information regarding this
assessment, please see Note 12 to our consolidated financial statements.

2003
vs. 2002

We
received a tax benefit of $29,000 in 2002, compared with a tax expense of
$38,000 in 2003, which benefit was primarily related to a revised
estimation based on our discussion regarding our tax assessment. In 2002 a
large portion of our pre-tax income resulted from our Israeli operations,
offset by the pre-tax loss from our U.S. operations. Our effective tax
rate in Israel is significantly lower than our effective tax rate in the United
States.

Net income
(loss) from continuing operations

Net
loss from continuing operations was $1.4 million in 2002 compared with net loss
of $35.8 million in 2003 and net loss of $25.8 million in 2004. Net loss
from continuing operations margin was 2.7% in 2002, Net loss from continuing
operations margin increased from 124.1% in 2003 to 204.6% in 2004. These
changes were primarily due to the significant decrease in revenues.

Net income
(loss) from discontinued operations

Net
income from discontinued operations was $12.2 million in 2004 compared with net
loss of $4.8 million in 2003 and net income of $18.7 million in 2002.

Net (loss)
income

2004
vs. 2003

Net
loss was $40.7 million in 2003 compared with net loss of $13.5 million in
2004. This change is due to the decrease in net loss from continuing
operations as a result of implementation of our recovery plan, which resulted in
a decrease in expenses during 2004, and from income from the sale of our
government surveillance business.



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2003
vs. 2002

Net
income was $17.3 million in 2002 compared to net loss of $40.7 million in
2003. This change derived from the increase in net loss from continuing
operations as well as the shift from net income to net loss of our discontinued
operations.

Critical Accounting Policies

The
preparation of our financial statements in conformity with generally accepted
accounting principles in the United States requires our management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period, which could potentially result in materially
different results under different assumptions and conditions. These are
our managements best estimates based on experience and historical data;
however, actual results could differ materially from these estimates. The
following sections include references to certain critical accounting policies
that are impacted significantly by judgments, assumptions and estimates used in
the preparation of our consolidated financial statements. For a full discussion
of the application of these and other accounting policies, see Note 2 in the
notes to our consolidated financial statements.

Revenue
Recognition

Our
revenue recognition policy is significant because our revenue is a key
component of our results of operations. We follow very specific and detailed
guidelines in measuring revenues, as discussed below. However, such
guidelines may require the exercise of certain judgments, estimates and
assumptions.

We
have adopted the requirements of SOP 97-2. Revenue from product sales
(which include software) is recognized, in accordance with SOP 97-2, Software
Revenue Recognition, upon delivery to customers and when the following
criteria are met: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred; (3) the vendors fee is fixed or determinable and (4)
collectibility is probable. We include post contract customer support, or
PCS, within the price of the product sale. This PCS is for a one-year
period and includes a standard product warranty and upgrades and enhancements
to correct minor bugs or errors in the software. The cost of providing
the PCS is insignificant and the warranty and bug fixes have been
infrequent. Therefore, the PCS revenue is recognized upon delivery of the
product in accordance with SOP 97-2.

In
certain cases, when the sale contract includes provisions under which the
customers acceptance is conditioned upon our compliance with performance
guarantees, we recognize revenue when we have demonstrated that the criteria
specified in the provisions have been satisfied.

Service
revenues from product maintenance contracts and separately priced extended
warranty contracts are recognized ratably over the contract period.

Long-term
contracts are those requiring design, development, engineering and modification
and are of a significantly longer duration than contracts for system
sales.  Revenue from long-term contracts
is recognized using the percentage of completion method, which is in accordance
with statement of position 81-1 (SOP 81-1). 
The percentage of completion is determined as a ratio of the extent of
the progress toward completion of the contract using an output measure method
made in terms of results achieved and based on time invested and contract
milestones.  In the event that
management anticipates a loss on a particular contract, such anticipated loss
is provided for in full in the period when the loss is first anticipated.

Inventory

Inventories
are stated at the lower of cost or market. As regards to raw materials
(including components), the cost is determined on the moving average
basis. As regards to work in process and finished products: (1) the cost
of raw materials and components is determined on the moving average basis and
(2) labor costs and the cost of overhead components are determined on the basis
of actual manufacturing costs. We evaluate inventory value in connection
with damaged, obsolete, excess and slow-moving inventory based on inventory
aging reports and specific identification. If actual market conditions are less
favorable than those projected by us or if there is no future demand for part
or all of our inventories, we will need to write off the affected inventories.
This would result in an increase in our operating expenses. For example, in the
first half of 2004, we recorded an inventory write off of approximately $915
thousand in connection with inventory that became obsolete or that we estimate
that we will not be able to sell.



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Allowance
for Doubtful Debts

Our
financial statements include an allowance, which we believe reflects adequately
the loss inherent in receivables for which collection is in doubt. In
determining the fairness of the allowance, we review and consider information
at hand about debtors financial situation, the volume of their operations,
aging of the balance and evaluation of the security received from them or their
guarantors. At year-end, we used our best estimate to assess the
recoverability of open accounts. If there is a major deterioration in a major
customers credit worthiness or actual defaults are higher than our historical
experience, our estimates of the recoverability of amounts due to us could be
adversely affected. This would result in an increase in our general and
administrative expenses by increasing the allowance for bad and doubtful debts
and would decrease the amount of our trade receivables.

Goodwill and other intangible assets

We
adopted SFAS No. 142 requirements regarding goodwill and other intangible
assets with indefinite useful lives. In 2002 an independent expert examined the
value of the reporting unit to which the goodwill was attributed. We
concluded that, in accordance with SFAS No. 142, there was no impairment in the
value of the goodwill.

In
June 2003 and 2004, due to significant reduction in our revenues, it was
determined that goodwill had been impaired. 
We obtained an independent appraisal to assess whether goodwill carried
on the books needed to be written down.

The
independent appraisal was conducted in accordance with paragraphs 19-22 of SFAS
142, which requires a two-step analysis. 
The first step used the discounted cash flow approach to measure the
fair value of our reporting unit, the result of which
indicated that the carrying amount of such reporting unit, including goodwill,
exceeded its fair value.  The second
step was then conducted in order to measure the amount of impairment loss, by
means of a comparison between the implied fair value of the goodwill and the
carrying amount of the goodwill.  In the
second step, the appraisal assigned the fair value of our reporting unit, as determined in the first step, to the reporting units
individual assets and liabilities.  The
excess of the fair value of the reporting unit over the amounts assigned to its
assets and liabilities represented the implied fair value of the goodwill.  In the second step, the appraisal assigned
the fair value of our reporting unit, as determined
in the first step, to the reporting units individual assets and liabilities.  The excess of the fair value of the reporting
unit over the amounts assigned to its assets and liabilities represented the
amount of the implied fair value of the goodwill.

We
impaired the goodwill to its fair value by $2.2 million and $6.0 million as at
June 30, 2004 and 2003, respectively.

We
believe that there is currently no need for additional analysis. However,
if our estimates regarding future revenues, operating expenses or other
assumptions made in order to determine the fair value of the reporting unit to
which goodwill was attributed, need to be adjusted, the fair value estimation
of the reporting unit could be adversely affected. As a result, we may be
required to amortize part or all of the goodwill, which would result in an
increase in our operating expenses.

The
estimated useful life of other purchased technology was changed as of April
2004 from 5 years to 2.5 years.  The
change was based on our managements estimation with regard to the useful life
of this technology and the development of a replacement solution for the year
2006 and beyond.  Therefore, the
amortization period has been adjusted for this change.

Deferred
Taxes

We
account for income taxes under SFAS 109, Accounting for Income Taxes. 
Under SFAS 109, deferred tax assets or liabilities are recognized in respect of
temporary differences between the tax bases of assets and liabilities and their
financial reporting amounts as well as in respect of tax losses and other
deductions which may be deductible for tax purposes in future years, based on
tax rates applicable to the periods in which such deferred taxes will be
realized. Deferred tax assets for future tax benefits from realization,
are included in the balance sheets, when, in our estimation, their realization
is more likely than not. At December 31, 2003, we estimated that deferred
taxes could be utilized against the gain on the sale of our government
surveillance business. However, after further consideration we have revised our
estimations, and currently believe that no deferred tax can be utilized against
the gain on the sale of the government surveillance business.  Therefore the balance of 2003s deferred tax
was expensed to the statement of profit and loss.



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Valuation
allowances are established when necessary to reduce deferred tax assets to the
amount expected to be realized. We have decided not to recognize deferred
tax benefits based on our expectation that future taxable earnings will not be
achieved. A valuation allowance has been made for certain of our deferred
tax assets and those of our subsidiary companies, where we believe that it is
more likely than not that a portion of the deferred tax assets will not be
realized. We have made a valuation allowance, as we are uncertain as to whether loss
carry forwards will be utilizable in the foreseeable future.

Impairment
of long-lived assets and assets to be disposed of

We
have investments in tangible and intangible long-lived assets. Changes in
technology or changes in our intended of these assets may cause the value of
these assets to change.

We
account for long-lived assets under the provisions of FAS No. 144, Accounting for
the Impairment or Disposal of Long-Lived Assets. SFAS 144 addresses financial
accounting and reporting for the impairment or disposal of long-lived assets.
SFAS 144 requires that long-lived assets be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an
asset may not be recoverable. Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset to future net cash
flows expected to be generated by the asset. If the carrying amount of an asset
exceeds its estimated future cash flows, an impairment charge is recognized by
the amount by which the carrying amount of the asset exceeds the fair value of
the asset. SFAS 144 requires companies to separately report discontinued
operations and extends that reporting to a component of an entity that either
has been disposed of (by sale, abandonment, or in a distribution to owners) or
is classified as held for sale. See also Note 19 to our consolidated
financial statements.

Our Functional Currency

Our
consolidated financial statements are prepared in dollars in accordance with
U.S. generally accepted accounting principles. The currency of the
primary economic environment in which we operate is the U.S. dollar. 
Transactions and balances denominated in dollars are presented at their
original amounts. Non-dollar transactions and balances have been
translated into dollars in accordance with the principles set forth in
Statement No. 52 of the Financial Accounting Standards Board (FASB) of the
United States. All exchange gains and losses from translation of monetary
balance sheet items denominated in non-dollar currencies are reflected in the
income statement when they arise. These exchange gains and losses are included
in the same income statement items in which the related transactions are
included.

B.           Liquidity
and Capital Resources

As
of December 31, 2004, we had $34.4 million in cash and cash equivalents,
compared to $28.0 million in cash and cash equivalents as of December 31, 2003.
As of December 31, 2004, we had $4.0 million in short-term deposits and
marketable securities and $10.8 million in long-term marketable securities.

A significant
part of our capital resources as of December 31, 2004 was comprised of $35
million of proceeds from the sale of our government business to Verint Systems.
However, during the second half of 2004 our cash burn was significantly
decreased and in the first quarter of 2005, we generated a positive cash flow.

Net
Cash Provided by/Used in Operating Activities.  Net cash used in our
operating activities was approximately $21.6 million in 2004. Cash used in
operations for 2004 was primarily attributable to net loss of $13.5 million
plus a decrease in trade payables and other payables and accrued liabilities,
which was offset by a decrease in trade receivables. The decrease in
trade and other payables was primarily attributable to our slight decrease in
activity and employee layoffs during 2004. The decrease in trade receivables
was primarily attributable to a decrease in revenues recorded during 2004 and
an increase in the net balance of provision for doubtful debts from $14.6
million in 2003 to $19.2 million in 2004.

Net
cash used in our operating activities in 2003 was approximately $14.3 million,
compared with net cash provided by operating activities in 2002 of $13.3
million. Cash used in operations for 2003 was primarily attributable to
net loss of $40.7 million plus a decrease in trade payables and other payables
and accrued liabilities which was offset by a decrease in other receivables and
trade receivables.   The decrease
in trade receivables was primarily attributable to a decrease in revenues
recorded during 2003 and an increase in the net of provision for doubtful debts
from $5.8 million in 2002 to $14.6 million in 2003.



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From
time to time, we sell trade accounts receivable to unaffiliated financial
institutions. During 2004 we sold trade account receivables aggregating
$2.8 million. Our ability to sell such receivables to these financial
institutions on current terms and conditions is uncertain and is dependent on
the creditworthiness of the customers involved, the credit risks in the
specific countries concerned and the institutions policies from time to time.

Capital
Expenditures.Our capital expenditures were $1.0 million in 2004, $1.8
million in 2003 and $ 2.1 million in 2002. Our capital expenditures in
each of these periods related primarily to the purchase of testing and computer
equipment. In addition, we invested $0.9 million and $0.3 million for
rights to technology in 2003 and 2002, respectively.

We
invest in capital expenditures pursuant to the requirements applicable to our
approved enterprise programs. At December 31, 2004, in order to comply
with current approved programs, $0.2 million remains to be invested. 
These programs provide us with tax benefits in the future.

Net
Cash Provided by/Used in Financing Activities.Our financing activities
provided $161,000 in 2004 and $169,000 in 2003, primarily due to the issuance
of our ordinary shares to employees upon the exercise of share
options.

Bank
Credit.In September 2002, we entered into an arrangement with an Israeli
bank which supplies us with various credit facilities and/or banking services,
such as bank guarantees to our customers to guarantee our contractual
obligations to such customers. As of December 31, 2004, outstanding bank guarantees
totaled approximately $1.9 million.  In
connection with this arrangement, we executed a negative pledge in favor of the
bank, in which we undertook not to perform the following without the banks
prior written consent:

| |   |                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------
| |  | mortgage, or
  undertake to mortgage, in any manner or form, any of our assets; or                                    
| |  | sell assets
  (other than in the ordinary course of business) the value of which exceed $1
  million in the aggregate.

In
addition, from time to time other banks make credit available to us in the form
of bonds to secure our obligations to our customers or in connection with
hedging transactions.

We
believe our cash and cash equivalents reserve will be sufficient to meet our
anticipated cash needs for working capital and capital expenditures for the
next twelve months. However, if we carry out acquisitions of other
companies or new technologies by paying cash, there may be a need to raise
additional capital by issuing debt or equity during the year.

Impact of Related Party Transactions

We
have entered into several agreements with ECI. Of these agreements, only
the agreement for the supply of certain components by ECI is material to our
operations.   We reviewed the pricing of the agreements and believed
that they were not less favorable to us than could have been obtained from
unaffiliated third parties. Please see Item 7  Major Shareholders and
Related Party Transactions for information on our relationship with ECI.

Corporate Tax Rate

Generally,
Israeli companies are subject to corporate tax at the rate of 34% on taxable
income and are subject to capital gains tax at a rate of 25% on capital gains
(other than gains derived from the sale of listed securities that are taxed at
the prevailing corporate tax rates) derived after January 1, 2003.  The
corporate tax rate was reduced in June 2004, from 36% to 35% for the
2004 tax year, 34% for the 2005 tax year, 32% for the 2006 tax year and 30% for
the 2007 tax year and thereafter.  However, the effective tax rate payable by a
company that derives income from an approved enterprise (as discussed below)
may be considerably less.

Our
manufacturing facilities in Petah Tikva have been granted approved enterprise
status under the Law for the Encouragement of Capital Investments, 1959. 
Consequently, these facilities are eligible for tax benefits. We have
derived, and expect to continue to derive, a substantial portion of our income
from our approved enterprise facilities. Subject to compliance with applicable
requirements, the income derived from our approved enterprise facilities will
be subject through 2016 to a reduced tax rate of a maximum of 25%. The
actual tax rate will depend upon the percentage of non-Israeli holders of our
share capital. Based on our information as to share ownership as at
December 31, 2004, our tax rate for 2004 applicable to our taxable income
derived from approved enterprises was 20%. 
However, according to the Law for the Encouragement of Capital
Investments, the tax benefits of the law require us to invest in qualifying
assets.  To the extent that we invest in
non-qualifying assets, we would not be entitled to the tax benefits under the
law for a portion of our taxable income reflecting the ratio of our qualifying
to non-qualifying assets.



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In
2001, we acquired technology from a wholly owned subsidiary and applied to have
this asset recognized as a qualifying asset under our investment program. As of
the date of this report, we have yet to receive an official response. See Item
10E  Taxation below and Note 12 to our consolidated financial statementsfor
more information on our income taxes.

The
above benefits are conditioned upon our fulfillment of conditions stipulated by
the Law for the Encouragement of Capital Investments, the regulations
promulgated thereunder and the instruments of approval for the specific
investments in approved enterprises. If we fail to comply with these
conditions, our benefits may be canceled and we may be required to refund the
amount of the benefits received, in whole or in part.

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

The
dollar cost of our operations is influenced by the extent to which any increase
in the rate of inflation in Israel is offset by the devaluation of the NIS in
relation to the U.S. dollar. Inflation in Israel will cause contracts
under which we are to receive payment in dollars or dollar-linked NIS, while
incurring expenses in NIS linked to the Israeli consumer price index, to be
less profitable, unless such inflation is offset by a devaluation of the NIS.

Most
of our sales are denominated in dollars or are dollar linked. However, a
significant portion of our expenses, primarily expenses associated with
employee compensation, is denominated in NIS unlinked to the dollar. A
devaluation of the NIS in relation to the dollar has the effect of decreasing
the dollar value of any asset of ours which consists of NIS or receivables
payable in NIS, unless such receivables are linked to the dollar. Such a
devaluation also has the effect of reducing the dollar amount of any of our
expenses or liabilities which are payable in NIS, unless such expenses or
payables are linked to the dollar. Conversely, any increase in the value
of the NIS in relation to the dollar has the effect of increasing the dollar
value of any of our unlinked NIS assets and the dollar amounts of any of our
unlinked NIS liabilities and expenses.

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

|                        |  |                            |   |                            |      |                                               |  |      |   | 
|----------------------- |  | -------------------------- | - | -------------------------- | ---- | --------------------------------------------- |  | ---- | - | 
|Year Ended December 31, |  | Israeli
  Inflation
  Rate |   | Israeli
  Devaluation Rate |      | Israel Inflation
  Adjusted for
  Devaluation | 
|                        |  |                            |   |                            |      |                                               | 
|                        |  |                            |   |                            |      |                                               |  |      |   | 
|1998                    |  | 8.6                        |   |                            | 17.6 |                                               |  | (9.0 | ) | 
|1999                    |  | 1.3                        |   |                            | (0.2 | )                                             |  | 1.5  |   | 
|2000                    |  | 0.0                        |   |                            | (2.7 | )                                             |  | 2.7  |   | 
|2001                    |  | 1.4                        |   |                            | 9.3  |                                               |  | (7.8 | ) | 
|2002                    |  | 6.5                        |   |                            | 7.3  |                                               |  | (0.8 | ) | 
|2003                    |  | (1.9                       | ) |                            | (7.6 | )                                             |  | 5.7  |   | 
|2004                    |  | (1.2                       | ) |                            | (1.6 | )                                             |  | (2.8 | ) | 

Because
exchange rates between the NIS and the dollar fluctuate continuously, albeit
with a historically declining trend in the value of the NIS, exchange rate
fluctuations and especially larger periodic devaluations will have an impact on
our profitability and period-to-period comparisons of our results. The effects
of foreign currency re-measurements are reported in our consolidated financial
statements. We believe that inflation in Israel and exchange rate fluctuations
between the NIS and the dollar have not had a material effect on our results of
operations.

Market Risk

For
information on our market risk, see Item 11  Quantitative and Qualitative
Disclosures About Market Risk.



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C.        Research and
Development, Patents and Licenses

In
order to accommodate the rapidly changing needs of our markets, we place
considerable emphasis on research and development projects designed to improve
our existing product lines and to develop new product lines to meet the
changing needs of our market. Our research and development expenses, net
were $5.4 million for the year ended December 31, 2004, $10.0 million for the
year ended December 31, 2003 and $9.2 million for the year ended December 31,
2002.  As of March 31, 2005, 22 of our
employees were engaged primarily in research and development activities. We
expect that we will continue to commit substantial resources to research and
development in the future.

Grants from the Office of the Chief Scientist

From
time to time we receive grants under programs of the Office of the Chief
Scientist of the Ministry of Industry, Trade and Labor of the Government of
Israel. We recorded grant participations from the Office of the Chief
Scientist totaling $0.9 million in 2002, $0.8 million in 2003 and $1.4 million
in 2004. Pursuant to the terms of these grants we are obligated to pay
royalties of 3.5% of revenues derived from sales of products funded with these
grants. As of December 31, 2004, our contingent liability to the Office of the
Chief Scientist in respect of grants received was approximately $3.3
million.

This
governmental support is conditioned upon our ability to comply with certain
applicable requirements and conditions specified in the Chief Scientists
program and with the provisions of the Law for the Encouragement of Research
and Development in the Industry, 1984, and the regulations promulgated
thereunder, or the Research and Development Law.

Under
the Research and Development Law, research and development programs that meet
specified criteria and are approved by the research committee of the Office of
the Chief Scientist are eligible for grants of up to 50% of certain approved
expenditures of such programs, as determined by said committee.

In
exchange, the recipient of such grants is required to pay the Office of the
Chief Scientist royalties from the revenues derived from products incorporating
know-how developed within the framework of each such program or derived
therefrom (including ancillary services in connection therewith), up to an
aggregate of 100% of the dollar-linked value of the total grants received in
respect of such program, plus interest, or up to 150% thereof in the case of
some of our earliest programs.

The
State of Israel does not own proprietary rights in technology developed with
OCS funding and there is no restriction on the export of products manufactured
using technology developed with OCS funding. 
The technology is, however, subject to transfer restrictions, as
described below.  These restrictions may
impair our ability to sell our technology assets or to outsource manufacturing
and the restrictions continue to apply even after we have paid the full amount
of royalties payable for the grants.  In
addition, the restrictions may impair our ability to consummate a merger or
similar transaction in which the surviving entity is not an Israeli company.

The
transfer to a non-Israeli entity of technology developed with OCS funding,
including pursuant to a merger or similar transaction, and the transfer of
rights related to the manufacture of more than ten percent of a product
developed with OCS funding are subject to approval by an OCS committee and to
the following conditions:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Transfer of
Technology. If the committee approves the transfer of OCS-backed technology,
such a transfer would be subject to the payment to the OCS of a portion of
the consideration we receive for such technology.  The amount payable would be a fraction of the consideration
equal to the relative amount invested by the OCS in the development of such
technology compared to our total investment in the technology, but in no
event less than the amount of the grant. However, in the event that in
consideration for our transfer of technology out of Israel we receive
technology from a non-Israeli entity for use in Israel, we would not be
required to make payments to the OCS if the approval committee finds that
such transfer of non-Israeli technology would significantly increase the
future return to the OCS.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Transfer of
Manufacturing Rights. The committee is authorized to approve transfers of
manufacturing rights only if the transfer is conditioned upon either (1)
payment of increased aggregate royalties, ranging from 120% to 300% of the
amount of the grant plus interest, depending on the percentage of foreign
manufacture or (2) a transfer of manufacturing rights into Israel of another
product of similar or more advanced technology.                                                                                                                                                                                                                                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |  | Merger or
Acquisition. If the committee approves a merger or similar transaction in
which the surviving entity is not an Israeli company, such a transaction
would be subject to the payment to the OCS of a portion of the consideration
paid.  The amount payable would be a
fraction of the consideration equal to the relative amount invested by the
OCS in the development of such technology compared to the total investment in
the company, net of financial assets that the company has at the time of the
transaction, but in no event less than the amount of the grant.                                                                                                                                                                                                                                                     

In the event
that the committee believes that the consideration to be paid in a transaction
requiring payment to the OCS pursuant to the provisions of the law described
above does not reflect the true value of the technology or the company being
acquired, it may determine an alternate value to be used as the basis for
calculating the requisite payments.



38

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

The
funds available for Office of the Chief Scientist grants out of the annual
budget of the State of Israel were reduced in 1998 and again in 2004, and the
Israeli authorities have indicated in the past that the government may further
reduce or abolish Office of the Chief Scientist grants in the future. 
Even if these grants are maintained, we cannot presently predict what would be
the amounts of future grants, if any, that we might receive.

D.        Trend
Information

Beginning
in late 2000 and continuing into 2003, the deterioration of the global economy
in general and economic uncertainty in the telecommunications market in
particular resulted in a decline of capital investment by telecommunications
service providers This decline in capital expenditures significantly reduced
our sales and also resulted in pressure on the prices we charge for our
products. Recovery of the telecommunication market was evident in
2004.  However, of the two principal
markets in which we compete, (a) the fraud prevention solution market remained
highly competitive with revenue levels still not rising to their pre-crisis
levels and (b) the revenue assurance market is still developing and fragmented,
consisting of quite a few smaller sized participants and lacking major software
vendors.

New
technologies, such as VoIP, are facilitating the use of cheaper
communications media by some telecom service providers. Such service
providers may be less inclined to invest in high-end solutions like
ours. Moreover, since these technologies enable the service providers to
offer relatively low calling rates to subscribers, this may reduce the
incentive to commit telecom fraud and thereby reduce the demand for anti-fraud
solutions like ours. This trend may harm our revenues and results of
operations.

E.        Off-Balance
Sheet Arrangements

We
have no off-balance sheet arrangements.

F.        Tabular
Disclosure of Contractual Obligations

The
following table sets forth, as of December 31, 2004, our known contractual
obligations by type of obligation and for the periods indicated:

| |                                                         |  |                                        |       |                     |   |             |  |           |       |                     |   |     |  |  |   | 
| | ------------------------------------------------------- |  | -------------------------------------- | ----- | ------------------- | - | ----------- |  | --------- | ----- | ------------------- | - | --- |  |  | - | 
| |                                                         |  | Payments due by period  (in thousands) |      
| | Contractual
  Obligations                               |  | Total                                  |       | Less than 
  1 year |   | 1-3
  years |  | 3-5 years |       | More than
  5 years |  
| |                                                         |  |                                        |       |                     |   |             |  |           |       |                     |  
| |                                                         |  |                                        |       |                     |   |             |  |           |       |                     |   |     |  |  |   | 
| | Operating
  lease obligations (vehicles and facilities) |  | $                                      | 2,969 |                     | $ | 1,188       |  | $         | 1,361 |                     | $ | 420 |  |  | - | 
| |                                                         |  |                                        |       |                     |   |             |  |           |       |                     |   |     |  |  |   | 
| | Total                                                   |  | $                                      | 2,969 |                     |   | 1,188       |  | $         | 1,361 |                     | $ | 420 |  |  | - | 



39

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As to our
royalty obligations and outstanding guarantees as at December 31, 2004, see
Note 10 to our consolidated financial statements included elsewhere in this
annual report.

Item 6.
Directors, Senior Management and Employees.

A.        Directors
and Senior Management

The
following table sets forth information with respect to our directors and senior
managers:

|                                 |     |  |                                                               
|-------------------------------- | --- |  | --------------------------------------------------------------
|Name                             | Age |  | Position                                                      
|                                 |     |  |                                                               
|Eitan Naor                       | 42  |  | President, Chief
  Executive Officer and Director             
|Ron Fainaro                      | 37  |  | Senior Vice
  President and Chief Financial Officer           
|Itzik
  Weinstein                | 46  |  | Senior Vice
  President for Professional Services & Operations
|Bruno
  Escojido                 | 39  |  | Senior Vice
  President, Worldwide Sales                      
|Nancy Yavne                      | 51  |  | Senior Vice
  President, R&D                                  
|Itzik Dvir                       | 39  |  | Vice
  president, CTO                                         
|Noam Kimmel                      | 45  |  | Vice
  President, Management Resources                        
|Hadar
  Solomon                  | 48  |  | Vice
  President, General Counsel and Corporate Secretary     
|Harel
  Beit-On (1) (3)          | 45  |  | Chairman of
  the Board of Directors                          
|Prof. Gil
  Epstein (1) (2)  (3) | 40  |  | Director                                                      
|Giora Bitan
  (1) (3)            | 51  |  | Director                                                      
|Rami Entin
  (2) (3)             | 53  |  | Director                                                      
|Talia Livni
  (1) (2) (3)        | 62  |  | Director                                                      

|                                          
|------------------------------------------
|                                          
|(1) Member
  of the compensation committee
|(2) Member
  of the audit committee       
|(3) Member
  of the investment committee  

Eitan
Naor has served as our President and Chief Executive Officer since February
2004 and as a director since June 2004. Prior thereto, he worked at Amdocs
Limited, where he served as Division President, OSS & Order Management
Systems, from 2002 to 2004 and as Vice President, Customer Care and Billing
from 1999 to 2002. From 1996 to 1999, Mr. Naor served as Vice President, Oracle
Applications at Oracle Israel and from 1993 to 1996 he served as Head of
Professional Services at Hewlett Packard Israel. Mr. Naor holds a B.A. degree
in Economics from the Tel-Aviv University and an M.B.A. in Strategic Management
from the Hebrew University in Jerusalem.

Ron
Fainaro has served as our Senior Vice President and Chief Financial Officer
since June 1, 2005.  Mr. Fainaro
replaced Mr. Avi Goldstein, who served as our Senior Vice President and Chief
Financial Officer since September 2001 and left our company to pursue other
business opportunities.  Prior to
joining us, Mr. Fainaro served as CFO and Vice President of the American
operations of Tecnomatix Technologies Ltd., a global software company.  Prior to his position at Tecnomatix, Mr.
Fainaro served as the CFO of Lucent Technologies (Waveaccess), a former division
of Lucent Technologies and as the CFO of Habas Group. Mr. Fainaro is a
certified public accountant.  He holds a
B.A in Accounting from Tel-Aviv University and a B.Sc in Physics and Materials
Engineering from the Technion - Israels Institute of Technology, both with
honors.

Itzik
Weinstein has served as our Senior Vice President for Professional Services
& Operations since July 2004. Prior to that he was Vice President -
Customer Services and Product Management at VocalTec since the year 2000. Prior
to this position, Mr. Weinstein served as Engineering Site Manager at NetManage
since the year 1999, and Software Engineering Manager of KLA-Tencor Corporations
optical metrology division since the year 1995. Mr. Weinstein holds an MBA from
the Kellogg-Recanati Executive MBA Program of Tel Aviv University and a B.Sc.
in Computer Engineering from the Technion - Israel Institute of Technology.



40

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Bruno
Escojido has served as our Senior Vice President of Worldwide Sales since May
2004. From 2001 to April 2004, he led the worldwide sales team of the Order
Management System Division of Amdocs. Prior thereto, he served as Vice
President of Sales at PowerDsine from 1999 to 2001 and led the sales team in
Europe and Asia for the Access Division of ECI from 1995 to 1999. Mr. Escojido
holds a B.Sc. in Electronic Engineering from the Jerusalem College of
Technology.

Nancy
Yavne has served as our Senior Vice President of R&D since December 2004.
From 1997 to November 2004, she founded and led the Sun Microsystems
Israel Development Center. Prior thereto, she served as Group Development
Manager at Comverse from 1995 to 1996 and was Director of Programming
Environments with Sun Microsystems, Inc. based in California from 1988 to 1994.
Ms. Yavne holds a B.S. in Psychology and an M.Sc. in Computer Science from
the University of California, Los Angeles.

Yitzik
Dvir has served as our Chief Technology Officer since December, 2004, and prior
thereto he was our Vice President of Projects and R&D since October
2003. From 1999 to September 2003, Mr. Dvir served as our Director of
Customer Projects. Prior to joining ECtel, Mr. Dvir served as Technical
Director in RAD WIN from 1998 to 1999 and as Manager of Projects Group in ECI
from 1993 to 1996. He holds a B.Sc. in Electronic Engineering from Tel Aviv
University.

Noam
Kimmel has served as our Vice-President, Management Resources since October
2002. Mr. Kimmel is a veteran of the Israeli Defense Forces, where he
served in various positions relating to human and management resources from
1978 to 2002. His last position was head of the human resource division
of the Intelligence Corp. Mr. Kimmel retired from the IDF as a colonel in
2002. Mr. Kimmel holds a B.Sc. in Mathematics and Computer Science from
Tel-Aviv University and an M.B.A. from Beer Sheva University.

Hadar
Solomon joined us in March 2003 and has served as Vice President and General
Counsel since May 2003. From February 2002 until March 2003, he was
Managing Director of Lumenis Luxembourg Sarl, Schaffhausen Branch. Prior
to that, Mr. Solomon served as Executive Vice President, General Counsel and
Corporate Secretary of Lumenis Ltd. and as Vice President, Corporate Affairs,
General Counsel and Secretary of Laser Industries Ltd. since May 1988. 
Mr. Solomon is a Graduate of the Faculty of Law of the Hebrew University of
Jerusalem and is a member of the Israeli Bar.

Harel
Beit-On has served as Chairman of our Board of Directors since June 21, 2004.
Mr. Beit-On served as Chairman of the Board of Directors of Tecnomatix
Technologies Ltd. from December 2001 and as a Director from 1999 until the
acquisition of Tecnomatix in March 2005 by UGS Corp. From 1996 until February
2004 Mr. Beit-On served as the Chief Executive Officer of Tecnomatix. Mr.
Beit-On also served as the President of Tecnomatix from 1995 until October
2002. From 1994 to 1996, Mr. Beit-On served as Chief Operating Officer of
Tecnomatix. Between 1991 and 1994, Mr. Beit-On served as Executive Vice
President of Sales and Engineering of Tecnomatix. From 1988 to 1991, Mr.
Beit-On served as President of Tecnomatixs United States Sales and Support
subsidiary. From 1985 to 1988, Mr. Beit-On served in various marketing
positions with Tecnomatix. Mr. Beit-On holds a B.A. degree in Economics from
the Hebrew University and an M.B.A. degree from MIT.

Professor
Gil Epstein has served as one of our directors since June 2000. Prof.
Epstein has been a member of the Department of Economics at Bar-Ilan University
since 1996 and is currently Vice-Chairman of the Department.   Prior
to that, he was a visiting lecturer at the University of Pennsylvania
(Department of Economics). Prior to that, Prof. Epstein was a lecturer in
the Department of Economics and Department of Statistics at the Hebrew University
in Jerusalem. Prof. Epstein holds a B.A., M.A. and Ph.D. in Economics and
Statistics from the Hebrew University of Jerusalem.

Giora
Bitan has served as one of our directors since October 2002. Mr. Bitan
has served as Executive Vice President and Chief Financial Officer of ECI since
joining ECI in August 2002. From 1997 to 2002, Mr. Bitan was a general
partner at Giza Venture Capital, where he focused on investments in the
communications and software sectors. From 1982 until 1996, he served in
senior management positions in Scitex Corporation Ltd., nine years of which he
served as Executive Vice President and CFO. Mr. Bitan holds an MBA from
the University of California at Los Angeles and a BA in Economics and
International Relations from the Hebrew University in Jerusalem.

Rami
Entin has served as one of our directors since June 2004.  From 2001 until 2003, Mr. Entin was the
chairman of the Hashavim Group, a data center for direct taxation and
employment laws and a processor of wages and personnel data. From 1999 until
2001, Mr. Entin was Co-Chief Executive Officer and a director of Hilan-Tech
Ltd., where he was in charge of financial, personnel, sales and marketing and
Lotus Notes operations. From 1985 until 1999 he was financial manager and a
director of Hilan Ltd., where he was in charge of financial and personnel
operations. From 1981 until 1985, Mr. Entin worked for Kesselman &
Kesselman, an accounting firm, where he served various publicly traded
companies engaged in the services and industry fields. Mr. Entin is a director
of Maccabee-Dent, which is engaged in the management and operation of dental
clinics, and is an external director of Solomon Holdings Ltd., an Israeli
publicly traded construction company. Mr. Entin holds a B.A. degree in
accounting and economics and an M.B.A. degree from the Tel Aviv University, and
is a certified accountant in Israel. He is also a graduate of the Advanced
Management Program at Harvard University.



41

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Talia
Livni has served as one of our directors since June 2004.  Since 2002, Ms. Livni has served as president
of Naamat  The Movement for the Advancement of Status of Women. From 1997
until 2001, she served as the legal advisor of the Israeli General Federation
of Labor. From 1992 until 1997, she served as Head of the Human Resources
Division of the Israeli Ministry of Defense. From 1975 until 1992, Ms. Livni
served as Senior Deputy Legal Advisor to the Israeli Ministry of Defense. From
1973 until 1975, Ms. Livni served as Legal Adviser to RAFAEL Israel Armament
Development Authority Ltd. Ms. Livni also served as an external director of
Tecnomatix from August 2000 until its acquisition by UGS Corp. in March 2005.

There
are no family relationships between any director or senior
manager.

B.        Compensation

The
aggregate direct remuneration paid during 2004 to executive officers and
directors as a group (12 persons ), as well as remuneration paid to former
executives in connection with their termination, was approximately $4.5
million. This amount also included payments made to Mr. Avi Goldstein, our
former Senior Vice President and Chief Financial Officer, during 2004. 
This does not include amounts expended by us 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 by companies in Israel. Employee directors do not
receive additional fees for their services as directors, and our other
directors do not receive any fees except as described below.

Our
board of directors granted options to executive officers to purchase an
aggregate of 580,000 ordinary shares, at an exercise price ranging $2.813.56
per share, during 2004. The exercise price was equal to the fair market
value of our ordinary shares on the date of grant. These options vesting
is spread over various periods commencing on various dates from May 2004 and
ending December 2008, unless terminated sooner in accordance with their terms.

C.        Board
Practices

Board of Directors

According
to the Companies Law and our articles of association, the management of our
business is vested in our board of directors. The board of directors may
exercise all powers and may take all actions that are not specifically granted
to our shareholders. As part of its powers, our board of directors may
cause us to borrow or secure payment of any sum or sums of money for our
purposes, at times and upon terms and conditions as it thinks fit, including
the grant of security interests in all or any part of our property.

Our
directors are elected at annual meetings of our shareholders. Except for
outside directors, our directors hold office until the next annual meeting of
shareholders following the annual meeting at which they were appointed, which
is required to be held at least once during every calendar year and not more
than fifteen months after the last preceding meeting. Directors may be
removed earlier from office by resolution passed at a general meeting of our
shareholders. Our board of directors may temporarily fill vacancies in
the board until the next annual meeting of shareholders.

There
are no arrangements or understandings between us and any of our directors for
benefits upon termination of service, except that the vesting date of the
options held by directors may accelerate upon termination in certain
circumstances.

Audit Committee

Nasdaq
Requirements

Our
ordinary shares are listed for quotation on the Nasdaq National Market and we
are subject to the rules of Nasdaq applicable to listed companies. 
Pursuant to the current listing requirements of the Nasdaq National Market, we
are required to have at least three independent directors on our audit
committee.  We have appointed such audit
committee. Pursuant to the Sarbanes-Oxley Act of 2002, the Nasdaq National
Market has introduced new listing standards requiring all members of an audit
committee to comply with tightened independence requirements.  All members of our audit committee currently
comply with those requirements.



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We
have adopted an audit committee charter, which sets forth the powers and responsibilities
of our audit committee. Our audit committee assists the board in
fulfilling its responsibility for oversight of the quality and integrity of our
accounting, auditing and financial reporting practices and financial statements
and the independence qualifications and performance of our independent
auditors. Our audit committee also has the authority and responsibility
to oversee our independent auditors, to recommend for shareholder approval the
appointment and, where appropriate, replacement of our independent auditors and
to pre-approve audit engagement fees and all permitted non-audit services and
fees.

Our
board of directors has resolved to authorize our audit committee to serve as
our qualified legal compliance committee. As such, our audit committee will be
responsible for investigating reports, made by attorneys appearing and
practicing before the SEC in representing us, of perceived material violations
of U.S. federal or state securities laws, breaches of fiduciary duty or similar
violations by us or any of our agents.

Companies
Law Requirements

Under
the Companies Law, the board of directors of a public company is required to
appoint an audit committee, which must be comprised of at least three directors
and include all of the outside directors, but may not include:

| |   |                                                                                                  
| | - | -------------------------------------------------------------------------------------------------
| |  | the chairman
  of the board of directors;                                                        
| |   |                                                                                                  
| |  | any
  controlling shareholder or any relative of a controlling shareholder; and                  
| |   |                                                                                                  
| |  | any director
  employed by the company or providing services to the company on a regular
  basis.

The
duty of the audit committee is to identify flaws in the management of the
company s business, including in consultation with the internal auditor and
the companys independent accountants, and to recommend remedial action. 
In addition, the approval of the audit committee is required under the
Companies Law to effect certain related-party transactions.

Outside Directors

Under
the Companies Law, public companies are required to have at least two outside
directors. Our outside directors are Prof. Gil Epstein and Talia Livni.

The
Companies Law provides that a person may not be appointed as an outside
director of a company if the person or the persons relative, partner, employer
or any entity under the persons control has, as of the date of the persons
appointment to serve as an outside director, or had, during the two years
preceding that date any affiliation with:

| |                                  |                                                                         
| | -------------------------------- | ------------------------------------------------------------------------
| |                                 | the company;                                                            
| |                                  |                                                                         
| |                                 | any entity
  controlling the company; or                                
| |                                  |                                                                         
| |                                 | any entity
  controlled by the company or by its controlling entity.    
| |                                  |                                                                         
| | The term
  affiliation includes:
| |                                  |                                                                         
| |                                 | an
  employment relationship;                                           
| |                                  |                                                                         
| |                                 | a business
  or professional relationship maintained on a regular basis;
| |                                  |                                                                         
| |                                 | control; and                                                            
| |                                  |                                                                         
| |                                 | service as
  an office holder.                                          

The
Companies Law defines the term office holder of a company to include a
director, the chief executive officer, the chief business manager, a vice
president and any officer that reports directly to the chief executive officer.



43

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No
person can serve as an outside director if the persons position or other
business creates, or may create conflict of interests with the persons
responsibilities as an outside director or may otherwise interfere with the persons
ability to serve as an outside director. Until the lapse of two years from
termination of office, a company may not engage an outside director to serve as
an office holder and cannot employ or receive services from that person, either
directly or indirectly, including through a corporation controlled by that
person.

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

| |   |                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | at least one
  third of the shares of non-controlling shareholders voted at the meeting vote
  in favor of the election; or                                 
| |   |                                                                                                                                                             
| |  | the total
  number of shares voted against the election of the outside 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 from office 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. If all directors are of the same gender, the next new
outside director elected must be of the other gender.  Each committee of a companys board of directors is required to
include at least one outside director, except for the audit committee, which is
required to include all outside directors. The Companies Law was recently
amended to require that in a public company, in addition to the one outside
director with the financial and accounting expertise (See Outside Directors
section below), such number of directors as will be determined by the board of
directors, shall have financial and accounting expertise. This amendment will
only take effect after the adoption of regulations to define the prerequisites
for meeting these qualifications.

Other Committees

Subject
to the provisions of the Companies Law, our board of directors may delegate its
powers to committees consisting of board members. In addition to our
audit committee, which is described above, our board of directors has also
appointed a compensation committee, which reviews and handles certain
compensation matters, and an investment committee, which reviews and approves
our investment policy.

Internal Auditor

Under
the Companies Law, our board of directors is also required to appoint an
internal auditor proposed by the audit committee. The role of the
internal auditor is to examine, among other things, whether our activities
comply with the law and orderly business procedure. The internal auditor
may not be an interested party or office holder, or a relative of any
interested party or office holder, nor a member or representative of our
independent accounting firm. The Companies Law defines the term interested
party to include a person who holds 5% or more of the companys outstanding
share capital or voting rights, a person who has the right to appoint one or
more directors or the general manager, or any person who serves as a director
or as the general manager.

Mr.
Meir Schweitzer serves as our internal auditor, as well as the internal auditor
of ECI.

Nasdaq Listing Requirements

Recently
adopted Nasdaq rules enable foreign private issuers, such as ourselves, to
comply with the prevalent practice in our jurisdiction of incorporation in
place of certain Nasdaq listing requirements. To the extent that we
choose to do so, we will be required to disclose in our annual reports filed
with the Commission each Nasdaq listing requirement that we do not follow and
describe the home country practice we follow in lieu of such requirement.



44

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D.        Employees

Number. 
The following table describes the number of our employees as of March 31, 2005
and December 31 of each of the indicated years:

|                                                                      |  |  | March 31,
  2005 |  |  | 2004 |  |  | 2003 |  |  | 2002 | 
|--------------------------------------------------------------------- |  |  | ---------------- |  |  | ---- |  |  | ---- |  |  | ---- | 
|Approximate numbers of employees by geographic location:              |  |  |                  |  |  |      |  |  |      |  |  |      | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Israel                                                                |  |  | 119              |  |  | 117  |  |  | 217  |  |  | 251  | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|United
  States                                                       |  |  | 10               |  |  | 12   |  |  | 43   |  |  | 47   | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Europe and
  elsewhere                                                |  |  | 11               |  |  | 14   |  |  | 21   |  |  | 22   | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Total workforce                                                       |  |  | 140              |  |  | 143  |  |  | 281  |  |  | 320  | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Approximate numbers of employees by category of activity:             |  |  |                  |  |  |      |  |  |      |  |  |      | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Management
  and administration                                       |  |  | 22               |  |  | 20   |  |  | 21   |  |  | 23   | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Research and
  development + Testing + Customization                  |  |  | 41               |  |  | 49   |  |  | 117  |  |  | 133  | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Operations                                                            |  |  | 8                |  |  | 8    |  |  | 23   |  |  | 25   | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Sales and
  marketing                                                 |  |  | 26               |  |  | 28   |  |  | 58   |  |  | 68   | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Other
  (project managers, field engineering, customer support, etc.) |  |  | 43               |  |  | 38   |  |  | 62   |  |  | 71   | 
|                                                                      |  |  |                  |  |  |      |  |  |      |  |  |      | 
|Total
  workforce                                                     |  |  | 140              |  |  | 143  |  |  | 281  |  |  | 320  | 

Relationship
with Employees.  Competition for highly-qualified technical and
engineering personnel in the telecommunications industry is intense. We
believe we have been able to attract talented engineering and other technical
personnel. None of our employees are represented by a labor union, and we
have not experienced any work stoppage. We believe our relations with our
employees to be good and that our future success will depend in part on a
continuing ability to hire, assimilate and retain qualified personnel.

Labor
Laws; Pension Funds.  Israeli labor laws and regulations apply to all of
our employees in Israel. The laws principally concern matters such as
paid vacation, paid sick days, length of the workday, payment for overtime and
severance payments upon the retirement or death of an employee or termination
of employment under specified circumstances. The severance payments may
be funded, in whole or in part, through Managers Insurance or a Pension Fund,
as described below. The payments to the Managers Insurance fund or
Pension Fund toward severance amount to 8.3% of wages. Furthermore,
Israeli employees and employers are required to pay predetermined sums to the
National Insurance Institute, which is similar to the U.S. Social Security
Administration. Since January 1, 1995, these amounts also include
payments for health insurance. The payments to the National Insurance
Institute amount to approximately 14.5% of wages, of which the employee
contributes 66% and the employer contributes 34%.

Our
general practice is to contribute funds on behalf of all of our employees to
Managers Insurance or a Pension Fund. Each employee who agrees to
participate in the Managers Insurance plan contributes 5% of his or her base
salary and we contribute 13.3%. Each employee who agrees to participate
in the Pension Fund contributes 5.5% of his or her base salary and we
contribute 14.3%. Another savings plan we offer some of our employees,
although not legally required, is known as the Advanced Studies Fund. 
Each employee who agrees to participate in the Advanced Studies fund
contributes 2.5% of his or her base salary and we contribute 7.5%.

Labor
Unions.  We are a member of the Industrialists Association in Israel, an
employers union. As a result of this membership, a number of collective
bargaining agreements apply to us. These agreements principally concern
cost-of-living wage increases, paid vacation and holidays, length of the
workday, wage tariffs, termination, severance payments and other conditions of
employment. We provide our employees with benefits and working conditions
that are at least as favorable as the conditions specified in the collective
bargaining agreements.



45

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E.        Share
Ownership

Security
Ownership of Our Directors and Executive Officers

Other
than Harel Beit On and Giora Bitan, as of May 31, 2005, none of our directors
or executive officers beneficially owns shares, including options to acquire
our ordinary shares that are vested or vest within 60 days, which represent
more than 1% of our outstanding ordinary shares. Mr. Beit On, in the capacity
of his position as General Partner of Carmel V.C. Ltd., may be deemed to
beneficially own options to purchase 181,153 of our ordinary shares, and Mr.
Bitan, in his capacity as Executive Vice President and Chief Financial Officer
of ECI, may be deemed to beneficially own the 2,890,325 shares of our company
owned by ECI. As of May 31, 2005, our officers and directors as a group
held 2,896,269 of our ordinary shares and options to purchase
additional  1,709,242 of our ordinary
shares. The following table sets forth detailed information about the granted
options, for the periods indicated:

|Grant date |  | Exercise
  price |            | Granted
  amount |  | Vested
  options |  | Non-vested
  options |           |  | Options
  which
  were exercised |        
|---------- |  | ---------------- | ---------- | ---------------- |  | ---------------- |  | -------------------- | --------- |  | -------------------------------- | -------
|2000       |  | $                | 4.66-15.75 |                  |  | 427,850          |  |                      | 320,300   |  |                                  | -      
|2001       |  | $                | 8.82-11.55 |                  |  | 251,000          |  |                      | 221,500   |  |                                  | -      
|2002       |  | $                | 7.90       |                  |  | 127,000          |  |                      | 84,666    |  |                                  | 42,334 
|2003       |  | $                | 4.67       |                  |  | 40,000           |  |                      | 26,664    |  |                                  | 13,336 
|2004       |  | $                | 2.63-3.56  |                  |  | 852,308          |  |                      | 382,580   |  |                                  | 469,728
|2005       |  | $                | 3.64-3.70  |                  |  | 220,000          |  |                      | 10,000    |  |                                  | 210,000
|           |  |                  |            |                  |  |                  |  |                      |           |  |                                  |        
|           |  |                  |            |                  |  | 1,918,518        |  |                      | 1,045,710 |  |                                  | 735,398

All these
options expire ten years after the date of grant unless terminated sooner in
accordance with their terms.

Options to Purchase Our Ordinary Shares

In
1998, our board of directors adopted a share option plan for our
employees. In 1999, our board of directors adopted a share option plan
for our non-employee directors. Terms of the options granted under the
plans, such as length of term, exercise price, vesting and exercisability, are
determined by our board of directors.

In
2003, our board of directors adopted the ECtel Ltd. 2003 Share Option Plan
for our officers, directors and consultants who are Israeli residents. 
Pursuant to the Israeli tax reform (described below under Item 10E  Taxation-Israeli
Taxation), our board of directors resolved to elect the capital gains route.
Accordingly, subject to the fulfillment of certain conditions, gains realized
by Israeli residents from the sale of shares issued upon exercise of options
will be taxed at a rate of only 25% and not at the marginal income tax rate
applicable to the grantee (up to 50%). Also in 2003, our board of
directors adopted the ECtel Ltd. U.S. Employee Stock Option Plan for
residents of the United States to enable eligible grantees to benefit from
favorable U.S. federal income tax treatment of options that qualify as
incentive stock options. These plans were approved by our shareholders
and currently have pools of 1,700,000 shares and 50,000 ordinary shares,
respectively. Terms of the options granted under the plans, such as
length of term, exercise price, vesting and exercisability, are determined by
our board of directors.

In
September 2004, our shareholders resolved to increase the number of Ordinary
Shares underlying our 2003 Share Option Plan from 200,000 Ordinary Shares to
1,700,000 Ordinary Shares and to decreases the number of Ordinary Shares
underlying our other share option plans (other than the 2003 U.S. Stock Option
Plan) by an aggregate of (i) 490,266 Ordinary Shares as of the date of said
resolution and (ii) 437,933 Ordinary Shares underlying the then outstanding
options, which were scheduled to expire within 30 days following the date of
said resolution.

As
of May 31, 2005, options to purchase a total of 3,292,271 of our ordinary
shares were outstanding. As of May 31, 2005, options to purchase an
aggregate of 1,330,190 ordinary shares granted under the plans have been
exercised. During 2005, our board of directors granted options to our
employees, including executive officers, to purchase an aggregate of 220,000
ordinary shares. The exercise price was equal to the fair market value of
our ordinary shares on the date of grant. These options vesting is
spread over various periods commencing on various dates from May 2005 and
ending August 2009  unless terminated
sooner in accordance with their terms.



46

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Item 7.
Major Shareholders and Related Party Transactions

A.        Major
Shareholders

The
following table shows the number of our ordinary shares beneficially owned by
the only shareholders known to us as of March 31, 2005, to beneficially own more than 5% of our outstanding ordinary
shares. As of that date, 18,151,172 of our ordinary shares were
issued and outstanding. In accordance with the rules of the Securities
and Exchange Commission, the number of ordinary shares used in calculating the
percentage for each person listed below includes the shares underlying options
or warrants held by such person that are exercisable within 60 days, but
excludes the shares underlying options or warrants held by any other
person.

|                                       |  | Shares Beneficially Owned
|-------------------------------------- |  | -------------------------
|                                       |  |                          
|Name                                   |  | Number                   
|                                       |  |                          
|                                       |  |                          
|Koor
  Industries Ltd. (1)             |  |                          
|ECI Telecom
  Ltd. (2)                 |  |                          
|FMR Corp.
  (3)                        |  |                          
|Royce &
  Associates, LLC (4)          |  |                          
|Clal
  Electronics Industries Ltd. (5) |  |                          

---

(1) Based upon
a Schedule 13D filed in June 2004. Includes 369,035 ordinary shares and
currently exercisable warrants to purchase 1,000,000 ordinary shares at an
exercise price of $24 per share and 250,000 ordinary shares at an exercise
price of $28 per share, held by Telrad Networks Ltd., which is a subsidiary of
Koor Industries Ltd. Also includes 2,318,417 ordinary shares held by
M.A.G.M. Chemistry Holdings Ltd., which is a subsidiary of Koor Industries
Ltd. M.A.G.M. is a shareholder of ECI and acquired its ECtel shares in
ECIs share distribution in May 2004. Koor Industries Ltd. is an Israeli
corporation whose ordinary shares are traded on the Tel Aviv Stock Exchange and
whose ADRs (American depositary shares) are traded on the New York Stock
Exchange.

(2) 
Based upon a Schedule 13G/A filed in August 2004. We were initially a wholly
owned subsidiary of ECI. After the completion of our initial public offering in
October 1999, ECI owned approximately 74% of our ordinary shares. In March
2002, ECI sold 1,572,175 ordinary shares to institutional investors in a
private placement, which reduced its interest in us to approximately 59%. 
In May 2004, ECI distributed 7,600,000 ordinary shares to its shareholders, of
which 544,054 shares, which were withheld by ECI pursuant to Israeli tax law,
were placed in an irrevocable trust with instructions to sell on the Nasdaq
Stock Market to reimburse the tax payable by ECI to the Israeli government,
subject to the terms of the trust and applicable securities laws. As of
January 31, 2005, 195,321 shares were still held in the trust. The
trustee is the record owner of the withheld shares, and ECI is the sole
beneficiary with respect to the proceeds of the sale of shares held by the
trustee. ECI does not have any voting rights with respect to the shares held in
trust. Mr. Bitan, who serves as our director and also as an officer of ECI, may
be deemed to beneficially own the shares held by ECI by virtue of his position
in ECI. However, he disclaims beneficial ownership of these shares.

(3) Based upon
a Schedule 13D filed with the SEC in February 2004 and subsequent information
provided to us by FMR Corp. on April 14, 2005. FMR Corp. owns Fidelity
Management & Research Company, an investment adviser registered under
Section 203 of the Investment Advisers Act of 1940 that manages various
registered investment companies that own some of our shares. One such
investment company is a shareholder of ECI and acquired ECtel shares in ECIs
share distribution in May 2004. FMR Corp. also owns Fidelity Management
Trust Company, a bank that owns some of our shares. Edward C. Johnson 3rd
and other members of his family are the predominate owners of, and may be
deemed to form a controlling group of, FMR Corp.

(4) Based upon
a Schedule 13D filed with the SEC in February 2004, containing information as
of December 31, 2003.

(5) Clal Electronics Industries
Ltd. (Clal) is a wholly owned subsidiary of Clal Industries & Investments
Ltd. (CII). CII is controlled by IDB Development Corporation Ltd. (IDBD),
which, in turn, is controlled by IDB Holding Corporation (IDBH). Clal
is a shareholder of ECI and acquired its ECtel shares in ECIs share
distribution in May 2004. In addition to Clals holdings, based upon
reports received by us,  various entities within the aforesaid group
beneficially own our shares as a result of ECIs distribution, as
follows:  IDBD (7,015 shares); Badal Securities Ltd. (Badal), a wholly
owned subsidiary of IDBH (7,015 shares); Clal Insurance Enterprises Holdings
Ltd. (Clal Insurance), a majority-owned subsidiary of IDBD (2,926 shares);
and PEC Israel Economic Corporation (PEC), a wholly owned US subsidiary of
Discount Investment Corporation Ltd. (DIC), a company controlled by IDBH
(1,167 shares). CII, IDBD, IDBH, Clal Insurance and DIC are all Israeli
corporations whose shares are publicly traded on The Tel Aviv Stock Exchange.



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Based upon
reports received by us, since May 19, 2003, IDBH is controlled by a group
comprised of: (i) Ganden Investments I.D.B. Ltd. (Ganden), a private
Israeli company controlled by Nochi Dankner (who is the chairman of IDBH, IDBD,
CII and DIC) and his sister Shelly Dankner-Bergman (who is a director of IDBH,
IDBD, CII and DIC), which holds 31.02% of the equity of and voting power in
IDBH; (ii) Manor Investments  IDB Ltd. (Manor), a private Israeli
company controlled by Ruth Manor (whose husband, Isaac Manor, and their son,
Dori Manor, are directors of IDBH, IDBD, CII and DIC), which holds 10.34% of
the equity of and voting power in IDBH; and (iii) Avraham Livnat
Investments (2002) Ltd. (Livnat), a private Israeli company controlled by
Avraham Livnat (whose son, Zvi Livnat, is a director of IDBH, IDBD, CII and
DIC), which holds 10.34% of the equity of and voting power in IDBH. 
Ganden, Manor and Livnat, owning in the aggregate approximately 51.7% of the
equity of and voting power in IDBH, entered into a Shareholders Agreement
relating, among other things, to their joint control of IDBH, the term of which
is until May 19, 2023. In addition, Ms. Bergman owns approximately 4.75%
of the equity and voting power of IDBH.

Based on the
foregoing, IDBH (by reason of its control of IDBD), Ganden, Manor and Livnat
(by reason of their control of IDBH), Mr. Dankner, Ms. Bergman, Ms. Manor and
Mr. A. Livnat (by reason of their control, respectively, of Ganden, Manor and
Livnat) may be deemed to share the power to vote and dispose: (i) with
IDBD (by reason of its control of CII and Clal), CII and Clal, of the ECtel
shares held by Clal; (ii) with Badal, of the ECtel shares held by Badal; (iii)
with IDBD, of the ECtel shares held by IDBD; (iv) with IDBD and Clal Insurance,
of ECtel shares held by Clal Insurance; and (v) with IDBD, DIC and PEC, of the
ECtel shares held by PEC.

Record Holders

As of May 31,
2005, there were 354 holders of record of our ordinary shares. 289 record
holders, holding approximately 12,330,789], or 68%, of our outstanding ordinary
shares, were located in the United States. These numbers are not
representative of the number of beneficial holders of our shares nor is it
representative of where such beneficial holders reside since many of these ordinary
shares were held of record by brokers or other nominees.

There
is currently no trading market for our ordinary shares outside of the United
States.

B.        Related Party Transactions

Commercial Agreements

In
January 2001, we entered into several services agreements, for the purpose of
defining our continuing relationship with ECI. We believe that the cost
of services and other terms of the agreements are no less favorable than those
that we would be able to obtain from independent third parties. We agreed
on the prices and other terms in these agreements in negotiations with ECI
after considering the prices and terms offered by other providers of similar
services.

Services
Arrangements

The
various services arrangements with ECI call for ECI to provide us with the
following services:

| |   |                                                                                                 
| | - | ------------------------------------------------------------------------------------------------
| |  | intellectual
  property management assistance;                                                  
| |   |                                                                                                 
| |  | communications
  services;                                                                      
| |   |                                                                                                 
| |  | Internal
  audit services;                                                                      
| |   |                                                                                                 
| |  | other
  miscellaneous services, such as Security and limited human resources related
  services.

For
performance of each service we pay ECI amounts we agreed on, some of which are
based on our actual use of ECIs facilities or estimations of the cost of the
services based on the ratio of the total number of our employees to the total
number of ECIs employees in the companies facilities in Petah Tikva.



48

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We
believe that if ECI were to terminate any of these services arrangements, we
would be able to obtain the same services from a third party on terms no less
favorable than those currently contained in our agreements with ECI.

We
entered into an administrative services arrangement with ECI Telecom GmbH,
effective October 1, 2002, for the provision of various administrative
services, including the sub-lease of office space. The term of this
agreement was for an initial period of one year and was automatically renewed
for an additional period of one year.

Supply
Agreement

In
February 2004, we executed a new supply agreement with ECI, which replaced an
earlier supply agreement entered into in October 1999. Under the terms of the
new supply agreement, ECI supplies us with the components (modules) for use
in our products. We agreed on the prices for these modules after intense
negotiations with ECI. ECI may discontinue the production of any module
after giving us 12 months prior notice, in which case ECI would be obligated
to provide us with all necessary information for us to manufacture the modules
ourselves and integrate them into our products, as well as to supply us with
spare parts for such modules. In addition, under the terms of the supply
agreement, ECI has granted us (i) a non-exclusive, non-transferable license to
use the software embedded in the modules that are incorporated in our products
in the course of our regular business, (ii) the right to develop and change the
modules software and (iii) the right to sub-license the software to third
parties for use solely with our products. ECtel has undertaken not to
sell certain ECI components, other than for use and incorporation into final
products of ECtel. Under the Supply Agreement we are allowed to sell
these modules to Verint Systems under similar terms. The supply agreement has
an initial period of seven years and may be extended subject to a written
agreement of the parties. Either party may terminate the agreement at any
time upon a material breach by the other party or in the event of liquidation
or similar consequences of the other party. In addition, ECI has the right to
terminate the agreement with us in the event that (i) we shall have new
controlling shareholder, which is a company that directly competes with ECI
with respect to the ECI modules, or (ii) the final product in which the ECI
modules are to be used is in direct competition with ECIs DCME products.

Other Agreements with ECI

We
may, in the ordinary course of business, also enter into certain other leases,
sub-leases, operating agreements and other agreements that serve to define
various aspects of our relationship that will exist with ECI. None of
these agreements, either alone, or in the aggregate, is expected to materially
affect the results of operations of either company.

Please
see Item 10.C  Material Contracts for a description of certain agreements we
entered into with ECI in 2002.

C.        Interests of Expert and Counsel

Not
Applicable.

Item 8. Financial Information

A.        Consolidated Statements and Other Financial Information

Financial Statements

See
Item 18.

Legal Proceedings

In
January 2005, a class action complaint was filed against us, certain persons
who served as our officers and directors in the years 2001-2003, as well as ECI
Telecom Ltd. (a major shareholder of ours during that period), in the District
Court of the State of Maryland. The complaint alleges violation of U.S. Federal
securities laws and breach of fiduciary duties in connection with disclosure of
our financial results between April 2001 and April 2003. We have stated that we
believe that the allegations made in the complaint are without merit and that
we intend to vigorously defend against such complaint.



49

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Other
than this lawsuit, we are not party to any material legal proceedings.

Dividend Policy

We
anticipate that we will retain earnings to support operations and to finance
the growth and development of our business. Therefore, we do not expect
to pay cash dividends in the foreseeable future.

We
participate in the alternative benefits program under the Israeli Law for the
Encouragement of Capital Investments, 1959, under which we realize certain tax
exemptions. If we distribute a cash dividend from tax-exempt income, we
would have to pay corporate tax at a rate of up to 25% on the amount
distributed and to withhold an additional 15% of the amount distributed on
behalf of the recipient. For more information about the alternative
benefits program, see Israeli TaxationTax Benefits under the Law for the
Encouragement of Capital Investments, 1959.

Dividends
on our ordinary shares may be paid only out of profits and other surplus, as
defined in the Israeli Companies Law, as of the end of the most recent fiscal
period or as accrued over a period of two years, whichever is higher. Our
board of directors is authorized to declare dividends, provided that there is
no reasonable concern that the dividend will prevent us from satisfying our
existing and foreseeable obligations as they become due. Notwithstanding
the foregoing, dividends may be paid with the approval of a court, provided
that there is no reasonable concern that the dividend will prevent us from
satisfying our existing and foreseeable obligations as they become due.

B.        Significant Changes

Except
as otherwise disclosed in this annual report, there was no significant change
in our financial position since December 31, 2004.

Item 9. The Offer and Listing

A.        Offer and Listing Details

Our
ordinary shares have been quoted on the Nasdaq National Market under the symbol
ECTX since October 26, 1999. The following table sets forth, for the
periods indicated, the high and low closing prices of our ordinary shares, as
reported on the Nasdaq National Market.

|                  |  |      |       |     |  |       | 
|----------------- |  | ---- | ----- | --- |  | ----- | 
|                  |  | High |       | Low | 
|                  |  |      |       |     | 
|                  |  |      |       |     | 
|Calendar Year:    |  |      |       |     |  |       | 
|                  |  |      |       |     |  |       | 
|2000              |  |      | 39.94 |     |  | 10.25 | 
|2001              |  |      | 20.35 |     |  | 8.69  | 
|2002              |  |      | 20.00 |     |  | 7.00  | 
|2003              |  |      | 9.70  |     |  | 4.98  | 
|2004              |  |      | 5.85  |     |  | 2.10  | 
|                  |  |      |       |     |  |       | 
|Calendar Quarter: |  |      |       |     |  |       | 
|                  |  |      |       |     |  |       | 
|2003:             |  |      |       |     |  |       | 
|First Quarter     |  |      | 9.70  |     |  | 7.46  | 
|Second Quarter    |  |      | 8.47  |     |  | 4.98  | 
|Third Quarter     |  |      | 6.78  |     |  | 5.03  | 
|Fourth Quarter    |  |      | 7.41  |     |  | 4.59  | 
|                  |  |      |       |     |  |       | 
|2004:             |  |      |       |     |  |       | 
|First
  Quarter   |  |      | 5.49  |     |  | 3.70  | 
|Second
  Quarter  |  |      | 3.77  |     |  | 2.39  | 
|Third
  Quarter   |  |      | 2.91  |     |  | 2.11  | 
|Fourth
  Quarter  |  |      | 3.70  |     |  | 2.17  | 
|                  |  |      |       |     |  |       | 
|Calendar Month:   |  |      |       |     |  |       | 
|                  |  |      |       |     |  |       | 
|December 2004     |  |      | 3.70  |     |  | 2.91  | 
|January 2005      |  |      | 3.73  |     |  | 3.48  | 
|February 2005     |  |      | 3.95  |     |  | 3.64  | 
|March 2005        |  |      | 3.83  |     |  | 3.60  | 
|April 2005        |  |      | 3.67  |     |  | 3.34  | 
|May 2005          |  |      | 3.92  |     |  | 3.43  | 



50

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B.        Plan of Distribution

Not
Applicable.

C.        Markets

Our
ordinary shares are quoted on the Nasdaq National Market under the symbol
ECTX.

D.        Selling Shareholders

Not
Applicable.

E.        Dilution

Not
Applicable.

F.        Expenses of the Issue

Not
Applicable.

Item 10. Additional Information

A.        Share Capital

Not
Applicable.

B.        Memorandum and Articles of Association

We
were first registered under Israeli law on April 4, 1990 as a private company,
and on October 29, 1999 became a public company. Our registration number
with the Israeli registrar of companies is 52-004446-2.

Objects and Purposes

Our
object is to engage, directly or indirectly, in any lawful undertaking or
business whatsoever, including, without limitation, as stipulated in our
memorandum of association. See Article 1 of our articles of association, which
sets forth our purposes.

The
following sections, to the extent they refer to our articles of association are
qualified in their entirety by the articles themselves, filed as an exhibit to
our annual report submitted for 1999.

Transfer and Ownership of Shares; Notices

The
ownership or voting of our ordinary shares by non-residents of Israel, except
for citizens of countries that are in a state of war with Israel, is not
restricted in any way by our memorandum or articles of association or by the
laws of the State of Israel.



51

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Fully
paid ordinary shares may be freely transferred pursuant to our articles of
association unless the transfer is restricted or prohibited by another
instrument. Unless otherwise prescribed by law, each shareholder of
record will be provided at least 21 calendar days prior notice of any general
shareholders meeting.

Dividend and Liquidation Rights

Dividends
on our ordinary shares may be paid only out of profits and other surplus, as
defined in the Israeli Companies Law, as of the end of the most recent
financial statements or as accrued over a period of two years, whichever is
higher. Our board of directors is authorized to declare dividends,
provided that there is no reasonable concern that payment of the dividend will
prevent us from satisfying our existing and foreseeable obligations as they
become due. Notwithstanding the foregoing, dividends may be paid with the
approval of a court, provided that there is no reasonable concern that payment of
the dividend will prevent us from satisfying our existing and foreseeable
obligations as they become due. Dividends that remain unclaimed after
seven years will generally be forfeited and returned to the company. In
the event of our liquidation, after satisfaction of liabilities to creditors,
our assets will be distributed to the holders of ordinary shares in proportion
to their respective holdings. These dividend and liquidation rights may
be affected by the grant of preferential dividends or liquidation rights to the
holders of a class of shares with preferential rights that may be authorized in
the future.

Voting, Shareholders Meetings and
Resolutions

Holders
of ordinary shares have one vote for each ordinary share held on all matters
submitted to a vote of shareholders. Under the Companies Law and our
articles of association, all resolutions of our shareholders, except for a
resolution to liquidate the company, require approval by a simple majority of
the ordinary shares voting thereon. These voting rights may be affected
by the grant of any special voting rights to the holders of a class of shares
with preferential rights that may be authorized in the future. No
cumulative voting is permitted.

These
voting rights may be affected by the grant of any special voting rights to the
holders of a class of shares with preferential rights that may be authorized in
the future. We have two types of general shareholders meetings: the
annual general meetings and extraordinary general meetings. These
meetings may be held either in Israel or in any other place the board of
directors determines. An annual general meeting must be held in each
calendar year, but not more than 15 months after the last annual general
meeting. Our board of directors may convene an extraordinary meeting,
from time to time, at its discretion and is required to do so upon the request
of shareholders holding at least 5% of our ordinary shares or at least two
directors or one quarter of our directors then serving.

The
quorum required for a meeting of shareholders consists of at least two
shareholders present in person or by proxy who hold or represent in the
aggregate at least 33-1/3% of the outstanding voting shares.  A meeting
adjourned for lack of a quorum generally is adjourned to the same day in the
following week at the same time and place or any time and place as the chairman
may designate with the consent of the holders of a majority of the voting power
represented at the meeting and voting on the matter adjourned.

Mergers and Acquisitions under Israeli Law

The
Israeli Companies Law includes provisions that allow a merger transaction and
requires that each company that is a party to a merger have the transaction
approved by its board of directors and a vote of the majority of its shares, at
a shareholders meeting called on at least 21 days prior notice. For
purposes of the shareholder vote, unless a court rules otherwise, the merger
will not be deemed approved if a majority of the shares held by parties other
than the other party to the merger, or by any person who holds 25% or more of
the shares or the right to appoint 25% or more of the directors of the other
party, vote against the merger. Upon the request of a creditor of either
party to the proposed merger, the court may delay or prevent the merger if it
concludes that there exists a reasonable concern that as a result of the
merger, the surviving company will be unable to satisfy the obligations of any
of the parties to the merger. In addition, a merger may not be completed
unless at least 50 days have passed from the date that a proposal of the merger
was filed with the Israeli Registrar of Companies by each merging company and
30 days from the date that shareholder approval of both merging companies was
obtained. The request for the approval of a merger may be filed once a
shareholder meeting has been called to approve the merger.

The
Companies Law also provides that an acquisition of shares of a public company
must be made by means of a tender offer if as a result of the acquisition the
purchaser would become a 25% shareholder of the company and there is not any
other existing shareholder who holds 25% or more of the company. An
acquisition of shares of a public company must be made by means of a tender
offer if as a result of the acquisition the purchaser would become a 45%
shareholder of the company unless there already is another 45% shareholder in
the company. If following any acquisition of shares, the acquiror will
hold 90% or more of the companys shares, the acquisition may not be made other
than through a tender offer to acquire all of the shares of such class. 
If more than 95% of the outstanding shares are tendered in the tender offer,
all the shares that the acquiror offered to purchase will be transferred to
it. However, the remaining minority shareholders may seek to alter the
tender offer consideration by court order.



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Lastly,
Israeli tax law treats some acquisitions, such as stock-for-stock exchanges
between an Israeli company and a foreign company less favorably than U.S. tax
laws. For example, Israeli tax law may, under certain circumstances, subject a
shareholder who exchanges his ordinary shares for shares in another
corporation, to taxation prior to the sale of the shares received in such
stock-for-stock swap.

Modification of Class Rights

Our
articles of association provide that the rights attached to any class (unless
otherwise provided by the terms of that class), such as voting, rights to
dividends and the like, may be varied by a shareholders resolution, subject to
the sanction of a resolution passed by the holders of a majority of the shares
of that class at a separate class meeting.

Fiduciary Duties of Office Holders

The
Israeli Companies Law imposes a duty of care and a duty of loyalty on all
office holders of a company.

The
duty of care requires an office holder to act with the level of care with which
a reasonable office holder in the same position would have acted under the same
circumstances. The duty of care includes a duty to use reasonable means
to obtain:

| |   |                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------
| |  | information
  on the advisability of a given action brought for his approval or performed
  by him by virtue of his position; and
| |   |                                                                                                                                  
| |  | all other
  important information pertaining to these actions.                                                                   

The duty of loyalty of an
office holder includes a duty to:

| |   |                                                                                                                                                                         
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | refrain from
  any conflict of interest between the performance of his duties in the company
  and the performance of his other duties or his personal affairs;         
| |   |                                                                                                                                                                         
| |  | refrain from
  any activity that is competitive with the company;                                                                                                       
| |   |                                                                                                                                                                         
| |  | refrain from
  exploiting any business opportunity of the company to receive a personal gain
  for himself or others; and                                               
| |   |                                                                                                                                                                         
| |  | disclose to
  the company any information or documents relating to the companys affairs
  which the office holder has received due to his position as an office holder.

Approval of Related-Party Transactions under
Israeli Law

The
Israeli Companies Law requires that an office holder of a company disclose to
the company any personal interest that he may have and all related material
information known to him, in connection with any existing or proposed
transaction by the company. The disclosure is required to be made promptly
and in any event no later than the board of directors meeting in which the
transaction is first discussed. If the transaction is an extraordinary
transaction, 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 these people; or                                                     
| |   |                                                                                                                                                                                                   
| |  | any
  corporation in which the office holder is a 5% or greater shareholder,
  director or general manager or in which he has the right to appoint at least
  one director or the general manager.

Under the Companies Law, an
extraordinary transaction is a transaction:

| |   |                                                 
| | - | ------------------------------------------------
| |  | other than
  in the ordinary course of business;



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| |   |                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------
| |  | otherwise
  than on market terms; or                                                               
| |   |                                                                                                    
| |  | that is
  likely to have a material impact of the companys profitability, assets or
  liabilities.

Once
an office holder complies with the above disclosure requirement, the board of
directors may approve a transaction between the company and an office holder,
or a third party in which an office holder has a personal interest. A
transaction that is adverse to the companys interest may not be
approved.

If
the transaction is an extraordinary transaction, approval of both the audit
committee and the board of directors is required. Under specific
circumstances, shareholder approval may also be required. A director who
has a personal interest in an extraordinary transaction which is considered at
a meeting of the board of directors or the audit committee may not be present
at this meeting or vote on this matter, unless a majority of the members of the
board of directors or the audit committee, as the case may be, has a personal
interest in the matter. If a majority of members of the board of directors
have a personal interest therein, shareholder approval is also required.

Under
the Companies Law, all arrangements as to compensation of directors in public
companies generally require the approvals of the audit committee, board of
directors and shareholders, in that order.

Duties of Shareholders

Disclosure of Personal Interests of a Controlling
Shareholder

Under
the Israeli Companies Law, the disclosure requirements that apply to an office
holder also apply to a controlling shareholder of a public company. A
controlling shareholder is a shareholder who has the ability to direct the
activities of a company, including a shareholder that owns 25% or more of the
voting rights if no other shareholder owns more than 50% of the voting rights,
but excluding a shareholder whose power derives solely from his or her position
on the board of directors or any other position with the company. Extraordinary
transactions with a controlling shareholder or in which a controlling
shareholder has a personal interest, and the engagement of a controlling
shareholder as an office holder or employee, require the approvals of the audit
committee, the board of directors and the shareholders of the company, in that
order. The shareholder approval must be by a majority of the shares voted
on the matter, provided that either:

| |   |                                                                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | at least
  one-third of the shares of shareholders who have no personal interest in the
  transaction and who vote on the matter vote in favor thereof; or                          
| |   |                                                                                                                                                                                     
| |  | the
  shareholders who have no personal interest in the transaction who vote
  against the transaction do not represent more than one percent of the voting
  rights in the company.

Shareholders
generally have the right to examine document in the companys possession pertaining
to any matter that requires shareholder approval.

Duties
of Good Faith and Fairness

In
addition, under the Companies Law, each shareholder has a duty to act in good
faith toward the company and other shareholders and to refrain from abusing his
or her power in the company, such as in shareholder votes. In addition,
specified shareholders have a duty of fairness toward the company. These
shareholders include any controlling shareholder, any shareholder who knows
that it possesses the power to determine the outcome of a shareholder vote and
any shareholder who, pursuant to the provisions of the articles of association,
has the power to appoint an office holder or any other power with respect to
the company. However, the Companies Law does not define the substance of
this duty of fairness except to state that the remedies generally available
upon a breach of contract will apply also in the event of a breach of the duty
to act with fairness.

Indemnification of Directors and Officers

Exculpation
of Office Holders

Under
the Companies Law, an Israeli company may not exempt an office holder from
liability for breach of his duty of loyalty, but may exempt in advance an
office holder from liability to the company, in whole or in part, for a breach
of his duty of care provided that the articles of association of the company
allow it to do so. Our articles of association allow us to exempt our
office holders to the fullest extent permitted by law.



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Insurance
Relating to Office Holders

Our
articles of association provide that, subject to the provisions of the
Companies Law, we may enter into an insurance contract which would provide
coverage for any monetary liability incurred by any of our office holders, with
respect to an act performed in the capacity of an office holder for:

| |   |                                                                                                                                                                                       
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | A breach of
  his duty of care to us or to another person;                                                                                                                            
| |   |                                                                                                                                                                                       
| |  | A breach of
  his duty of loyalty to us, provided that the office holder acted in good
  faith and had reasonable cause to assume that his act would not prejudice our
  interests; or
| |   |                                                                                                                                                                                       
| |  | A financial
  liability imposed upon him in favor of another person.                                                                                                                  
| |   | We have
  obtained liability insurance covering our officers and directors.                                                                                                           

Indemnification
of Office Holders

An
Israeli company may indemnify an office holder in respect of certain
liabilities either in advance of an event or following an event provided a
provision authorizing such indemnification is inserted in its articles of association.  Our articles of association contain such
an
authorization.  An undertaking by an
Israeli company to indemnify an office holder with respect to a financial
liability for acts performed as an office holder imposed on him or her in favor
of another person pursuant to a judgment, settlement or arbitrators award
approved by court must be limited to foreseeable liabilities and reasonable
amounts determined by the board of directors.
In addition, a company may indemnify an office holder against the following
liabilities incurred for acts performed as an office holder:

Our
articles of association provide that we may indemnify an office holder against
the following obligations and expenses imposed on the office holder with
respect to an act performed in the capacity of an office holder:

| |   |                                                                                                                                                                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a financial
  obligation imposed on him or her in favor of another person by a court
  judgment, including a compromise judgment or an arbitrators award approved
  by court                                                                                                                                                                   
| |   |                                                                                                                                                                                                                                                                                                                                                 
| |  | reasonable
  litigation expenses, including attorneys fees, expended by the office holder
  or charged to him by a court in connection with:                                                                                                                                                                                                   
| |   |                                                                                                                                                                                                                                                                                                                                                 
| |  | proceedings
  we institute against him or that are instituted on our behalf or by another
  person;                                                                                                                                                                                                                                             
| |   |                                                                                                                                                                                                                                                                                                                                                 
| |  | A criminal
  charge from which he is acquitted; or                                                                                                                                                                                                                                                                                              
| |   |                                                                                                                                                                                                                                                                                                                                                 
| |  | A criminal
  proceeding in which he is convicted of an offense that does not require proof
  of criminal intent.                                                                                                                                                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                 
| |   | Our articles
  of association also include provisions:                                                                                                                                                                                                                                                                                          
| |   |                                                                                                                                                                                                                                                                                                                                                 
| |  | authorizing
  us to undertake to indemnify an office holder as described above, provided
  that the undertaking is limited to those types of events which our board of
  directors deems to be anticipated when the undertaking is given and to an
  amount determined by our board of directors to be reasonable under the circumstances;
  and
| |   |                                                                                                                                                                                                                                                                                                                                                 
| |  | authorizing
  us to retroactively indemnify an officer or director.                                                                                                                                                                                                                                                                             

Limitations
on Exculpation, Insurance and Indemnification

The Companies Law provides that a company may not exculpate or indemnify an
office holder, or enter into an insurance contract which would provide coverage
for any monetary liability incurred as a result of any of the following:

| |   |                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | A breach by
  the office holder of his duty of loyalty unless, with respect to insurance
  coverage, the office holder acted in good faith and had a reasonable basis to
  believe that the act would not prejudice the company;
| |   |                                                                                                                                                                                                                                 
| |  | A prohibited
  dividend or distribution to shareholders                                                                                                                                                                         
| |   |                                                                                                                                                                                                                                 
| |  | A breach by
  the office holder of his duty of care if the breach was committed
  intentionally or recklessly (excluding a breach arising out of negligent
  conduct of the office holder);                                     



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| |   |                                                                                          
| | - | -----------------------------------------------------------------------------------------
| |  | any act or
  omission committed with the intent to derive an illegal personal benefit; or
| |   |                                                                                          
| |  | any fine
  imposed on the office holder;                                                 

In
addition, under the Companies Law, exculpation and indemnification of, and
procurement of insurance coverage for our office holders must be approved by
our audit committee and our board of directors and, if the beneficiary is a
director, by our shareholders.

Our
articles of associations also provide that, subject to the provisions of
applicable law, we may procure insurance for, or indemnify, any person who is
not an office holder, including without limitation, any of our employees,
agents, consultants or contractors.

C.        Material Contracts

For
a description of agreements other than the ones described below that we entered
into with ECI, please refer to Item 7B  Related Party Transactions. 
For a description of the agreement we entered into with Telrad to acquire
NetEye, please see Item 5A  Operating Results  Acquisition of NetEye and Item
7B  Related Party Transactions.

Transactions with
ECI

The
following are brief summaries of the provisions of certain agreements. 
The summaries are qualified in their entirety by the agreements themselves,
which are either filed as exhibits to this annual report or have been filed as
exhibits to previous annual reports.

Registration Rights Agreement

In
January 2002, we entered into a Registration Rights Agreement with ECI, whereby
we granted to ECI rights in connection with sales, from time to time, of our
ordinary shares held by ECI. As required by the Israeli Companies Law, the
agreement was approved by our Audit Committee, Board of Directors and a special
majority of our shareholders. Under this agreement, ECI is entitled to
demand and piggyback registration rights, which are exercisable for a period of
ten years. During this period, ECI is entitled to five demand registrations and
unlimited piggyback registrations. ECI has agreed to reimburse us for the
expenses reasonably incurred by us in effecting such registrations, unless we
also issue ordinary shares in the same public offering.

In
addition, the Registration Rights Agreement provides that in the event that
ECI, from time to time, sells ordinary shares in a private transaction which is
conditioned upon the grant of registration rights with respect to such shares,
then, at ECIs request, we shall enter into a registration rights
agreement. Such registration rights agreements would require us to
register the purchasers shares on a shelf registration statement and to
maintain the effectiveness of the registration statement for two years. 
They would also include, among other things, an undertaking by us to indemnify
the purchasers for liabilities and expenses that may arise from any material
misstatements or omissions in our registration statement. ECI has agreed
to reimburse us for the expenses reasonably incurred by us in effecting such
registrations.

ECI Share Purchase Agreement

In
February 2002, we entered into a Share Purchase Agreement with ECI and several
investors under which ECI sold 1,572,175 of our ordinary shares held by ECI to
the investors. We made representations and warranties in the Share
Purchase Agreement for the benefit of the investors, which survived for a
period of two years following the closing of the transaction. In addition, as
contemplated in the Share Purchase Agreement, we entered into a Registration
Rights Agreement with ECI and the investors to register the ordinary shares to
be purchased pursuant to the Share Purchase Agreement. We filed a
registration statement with the SEC registering those shares, as well as
850,000 shares held by Telrad, which was declared effective in March
2002. ECI has agreed to bear all the expenses incurred by us in
connection with this transaction and the registration of the ordinary shares sold
thereunder. However, we could be held liable to the investors, or
purchasers of shares from the investors, if, during the two-year period
following the closing, our representations and warranties are found to have
been inaccurate or if our registration statement is found to contain a material
misstatement or omission. In addition, the Registration Rights Agreement
contains a customary undertaking by us to indemnify the investors for
liabilities and expenses that may arise from any material misstatements or omissions
in our registration statement. If ECI agrees to sell additional ordinary
shares, we are required to accept substantially the same undertakings with
respect to such ordinary shares. We believe that sales of our ordinary
shares into the public market as a result of this transaction increased the
public float and liquidity of our shares.



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As
required by the Companies Law, the agreement was approved by our Audit
Committee, Board of Directors and a special majority of our shareholders.

Transaction
with Verint Systems

On
February 9, 2004, we agreed to sell our government surveillance business to
Verint Systems Ltd., an Israeli subsidiary of Verint Systems Inc. Verint
Systems, which is listed on the Nasdaq National Market, provides analytic
software-based solutions for communications interception, digital video
security and surveillance, and enterprise business intelligence. The
transaction was consummated on March 31, 2004. The material terms of our
asset purchase agreement and ancillary agreements with Verint Systems are
summarized below. This summary is qualified in its entirety by reference
to the full agreements filed as exhibits to this annual report. See Item 19  Exhibits.

Pursuant
to the asset purchase agreement, Verint Systems purchased certain assets and
assumed certain liabilities relating to our government surveillance business
for $35 million in cash. The transferred assets included certain
intellectual property rights (as more fully described below), fixed assets,
backlog contracts, agreements with subcontractors and suppliers, third-party
software licenses and outstanding customer proposals. The assumed
liabilities included employment-related liabilities in respect of our employees
who were hired by Verint Systems, including retention bonuses, severance and
compensation liabilities with respect to the termination of certain of our
officers, and an accrual for certain research and development and
customization expenses. We have retained our existing government
surveillance projects and warranty obligations and subcontracted the
performance thereof to Verint Systems upon agreed terms. We made customary
representations and warranties to Verint Systems under the asset purchase agreement
and agreed to indemnify them for any breaches thereof, subject to certain
limitations set forth therein.

Pursuant
to a series of intellectual property agreements, we granted to Verint Systems
(i) co-ownership rights in software that is important to both our government
surveillance and telecom products, (ii) sole ownership in the intellectual
property rights that relates principally to our government surveillance
products, subject to a license-back in respect of certain rights that relate
also to our telecom products, and (iii) licenses to certain intellectual
property rights that relate principally to our telecom products and relate also
to our government surveillance products.

Pursuant
to a supply agreement, we agreed to supply to Verint Systems, and to support,
various components that are manufactured for us by ECI. The agreement is for a
period of seven years.

As
part of the asset purchase agreement we also agreed to contribute an aggregate
amount of $1.0 million for the development by Verint Systems of certain
government surveillance software. In exchange, we are entitled to receive
royalties equal to 1% of the sales of such software made between 2005 and 2010,
up to an aggregate amount of $1.2 million.

In
addition, we agreed to cover certain expenses of up to $1.4m plus 17% VAT,
related to the government surveillance business in 2004.

Verint
Systems hired most of our employees that worked in our government surveillance
business. We and Verint Systems mutually agreed to make our engineering
employees available to the other, primarily for support and bug fixing, for a
period of 18 months, at fixed hourly rates.

We
have undertaken with Verint Systems mutual non-competition covenants not to engage
in the respective businesses of the other (i) generally, for a period of three
years and (ii) using our respective technologies as they exist as of the
closing of the transaction, for a period of ten years. We also
mutually agreed, for a period of one year, not to solicit one anothers
employees, customers or suppliers.



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D.        Exchange Controls

Exchange Controls and Other Limitations
Affecting Security Holders

There
are currently no Israeli currency control restrictions on payments of dividends
or other distributions with respect to our ordinary shares or the proceeds from
the sale of the shares, except for the obligation of Israeli residents to file
reports with the Bank of Israel regarding some transactions. However, legislation
remains in effect under which currency controls can be imposed by
administrative action at any time.

The
ownership or voting of our ordinary shares by non-residents of Israel, except
with respect to citizens of countries which are in a state of war with Israel,
is not restricted in any way by our memorandum of association or articles of
association or by the laws of the State of Israel.

E.        Taxation

The
following is a general summary only and should not be considered as income tax
advice or relied upon for tax planning purposes. Holders of our ordinary shares
should consult their own tax advisors as to the United States, Israeli or other
tax consequences of the purchase, ownership and disposition of ordinary shares,
including, in particular, the effect of any foreign, state or local taxes.

U.S. FEDERALINCOME TAX CONSIDERATIONS

Subject
to the limitations described below, the following discussion summarizes the
material U.S. federal income tax consequences of the purchase, ownership and
disposition of our ordinary shares to a U.S. holder that owns our ordinary
share as capital assets.  A U.S. holder is a holder of our ordinary
shares who is:

| |                                                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                                                  | an
  individual citizen or resident of the United States,                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                  | a
  corporation (or other entity taxable as a corporation for U.S. federal tax
  purposes) created or organized in the United States or under the laws of the
  United States or any political subdivision thereof,                                                                                                                                       
| |                                                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                  | an estate,
  the income of which is subject to U.S. federal income tax regardless of its
  source, or                                                                                                                                                                                                                                                     
| |                                                                                                                                                                   |                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                  | a trust (i)
  if, in general, a court within the United States is able to exercise primary
  supervision over its administration and one or more U.S. persons have the
  authority to control all of its substantial decisions, or (ii) that has
  in effect a valid election under applicable U.S. Treasury regulations to be
  treated as a U.S. person.
| | Material
aspects of U.S. federal income tax relevant to a holder of our ordinary shares
that is not a U.S. holder (a non-U.S. holder) are also discussed below.

This
discussion is not a comprehensive description of all of the tax considerations
that may be relevant to each persons decision to purchase ordinary shares.

This
discussion is based on current provisions of the Internal Revenue Code of 1986
as amended (the Code), current and proposed Treasury regulations, and
administrative and judicial decisions as of the date of this annual report, all
of which are subject to change, possibly on a retroactive basis. This
discussion does not address all aspects of U.S. federal income taxation that
may be relevant to any particular U.S. holder in light of the holders
individual circumstances. In particular, this discussion does not address
the potential application of the alternative minimum tax or the U.S. federal
income tax consequences to U.S. holders that are subject to special treatment,
including U.S. holders that:

| |   |                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------
| |  | are
  broker-dealers or insurance companies,                                                           
|
| |  | have elected
  mark-to-market accounting,                                                              
|
| |  | are
  tax-exempt organizations or retirement plans,                                                    
|
| |  | are
  financial institutions or financial services entities,                                           
|
| |  | hold
  ordinary shares as part of a straddle, hedge or conversion transaction with
  other investments,
|
| |  | acquired
  their shares upon the exercise of employee stock options or otherwise as
  compensation,    
|
| |  | are, or hold
  their shares through, partnerships or other pass-through entities,                      
|
| |  | own
  directly, indirectly or by attribution at least 10% of our voting power, or                      
|
| |  | have a
  functional currency that is not the dollar.                                                   

In
addition, this discussion does not address any aspect of state, local or
non-U.S. tax laws or the possible application of United States federal gift or
estate tax.



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Each
holder of our ordinary shares is advised to consult his or her own tax advisor
with respect to the specific tax consequences to him or her of purchasing,
holding or disposing of our ordinary shares, including the applicability and
effect of federal, state, local and foreign income and other tax laws in his or
her particular circumstances.

Taxation of Dividends Paid on Ordinary Shares

Subject
to the discussion below under Tax Consequences if We are a Passive Foreign
Investment Company, a U.S. holder will be required to include in gross income
as dividend income the amount of any distribution paid on our ordinary shares,
including any Israeli taxes withheld from the amount paid, on the date the
distribution is received to the extent the distribution is paid out of our
current or accumulated earnings and profits, as determined for U.S. federal
income tax purposes. Distributions in excess of earnings and profits will
be applied against and will reduce the U.S. holders tax basis in our ordinary
shares and, to the extent in excess of that basis, will be treated as gain from
the sale or exchange of our ordinary shares. The dividend portion of such
distribution generally will not qualify for the dividends received deduction
otherwise available to corporations.

Dividends
that are received by U.S. holders that are individuals, estates or trusts will
be taxed at the rate applicable to long-term capital gains (a maximum rate of
15%), provided that such dividends meet the requirements of qualified dividend
income. Dividends that fail to meet such requirements, and dividends received
by corporate U.S. holders, are taxed at ordinary income rates. No dividend
received by a U.S. holder will be a qualified dividend (1) if the U.S.
holder held the ordinary share with respect to which the dividend was paid for
less than 61 days during the 121-day period beginning on the date that is 60
days before the ex-dividend date with respect to such dividend, excluding for
this purpose, under the rules of Code section 246(c), any period during which
the U.S. holder has an option to sell, is under a contractual obligation to
sell, has made and not closed a short sale of, is the grantor of a
deep-in-the-money or otherwise nonqualified option to buy, or has otherwise
diminished its risk of loss by holding other positions with respect to, such
ordinary share (or substantially identical securities); or (2) to the
extent that the U.S. holder is under an obligation (pursuant to a short sale or
otherwise) to make related payments with respect to positions in property
substantially similar or related to the ordinary share with respect to which
the dividend is paid. If we were to be a passive foreign investment company,
a foreign personal holding company or a foreign investment company (as such
terms are defined in the Code) for any year, dividends paid on our ordinary
shares in such year or in the following year would not be qualified dividends.
In addition, a non-corporate U.S. holder will be able to take a qualified dividend
into account in determining its deductible investment interest (which is
generally limited to its net investment income) only if it elects to do so; in
such case the dividend will be taxed at ordinary income rates.

Distributions
of current or accumulated earnings and profits paid in foreign currency to a
U.S. holder (including any Israeli taxes withheld from the distributions) will
be includible in the income of a U.S. holder in a dollar amount calculated by
reference to the exchange rate on the date of the distribution. A U.S.
holder that receives a foreign currency distribution and converts the foreign
currency into dollars after the date of distribution will have foreign exchange
gain or loss based on any appreciation or depreciation in the value of the
foreign currency against the dollar, which will generally be U.S. source
ordinary income or loss.

U.S.
holders will have the option of claiming the amount of any Israeli income taxes
withheld at source either as a deduction from gross income or as a
dollar-for-dollar credit against their U.S. federal income tax liability.
Individuals who do not claim itemized deductions, but instead utilize the
standard deduction, may not claim a deduction for the amount of the Israeli
income taxes withheld, but the amount may be claimed as a credit against the
individuals U.S. federal income tax liability. The amount of foreign
income taxes that may be claimed as a credit in any year is subject to complex
limitations and restrictions, which must be determined on an individual basis
by each shareholder. These limitations include rules which limit foreign
tax credits allowable for specific classes of income to the U.S. federal income
taxes otherwise payable on each such class of income. The total amount of
allowable foreign tax credits in any year cannot exceed the pre-credit U.S. tax
liability for the year attributable to foreign source taxable income.

A
U.S. holder will be denied a foreign tax credit for Israeli income tax withheld
from a dividend received on the ordinary shares:

| |   |                                                                                                                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | if the U.S.
  holder has not held the ordinary shares for at least 16 days of
  the 30day period beginning on the date which is 15 days before the
  ex-dividend date with respect to such dividend; or
| |   |                                                                                                                                                                                                         
| |  | to the
  extent the U.S. holder is under an obligation to make related payments with
  respect to positions in substantially similar or related property.                                               



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Any
days during which a U.S. holder has substantially diminished its risk of loss
on the ordinary shares are not counted toward meeting the required 16-day
holding period. Distributions of current or accumulated earnings and profits
will be foreign source passive income for U.S. foreign tax credit purposes.

Taxation of the Disposition of Ordinary
Shares

Subject
to the discussion below under Tax Consequences if We are a Passive Foreign
Investment Company, upon the sale, exchange or other disposition of our
ordinary shares, a U.S. holder will recognize capital gain or loss in an amount
equal to the difference between the U.S. holders basis in the ordinary shares,
which is usually the cost to the U.S. holder of the shares, and the amount
realized on the disposition. A disposition of shares will be considered
to occur on the trade date, regardless of the holders method of
accounting. Capital gain from the sale, exchange or other disposition of
ordinary shares held more than one year will be long-term capital gain and may,
in the case of individual U.S. holders, be subject to a reduced rate of
taxation. Gain or loss recognized by a U.S. holder on a sale, exchange or
other disposition of ordinary shares will be treated as U.S. source income for
U.S. foreign tax credit purposes. The deductibility of a capital loss
recognized on the sale, exchange or other disposition of ordinary shares is
subject to limitations.

A
U.S. holder that uses the cash method of accounting calculates the dollar value
of the proceeds received on the sale as of the date that the sale
settles. However, a U.S. holder that uses the accrual method of
accounting is required to calculate the value of the proceeds of the sale as of
the trade date and may therefore realize foreign currency gain or loss. A
U.S. holder may avoid realizing foreign currency gain or loss if he or she has
elected to use the settlement date to determine its proceeds of sale for
purposes of calculating the foreign currency gain or loss. In addition, a
U.S. holder that receives foreign currency upon disposition of ordinary shares
and converts the foreign currency into dollars after the settlement date or
trade date (whichever date the U.S. holder is required to use to calculate the
value of the proceeds of sale) will have foreign exchange gain or loss based on
any appreciation or depreciation in the value of the foreign currency against
the dollar, which will generally be U.S. source ordinary income or loss.

Tax Consequences if we are a Passive Foreign
Investment Company

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

For
U.S. federal income tax purposes, we will be classified as a PFIC for any
taxable year in which either (i) 75% or more of our gross income is passive
income, or (ii) at least 50% of the average value of all of our assets for the
taxable year produce or are held for the production of passive income. For this
purpose, cash is considered to be an asset which produces passive income.
Passive income includes dividends, interest, royalties, rents, annuities and
the excess of gains over losses from the disposition of assets which produce
passive income. As a result of our substantial cash position and the decline in
the value of our stock, we would be a PFIC if the asset test described above
were applied on the basis of our market capitalization.  There is a possibility that the application
of the asset test based on an alternative valuation of our total assets would
also result in our being classified as a PFIC.

If
we are a PFIC, a U.S. holder could elect to treat us as a qualified electing
fund (a QEF), in which case the U.S. holder would be taxed currently on its
pro rata share of our ordinary earnings and net capital gain (subject to a
separate election to defer payment of taxes, which deferral is subject to an
interest charge). Special rules apply if a U.S. holder makes a QEF
election after the first year in its holding period in which we are a
PFIC. We would supply U.S. holders with the information needed to report
income and gain under a QEF election if we were a PFIC. As another
alternative to the tax treatment described above, a U.S. holder could elect to
mark our shares to market annually, recognizing as ordinary income or loss each
year an amount equal to the difference as of the close of the taxable year between
the fair market value of our shares and the shareholders adjusted basis in the
shares. Losses would be allowed only to the extent of net mark-to-market
gain previously included in income by the U.S. holder.

The
U.S. federal income tax consequences to a U.S. holder if we were to be a PFIC
are complex. A U.S. holder should consult with his or her own advisor
with regard to those consequences, as well as with regard to whether he or she
should make either of the elections described above.



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Tax Consequences for Non-U.S. Holders of
Ordinary Shares

Except
as described in Information Reporting and Back-up Withholding below, a
non-U.S. holder of ordinary shares will not be subject to U.S. federal income
or withholding tax on the payment of dividends on, and the proceeds from the
disposition of, our ordinary shares, unless:

| |   |                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the item is
  effectively connected with the conduct by the non-U.S. holder of a trade or
  business in the United States and:                                                                                                       
| |   |                                                                                                                                                                                                                                      
| |  | in the case
  of a resident of a country which has a treaty with the United States, the
  item is attributable to a permanent establishment; or                                                                                      
| |   |                                                                                                                                                                                                                                      
| |  | in the case
  of an individual, the item is attributable to a fixed place of business in
  the United States;                                                                                                                        
| |   |                                                                                                                                                                                                                                      
| |  | the non-U.S.
  holder is an individual who holds the ordinary shares as a capital asset and
  is present in the United States for 183 days or more in the taxable year
  of the disposition and does not qualify for an exemption; or
| |   |                                                                                                                                                                                                                                      
| |  | the non-U.S.
  holder is subject to tax under the provisions of U.S. tax law applicable to
  U.S. expatriates.                                                                                                                       

Information Reporting and Back-up Withholding

U.S.
holders generally are subject to information reporting requirements with
respect to dividends paid in the United States on or proceeds from the
disposition of our ordinary shares. In addition, a U.S. holder may be
subject, under certain circumstances, to backup withholding at a rate of up to
28% with respect to dividends paid on or proceeds from the disposition of our
ordinary shares unless the U.S. holder provides proof of an applicable
exemption or correct taxpayer identification number and otherwise complies with
applicable requirements of the backup withholding rules. A holder of our
ordinary shares who provides an incorrect taxpayer identification number may be
subject to penalties imposed by the IRS. Amounts withheld under the
backup withholding rules are not an additional tax and may be refunded or
credited against the holders federal income tax liability, provided the required
information is furnished to the IRS.

Non-U.S.
holders generally are not subject to information reporting or back-up
withholding with respect to dividends paid on, or proceeds from the disposition
of, our ordinary shares, provided that the non-U.S. holder provides a taxpayer
identification number, certifies to its foreign status, or establishes another
exemption to the information reporting or back-up withholding requirements.

ISRAELI TAXATION

The following summary describes the current
tax structure applicable to companies incorporated in Israel, with special
reference to its effect on us. It also discusses Israeli tax consequences
material to persons purchasing our ordinary shares. To the extent that
the summary is based on new tax legislation yet to be judicially or
administratively interpreted, we cannot be sure that the views expressed will
accord with any future interpretation by the Israeli tax authorities or
courts. The summary is not intended, and should not be construed, as legal
or professional advice and does not exhaust all possible tax
considerations. Accordingly, you should consult your tax advisor as to
the particular tax consequences of an investment in our ordinary shares.

Tax Reform

On
January 1, 2003, the Law for Amendment of the Income Tax Ordinance (Amendment
No. 132), 5762-2002, as amended, known as the Tax Reform, came into
effect. The Tax Reform, aimed at broadening the categories of taxable
income and reducing the tax rates imposed on employment income, introduced,
among other things, the following provisions:

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Reduction of
  the tax rate levied on capital gains (other than gains from the sale of
  listed securities) derived after January 1, 2003, to a general rate of 25%
  for both individuals and corporations. Regarding assets acquired prior
  to January 1, 2003, the reduced tax rate will apply to a proportionate part
  of the gain, in accordance with the holding periods of the asset, before or
  after January 1, 2003, on a linear basis;
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |  | Imposition of
  Israeli tax on all income of Israeli residents, individuals and corporations,
  regardless of the territorial source of income, including income derived from
  passive sources such as interest, dividends and royalties;                                                                                                                                                                                                          



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Introduction
  of controlled foreign corporation (CFC) rules into the Israeli tax structure.
  Generally, under such rules, an Israeli resident who holds, directly or
  indirectly, 10% or more of the rights in a foreign corporation whose shares
  are not publicly traded (or which has offered less than 30% of its shares or
  any rights to its shares to the public), in which more than 50% of the rights
  are held directly or indirectly by Israeli residents, and a majority of whose
  income in a tax year is considered passive income, and the rate at which such
  passive income is taxed in the jurisdiction of such foreign corporation
  exceeds 20%, will be liable for tax on the portion of such income attributed
  to his holdings in such corporation, as if such income were distributed to
  him as a dividend;
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | Imposition
  of capital gains tax on capital gains realized as of January 1, 2003 by
  individuals who are Israeli residents, from the sale of shares of publicly
  traded companies on the Tel Aviv Stock Exchange and from the sale of shares
  of publicly traded Israeli companies on certain other stock exchanges (such
  gain was previously exempt from capital gains tax in Israel in certain
  cases). For information with respect to the applicability of Israeli capital
  gains taxes on the sale of ordinary shares, see Capital Gains Tax below;                                                                                                                                                                                                                                                                            
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | Effectuation
  of a new regime for the taxation of shares and options issued to employees,
  officers and directors; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | Introduction
  of tax at a rate of 25% on dividends paid by one Israeli company to another
  (which are generally not subject to tax), if the source of such dividends is
  income that was derived outside of Israel;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |  | Elimination
  of the seven year limit to carry forward capital losses with respect to
  capital losses arising from and after 1996.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

General Corporate Tax Structure

Generally, Israeli companies are subject to
corporate tax at the rate of 34% on taxable income and are subject to capital
gains tax at a rate of 25% on capital gains (other than gains derived from the
sale of listed securities that are taxed at the prevailing corporate tax rates)
derived after January 1, 2003.  The
corporate tax rate was reduced in June 2004, from 36% to 35% for the
2004 tax year, 34% for the 2005 tax year, 32% for the 2006 tax year and 30% for
the 2007 tax year and thereafter.  However, the effective tax rate payable by a
company that derives income from an approved enterprise (as discussed below)
may be considerably less.

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

The Law for
the Encouragement of Capital Investments, 1959, as amended, provides that upon
application to the Investment Center of the Ministry of Industry, Trade and
Labor of the State of Israel, a proposed capital investment in eligible
facilities may 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 derived from the specific
approved enterprise. If a company has more than one approval or only a
portion of its capital investments are approved, its effective tax rate is the
result of a weighted combination of the applicable rates. The tax
benefits under the law are not generally available with respect to income
derived from products manufactured outside of Israel.

Taxable
income of a company derived from an approved enterprise (including income
generated by a company from the grant of a usage right with respect to know-how
developed by the approved enterprise, income generated from royalties and
income derived from a service which is auxiliary to such usage right or
royalties, provided that such income is generated within the approved
enterprises ordinary course of business) is subject to company tax at the
maximum rate of 25%, rather than the usual rate of 34% (in the applicable rate
for 2005), for the Benefit Period. The Benefit Period is seven years
(and under certain circumstances, as further detailed below, ten years),
commencing with the year in which the approved enterprise first generates
taxable income, and is limited to 12 years from commencement of production or
14 years from the date of approval, whichever is earlier.

A
company that has an approved enterprise program is eligible for further tax
benefits if it qualifies as a foreign investors company. A foreign
investors company is a company more than 25% of whose shares of capital stock
and combined share and loan capital is owned by non-Israeli residents. A
company that qualifies as a foreign investors company and has an approved
enterprise program is eligible for tax benefits for a ten-year benefit period
and to a reduced tax rate of 10% to 20% depending on the level of foreign
investment in each year.



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A
company owning an approved enterprise may elect (as we have done) to forego
certain government grants extended to approved enterprises in return for an
alternative package of benefits known as the Alternate Path. Under the
alternative package, the companys undistributed income derived from an
approved enterprise will be exempt from tax for a period of between two and ten
years from the first year of taxable income, depending on the geographic
location of the approved enterprise within Israel, and the company will be
eligible for the  reduced tax rates
under the law for the remainder of the benefit period.

The
Investment Center bases its decision of whether to approve or reject a companys
application for designation as an approved enterprise, among other things, on
criteria set forth in the law and related regulations, the prevailing policy of
the Investment Center and the specific objectives and financial criteria of the
applicant. Accordingly, a company cannot be certain in advance whether
its application will be approved. In addition, the benefits available to
an approved enterprise are conditional upon compliance with the conditions
stipulated in the law and related regulations and the criteria set forth in the
specific certificate of approval. In the event that a company violates
these conditions, in whole or in part, it may be required to refund the amount
of tax benefits plus an amount linked to the Israeli consumer price index and
interest.

A
major portion of our production facilities have been granted the status of
approved enterprises. Income arising from our approved enterprises
facilities is tax-free under the alternative package of benefits described
above for the period in which such alternative package is in effect and
thereafter, entitled to reduced tax rates based on the level of foreign
ownership for specified periods. We have derived, and expect to continue
to derive, a substantial portion of our income from our approved enterprises
facilities. Subject to compliance with applicable requirements, the
benefits for most of our production facilities in Israel will continue until
termination between the years 2005 and 2016. Our current investments in
development facilities are made under new approvals.

We
received an approval in principle from the Investment Center with respect to
the sale of our government surveillance business to Verint Systems in March
2004. If the Investment Center declines, for any reason, to grant us the final
approval, our tax benefits under the Law for the Encouragement of Capital
Investments will be materially reduced.

All
dividends are considered to be attributable to the entire enterprise and their
effective tax rate is the result of a weighted combination of the applicable
tax rates. We currently intend to reinvest the amount of our income and
not to distribute such income as a dividend. In the event that we do pay
a cash dividend from income that is derived from our approved enterprises
pursuant to the alternative package of benefits, which income would normally be
tax-exempt, we would be required to pay tax on the amount intended to be
distributed as dividends at the rate which would have been applicable had we
not elected the alternative package of benefits, which rate is ordinarily up to
25%, and to withhold at source on behalf of the dividend recipient an
additional 15% of the amount distributed as dividends.

The
law also provides that an approved enterprise is entitled to accelerated
depreciation on its property and equipment that are included in an approved
investment program.

In
March 2005, the government of Israel passed an amendment to the Investment Law
in which it revised the criteria for investments qualified to receive tax
benefits as an approved enterprise. Among other things, companies that meet the
criteria of the alternate package of tax benefits will receive those benefits
without prior approval. However, no assurance can be given that we will
in the future be eligible to receive additional tax benefits under this law.

The
reform primarily included the following provisions:

| |  |   |                                                                                                                                                                                                                                                                                                                                                                                         
| |  | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | § | Companies that meet the criteria of the Alternate
  Path will receive its benefits without need for prior approval. In addition,
  such companies will not be required to file reports with the Investment
  Center. Audits will take place via the Income Tax Authority within the
  framework of general tax audits. Such companies will be able to request to
  obtain pre-rulings.
| |  |   |                                                                                                                                                                                                                                                                                                                                                                                         
| |  | § | Tax benefits of the Alternate Path include
  lower tax rates or exemptions, depending upon the field in which a company
  engages and the path chosen,  as
  well as lower tax rates on dividends and accelerated depreciation.                                                                                                                                                       



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| | § | In
order to receive benefits within the   framework of the Grant Path, under which a company
may elect to receive   certain grants instead of being eligible for tax reductions or
exemptions, or the Alternate Path, the Industrial Enterprise must be   deemed to
contribute to the economic independence of the State of Israels economy
  in one of the following manners:
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (i) | its
  primary activity involves the biotechnology or nanotechnology fields and   pre-approval
is received from the head of research and development at the   Office of the Chief
Scientist;
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (ii) | its
  revenue derived from activity within a specific country does not exceed 75%   of its
total revenuesin such year;
| | ---- | ----------------------------------------------------------------------------------------------------------------------

| | (iii) | 25%
  or more of its revenues are derived from a specific market of at least 12   million
residents.
| | ----- | ----------------------------------------------------------------------------------------------------

| | § | Upon
the establishment of an approved enterprise,   an investment, within three years, of at
least NIS 300,000 in production   machinery and equipment within is required.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | § | In
order to be eligible for increased tax   benefits under an expansion of the Industrial
Enterprise, a company is   required to invest, within three years of the establishment of
an approved   enterprise, the greater of NIS 300,000 in production machinery and
equipment or a certain percentage of its existing   production machinery and
equipment as follows:
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                           |  |                          |  |                          
| | ------------------------- |  | ------------------------ |  | -------------------------
| | Production assets         |  | % of required investment |  | Required investment      
| |                           |  |                          |  |                          
| | Up to NIS140 million      |  | 12%                      |  | Up to NIS 16.8 million   
| | From NIS140  500 million |  | 7%                       |  | From NIS 9.8  35 million
| | Over NIS 500 million      |  | 5%                       |  | From NIS 25 million      

Tax Benefits for Research and Development

Israeli
tax law allows, under specified circumstances, a tax deduction for expenditures
in the year incurred, including capital expenditures, in scientific research
and development projects, if the expenditures are approved by the relevant
Israeli government ministry and the research and development is for the
promotion of the company and carried out by or on behalf of the company seeking
such deduction. However, the amount of such deductible expenses must be reduced
by the sum of any funds received through government grants for the finance of
such scientific research and development projects. Expenditures not so
approved are deductible over a three-year period.

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

According
to the Law for the Encouragement of Industry (Taxes), 1969, an Industrial
Company is a company located in Israel, at least 90% of the income of which,
in any tax year, exclusive of income from defense loans, capital gains,
interest and dividends, is derived from an Industrial Enterprise owned by
it. An Industrial Enterprise is defined as an enterprise whose major
activity in a given tax year is industrial production activity. We
believe that we currently qualify as an Industrial Company within the
definition of the Law for the Encouragement of Industry (Taxes), 1969.

| |   |                                                                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | Under the
  law, Industrial Companies are entitled to preferred corporate tax benefits,
  among others, such as:                                                             
| |   |                                                                                                                                                                              
| |  | deduction of
  purchases of know-how and patents over an eight-year period for tax purposes;                                                                                 
| |   |                                                                                                                                                                              
| |  | deduction
  over a three-year period of expenses involved with the issuance and listing
  of shares on a stock exchange;                                                     
| |   |                                                                                                                                                                              
| |  | the right to
  elect, under certain conditions, to file a consolidated tax return with
  related Israeli Industrial Companies that satisfy conditions set forth in the
  law;
| |   |                                                                                                                                                                              
| |  | accelerated
  depreciation rates on equipment and buildings.                                                                                                                 



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Eligibility
for the benefits under the law is not subject to receipt of prior approval from
any governmental authority. However, the Israeli tax authorities may
determine that we do not qualify as an Industrial Company. In addition,
we might not continue to qualify as an Industrial Company in the future. 
As a result of either of the foregoing, the benefits described above might not
be available in the future.

Special Provisions Relating to Taxation Under
Inflationary Conditions

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

| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | A special
  tax adjustment for the preservation of equity whereby certain corporate
  assets are classified broadly into fixed (inflation immune) assets and
  non-fixed (soft) assets. Where a companys equity, as defined in the
  law, exceeds the depreciated cost of its fixed assets, as defined in the law,
  the company may take a deduction from taxable income that reflects the effect
  of multiplication of the annual rate of inflation on such excess, up to a
  ceiling of 70% of taxable income in any single tax year, with the unused
  portion carried forward, linked to the increase in the consumer price
  index. If the depreciated cost of fixed assets exceeds a companys
  equity, then the excess multiplied by the annual rate of inflation is added
  to taxable income.
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | Subject to
  certain limitations set forth in the law, depreciation deductions on fixed
  assets and losses carried forward are adjusted for inflation based on the
  increase of the Israeli consumer price index.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |  | Taxable
  gains on certain traded securities, which are taxed at a reduced tax rate
  with respect to individuals following the Tax Reform (and which were
  previously exempt from tax), are taxable at the companys tax rate in certain
  circumstances.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

However, the Minister of Finance may, with the approval of the Knesset Finance
Committee, determine by order, during a certain fiscal year (or until February 28th of the following year) in which the rate of increase of the
price index would not exceed or shall not have exceeded, as applicable, 3%,
that all or some of the provisions of this Law shall not apply to such fiscal
year, or, that the rate of increase of the price index relating to such fiscal
year shall be deemed to be 0%, and to make the adjustments required to be made
as a result of such determination.

Capital Gains Tax

Israeli
law generally imposes on residents and non-residents of Israel a tax on the
sale of any capital assets by residents of Israel, as defined for Israeli tax
purposes, and on the sale of assets in Israel, including our ordinary shares,
by both residents and non-residents of Israel, unless a specific exemption is
available or unless a tax treaty between Israel and the shareholders country
of residence provides otherwise. The law distinguishes between the
inflationary surplus and the real gain. The inflationary surplus is a
portion of the total capital gain which is equivalent to the increase of the
relevant assets purchase price that is attributable to the increase in the
Israeli consumer price index or, in certain circumstances, a foreign currency
exchange rate, between the date of purchase and the date of sale. The
real gain is the excess of the total capital gain over the inflationary
surplus.

Pursuant
to the Tax Reform, generally, capital gains tax is imposed on Israeli residents
at a rate of 15% on real gains derived on or after January 1, 2003, from the
sale of shares in (i) companies publicly traded on the Tel Aviv Stock
Exchange (TASE), or (ii) Israeli companies publicly traded on Nasdaq or on a
recognized stock exchange or regulated market in a country that has a treaty
for the prevention of double taxation with Israel (such as our company), or
(iii) companies dually traded on both the TASE and Nasdaq or on a recognized
stock exchange or a regulated market outside of Israel. This tax rate is
contingent upon the shareholder not claiming a deduction for financing
expenses, and does not apply to: (i) the sale of shares to a relative (as
defined in the Tax Reform); (ii) the sale of shares by dealers in securities;
(iii) the sale of shares by shareholders that report in accordance with the
Inflationary Adjustment Law; or (iv) the sale of shares by shareholders
who acquired their shares prior to an initial public offering (that are subject
to a different tax arrangement). The tax basis of shares acquired prior
to January 1, 2003 will be determined in accordance with the average closing
share price in the three trading days preceding January 1, 2003. However,
a request may be made to the tax authorities to consider the actual adjusted
cost of the shares as the tax basis if it is higher than such average price.

Non-Israeli
residents are exempt from Israeli capital gains tax on any gains derived from
the sale of shares of an Israeli corporation publicly traded on the TASE and/or
on a foreign stock exchange in
countries which are party to a tax treaty, provided such gains do not
derive from a permanent establishment of such shareholders in Israel, and are
exempt from Israeli capital gains tax on any gains derived from the sale of
shares of Israeli companies publicly traded on a recognized stock exchange or
regulated market outside of Israel, provided that such capital gains are not
derived from a permanent establishment in Israel and that such shareholders did
not acquire their shares prior to the issuers initial public offering.
However, non-Israeli corporations will not be entitled to such exemption if an
Israeli resident (i) has a controlling interest of 25% or more in such
non-Israeli corporation, or (ii) is the beneficiary of or is entitled to 25% or
more of the revenues or profits of such non-Israeli corporation, whether
directly or indirectly.



65

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In
some instances where our shareholders may be liable to Israeli tax on the sale
of their ordinary shares, the payment of the consideration may be subject to
the withholding of Israeli tax at the source.

Pursuant
to a treaty between the governments of the United States and Israel, the sale
of shares by a person who qualifies as a resident of the United States within
the meaning of the treaty and who is entitled to claim the benefits afforded to
a resident by the treaty will not be subject to Israeli capital gains
tax. This exemption does not apply if (i) the person holds, directly or
indirectly, shares representing 10% or more of our voting power during any part
of the 12-month period preceding the applicable sale, or (ii) the capital gains
from such sale can be allocated to a permanent establishment in Israel. 
However, the person would be permitted to claim a credit for the capital gains
tax paid in Israel against the U.S. income tax imposed with respect to the
applicable sale, subject to the limitations in U.S. laws applicable to foreign
tax credits.

Taxation of Dividends

Non-residents
of Israel are subject to income tax on income accrued or derived from sources
in Israel. These sources of income include passive income such as
dividends, royalties and interest, as well as non-passive income from services
rendered in Israel. On distributions of dividends other than bonus
shares, or stock dividends, we would be required to withhold income tax at the
rate of 25%. If the income out of which the dividend is being paid is
attributable to an approved enterprise under the Law for the Encouragement of
Capital Investments, 1959, the rate is 15%. A different rate may be
provided in a treaty between Israel and the shareholders country of
residence. Under the U.S.-Israel tax treaty, if the income out of which
the dividend is being paid is not attributable to an approved enterprise, then
income tax with respect to shareholders that are U.S. corporations holding at
least 10% of our voting power in the twelve-month period preceding the
distribution of such dividends, is required to be withheld at the rate of
12.5%.

F.        Dividends and
Paying Agents

Not
Applicable.

G.        Statement by
Experts

Not
Applicable.

H.        Documents on
Display

We
are subject to the informational requirements of the Securities Exchange Act of
1934, as amended, applicable to foreign private issuers and fulfill the
obligations with respect to such requirements by filing reports with the
Securities and Exchange Commission, or SEC. You may read and copy any
document we file, including any exhibits, with the SEC without charge at the
SECs public reference room at 450 Fifth Street, N.W., Washington, D.C.
20549. Copies of such material may be obtained by mail from the Public
Reference Branch of the SEC at such address, at prescribed rates. Please
call the SEC at 1-800-SEC-0330 for further information on the public reference
room. Certain of our SEC filings are also available to the public at the
SECs website at http://www.sec.gov.

As
a foreign private issuer, we are 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 short-swing
profit recovery provisions contained in Section 16 of the Exchange Act. 
In addition, we are not required under the Exchange Act to file periodic
reports and financial statements with the SEC as frequently or as promptly as
United States companies whose securities are registered under the Exchange
Act.

I.        SUBSIDIARY INFORMATION

Not
applicable.

Item 11. Quantitative
and Qualitative Disclosures about Market Risk

Through
our normal operations, we are exposed to market risks including movements in
currency exchange rates and interest rates. We are exposed to currency
risks mainly because we generate most of our revenues in dollars but incur a
majority of our salaries and related expenses and part of our other expenses in
New Israeli shekels. We do not actively hedge interest rate exposure or
engage in other transactions intended to manage risks relating to interest rate
fluctuations. We do hedge assets or liabilities denominated in currencies
other than the dollar.



66

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Presentation of interest rate risk (position as of December
31, 2004)

We
do not use any derivative instruments to protect us from fluctuations in
interest rates. Details regarding our interest rate exposure are set
forth in the table below. Interest rate exposure is monitored by tracking
actual and projected commitments and through the use of a sensitivity analysis.

|                                      |  |                                                                  |        |                 |  |              |  |      |        |      |  |            |  |                          |   |  |  |   |  |  |        | 
|------------------------------------- |  | ---------------------------------------------------------------- | ------ | --------------- |  | ------------ |  | ---- | ------ | ---- |  | ---------- |  | ------------------------ | - |  |  | - |  |  | ------ | 
|                                      |  | Total as of                                                      |        | Settlement Date |  | Fair valueas | 
|                                      |  |                                                                  |        |                 |  |              | 
|                                      |  | December31, 2004                                                 |        | 2005            |  | 2006         |  | 2007 |        | 2008 |  | After 2009 |  | of
  December
  31, 2004 |  
|                                      |  |                                                                  |        |                 |  |              |  |      |        |      |  |            |  |                          |  
|                                      |  | (All amounts in thousands of U.S. dollars, except
  percentages) |       
|                                      |  |                                                                  |       
|                                      |  |                                                                  |       
|Assets
  that incur interest          |  |                                                                  |        |                 |  |              |  |      |        |      |  |            |  |                          |   |  |  |   |  |  |        | 
|A. Cash and
  cash equivalents        |  |                                                                  |        |                 |  |              |  |      |        |      |  |            |  |                          |   |  |  |   |  |  |        | 
|U.S.
  dollars                        |  |                                                                  | 33,012 |                 |  | 33,012       |  |      |       |      |  |           |  |                          |  |  |  |  |  |  | 33,012 | 
|Weighted-average interest
  rate      |  |                                                                  | 2.1    | %               |  | 2.1          |  |      |       |      |  |           |  |                          |  |  |  |  |  |  |       | 
|NIS                                   |  |                                                                  | 1,078  |                 |  | 1,078        |  |      |       |      |  |           |  |                          |  |  |  |  |  |  | 1,078  | 
|Weighted-average interest rate        |  |                                                                  | 3.3    | %               |  | 3.3          |  |      |       |      |  |           |  |                          |  |  |  |  |  |  |       | 
|EUR                                   |  |                                                                  | 347    |                 |  | 347          |  |      |       |      |  |           |  |                          |  |  |  |  |  |  | 347    | 
|Weighted-average interest
  rate      |  |                                                                  | 0.0    | %               |  | 0.0          |  |      |       |      |  |           |  |                          |  |  |  |  |  |  |       | 
|B. Short-term marketable
  securities |  |                                                                  |        |                 |  |              |  |      |        |      |  |            |  |                          |   |  |  |   |  |  |        | 
|U.S.
  dollars                        |  |                                                                  | 4,033  |                 |  | 4,033        |  |      |       |      |  |           |  |                          |  |  |  |  |  |  | 4,033  | 
|Weighted-average interest
  rate      |  |                                                                  | 2.9    | %               |  | 2.9          |  |      |       |      |  |           |  |                          |  |  |  |  |  |  |       | 
|C. Long-term marketable
  securities  |  |                                                                  |        |                 |  |              |  |      |        |      |  |            |  |                          |   |  |  |   |  |  |        | 
|U.S.
  dollars                        |  |                                                                  | 10,752 |                 |  |             |  |      | 10,296 |      |  | 456        |  |                          |  |  |  |  |  |  | 10,752 | 
|Weighted-average interest
  rate      |  |                                                                  | 3.0    | %               |  |             |  |      | 3.0    |      |  | 3.2        |  |                          |  |  |  |  |  |  | 3.0    | 

Exchange Rate Risk Management

Our
functional currency and that of our subsidiaries is the dollar. From time
to time, we enter into forward exchange contracts to reduce the impact of
fluctuations of foreign currencies against the dollar resulting from existing
trade receivables and trade payables. We do not believe that our
activities in entering into these contracts subject us to exchange rate risk
because gains and losses on these contracts offset losses and gains on the
trade receivables or trade payables that are hedged.



67

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As
at December 31, 2004, we had entered into currency forward contracts, ending
March 2005, as a hedge against sales contracts receivable as follows:

| |   |                                                                      
| | - | ---------------------------------------------------------------------
| |  | Obligation to sell GBP 500,000 for a total amount of
  $960,875; and.
| |   |                                                                      
| |  | Obligation to sell GBP 500,000 for a total amount of
  $953,715      

Presentation of foreign currency-denominated assets
and liabilities
(position as of December 31, 2004)

Details
regarding our foreign exchange exposure are set forth in the table below. 
Foreign exchange exposure is monitored by tracking actual and projected
commitments and through the use of a sensitivity analysis.

|                        |  |                                            |       |                 |  |               |  |      |   |      |  |            |  |                        |   |  |  |       |  |  |       | 
|----------------------- |  | ------------------------------------------ | ----- | --------------- |  | ------------- |  | ---- | - | ---- |  | ---------- |  | ---------------------- | - |  |  | ----- |  |  | ----- | 
|                        |  | Total as of                                |       | Settlement Date |  | Fair value as | 
|                        |  |                                            |       |                 |  |               | 
|                        |  | December31, 2004                           |       | 2005            |  | 2006          |  | 2007 |   | 2008 |  | After 2009 |  | of
  December
  312004 |  
|                        |  |                                            |       |                 |  |               |  |      |   |      |  |            |  |                        |  
|                        |  | (All amounts in thousands of U.S. dollars) |      
|                        |  |                                            |      
|                        |  |                                            |      
|Current
  Assets        |  |                                            |       |                 |  |               |  |      |   |      |  |            |  |                        |   |  |  |       |  |  |       | 
|NIS                     |  |                                            | 1,755 |                 |  | 1,755         |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 1,755 | 
|U.K. pound sterling     |  |                                            | 2,620 |                 |  | 2,620         |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 2,620 | 
|Euro                    |  |                                            | 2,863 |                 |  | 2,863         |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 2,863 | 
|Other                   |  |                                            | 1,620 |                 |  | 1,620         |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 1,620 | 
|Total                   |  |                                            | 8,858 |                 |  | 8,858         |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 8,858 | 
|Long-term
  assets      |  |                                            |       |                 |  |               |  |      |   |      |  |            |  |                        |   |  |  |       |  |  |       | 
|NIS                     |  |                                            | 524   |                 |  |              |  |      |  |      |  | 163        |  |                        |  |  |  | 356   |  |  | 524   | 
|Current
  liabilities   |  |                                            |       |                 |  |               |  |      |   |      |  |            |  |                        |   |  |  |       |  |  |       | 
|NIS                     |  |                                            | 5,434 |                 |  | 5,434         |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 5,434 | 
|U.K. pound sterling     |  |                                            | 85    |                 |  | 85            |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 85    | 
|Euro                    |  |                                            | 189   |                 |  | 189           |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 189   | 
|Other                   |  |                                            |      |                 |  |              |  |      |  |      |  |           |  |                        |  |  |  |      |  |  |      | 
|Total                   |  |                                            | 5,708 |                 |  | 5,708         |  |      |  |      |  |           |  |                        |  |  |  |      |  |  | 5,708 | 
|Long-term
  liabilities |  |                                            |       |                 |  |               |  |      |   |      |  |            |  |                        |   |  |  |       |  |  |       | 
|NIS                     |  |                                            | 1,774 |                 |  |              |  |      |  |      |  |           |  |                        |  |  |  | 1,774 |  |  | 1,774 | 



68

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Item 12. Description
of Securities Other Than Equity Securities

Not
applicable.

PART   II

Item 13. Defaults, 
Dividend Averages and Delinquencies

Not
applicable.

Item 14. Material
Modifications to the Rights of Security Holders and Use of Proceeds

Modification of Rights

Not
applicable.

Use of Proceeds

The
net proceeds of our initial public offering were $43,200,000. Of the net
proceeds, we used $3.0 million to repay a portion of our indebtedness to
ECI. The remaining proceeds were invested in cash equivalents and are
used for general corporate purposes and funding our current activities.

Item 15. Controls
and Procedures

(a) Disclosure Controls and
Procedures.

Our
chief executive officer, or CEO, and chief financial officer, or CFO, are
responsible for establishing and maintaining our disclosure controls and
procedures. These controls and procedures were designed to ensure that
information required to be disclosed in the reports that we file under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported within the time periods specified in the rules and forms of the
SEC. We evaluated these disclosure controls and procedures under the
supervision of our CEO and CFO as of December 31, 2004. Based on this
evaluation, our CEO and CFO concluded that our disclosure controls and
procedures are effective in timely alerting them to information required to be
disclosed in our periodic reports to the SEC.

(b) Internal Control Over
Financial Reporting.

There
were no changes in the Companys internal control over financial reporting that
occurred during the year ended December 31, 2004 that have materially affected,
or are reasonably likely to materially affect, our internal control over
financial reporting.

Item
16A. Audit Committee Financial Expert

Mr.
Rami Entin is our Audit Committee financial expert.

Item
16B. Code of Ethics

Our
board of directors has adopted our Code of Ethics and Business Conduct, a code
that applies to all of our directors and employees. A copy of our Code of
Ethics and Business Conduct may be obtained, free of charge, by writing to
ECtel Ltd., Attention: Corporate Secretary, 43 Hasivim Street, Petah Tikva,
Israel.

Item
16C. Principal Accountant Fees and Services

At
the annual meeting held in July 2004, our shareholders re-appointed KPMG to
serve as our independent auditors.

KPMG
billed the following fees to us for professional services in each of the last
two fiscal years:



69

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|                   |  |                         |         |      |   |         | 
|------------------ |  | ----------------------- | ------- | ---- | - | ------- | 
|                   |  | Year Ended December 31, |        
|                   |  | 2003                    |         | 2004 |  
|                   |  |                         |         |      |  
|                   |  |                         |         |      |  
|Audit Fees         |  | $                       | 203,475 |      | $ | 182,241 | 
|Audit-Related Fees |  |                         | -       |      |   | -       | 
|Tax Fees           |  |                         | 12,200  |      |   | 18,000  | 
|All Other Fees     |  |                         | -       |      |   | -       | 
|                   |  |                         |         |      |   |         | 
|                   |  |                         |         |      |   |         | 
|Total              |  | $                       | 215,675 |      | $ | 202,241 | 

Audit
Fees are the aggregate fees billed for the audit of our annual financial
statements. This category also includes services that generally the independent
accountant provides, such as statutory audits (including audits required by the
Office of the Chief Scientist and other Israeli government institutes), and
consents and assistance with and review of documents filed with the SEC. Tax
Fees are the aggregate fees billed for professional services rendered for tax
compliance, other than in connection with the audit. Tax compliance
involves preparation of original and amended tax returns, tax planning and tax
advice.

Our
audit committees policy is to approve each audit and non-audit service to be
performed by our independent accountant before the accountant is engaged.

Item
16D. Exemptions from Listing Standards for Audit Committees

Not applicable.

Item 16E: Purchases
of Equity Securities by the Issuer and Affiliated Purchasers

None.

PART   III

Item 17. Financial
Statements

We
have responded to Item 18 in lieu of this item.

Item 18. Financial
Statements



70

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Item 19. Exhibits

|            |                                                                                                                                               
|----------- | ----------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. | Exhibit                                                                                                                                       
|            |                                                                                                                                               
|1.1         | Memorandum of Association*                                                                                                                    
|1.2         | Amended and Restated
  Articles of Association**                                                                                              
|4.1         | ECtel Managers and
  Employees Option Allotment Plan, as amended**(1)                                                                         
|4.2         | ECtel International
  Employee Stock Option Plan, as amended**                                                                                
|4.3         | ECtel Director Share
  Option Plan 1999*                                                                                                      
|4.4         | Form of Services Agreement
  by and between ECI Telecom Ltd. and the Registrant*                                                              
|4.5         | Supply Agreement, dated
  February 9, 2004, by and between ECI Telecom Ltd. And the Registrant*****                                           
|4.6         | Form of Non-Exclusive
  Sales Agency Agreement (Germany)*                                                                                     
|4.7         | Form of Infrastructure
  Services Agreement by and between ECI Telecom Ltd. and the Registrant***(2)                                          
|4.8         | Share and Asset Purchase
  Agreement, dated August 7, 2001, by and among Telrad Networks Ltd., Telrad
  Hawk Net-I Ltd. and the Registrant****
|4.9         | Form of Warrants issued to
  Telrad Networks Ltd. on October 1, 2001****                                                                      
|4.10        | Registration Rights
  Agreement, dated October 1, 2001, by and between Telrad Networks Ltd. and the
  Registrant****                          
|4.11        | Registration Rights
  Agreement, dated January 22, 2002, by and between ECI Telecom Ltd. and the
  Registrant****                             
|4.12        | Share Purchase Agreement,
  dated February 6, 2002, by and among ECI Telecom Ltd., the Registrant and
  certain investors****                 
|4.13        | Registration Rights
  Agreement, dated February 6, 2002, by and among certain investors and the
  Registrant****                              
|4.14        | ECtel 2003 Share Option
  Plan*****                                                                                                           
|4.15        | ECtel 2003 U.S. Employee
  Stock Option Plan*****                                                                                             
|4.16        | Asset Purchase Agreement,
  dated February 9, 2004, by and between Verint Systems Ltd. and the Registrant*****                                
|4.17        | Joint Intellectual
  Property Agreement, dated March 31, 2004, by and between Verint Systems Ltd.
  And the Registrant*****                   
|4.18        | Patent License-Back
  Agreement, dated March 31, 2004, by and between Verint Systems Ltd. And the
  Registrant*****                           
|4.19        | Summary Translation of Lease
  Agreement, dated March 2005                                                                                    
|8.1         | List of Significant
  Subsidiaries                                                                                                            
|12.1        | Certification of Principal
  Executive Officer pursuant to 17 CFR 240.13a-14(a), as adopted pursuant to
  §302 of the Sarbanes-Oxley Act      
|12.2        | Certification of Principal
  Financial Officer pursuant to 17 CFR 240.13a-14(a), as adopted pursuant to
  §302 of the Sarbanes-Oxley Act      
|13.1        | Certification of Principal
  Executive Officer pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906
  of the Sarbanes-Oxley Act         
|13.2        | Certification of Principal
  Financial Officer pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906
  of the Sarbanes-Oxley Act         
|14(a)       | Consent of Independent
  Registered Public Accounting Firm                                                                                    



---

|      |                                                                                                                                     
|----- | ------------------------------------------------------------------------------------------------------------------------------------
|*     | Incorporated by reference
  to our Registration Statement on Form F-1 (File No.333-10950).                                          
|**    | Incorporated by reference
  to our Annual Report on Form 20-F for the fiscal year ended December 31,
  1999, filed June 30, 2000    
|      | (File No. 0-30348).                                                                                                                 
|***   | Incorporated by reference
  to our Annual Report on Form 20-F for the fiscal year ended December 31,
  2000, filed June 28,2001     
|      | (File No. 0-30348).                                                                                                                 
|****  | Incorporated by reference
  to our Annual Report on Form 20-F for the fiscal year ended December 31,
  2001, filed February 28, 2002
|      | (File No. 0-30348).                                                                                                                 
|***** | Incorporated by reference
  to our Annual Report on Form 20-F for the fiscal year ended December 31,
  2003, filed June 28, 2004    
|      | (File No. 000-30348)                                                                                                                
|(1)   | English translation from
  Hebrew original.                                                                                         
|(2)   | Includes an English
  translation from Hebrew original of an exhibit attached to this Agreement.                                    



71

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SIGNATURES

The
Registrant hereby certifies that it meets all of the requirements for filing on
Form 20-F and that it has duly caused and authorized the undersigned to sign
this Annual Report on its behalf.

|                    |                                         |               
|------------------- | --------------------------------------- | --------------
|                    | ECTEL LTD.                             
|                    | (Registrant)                           
|                    |                                        
|                    | By                                      | /s/ Eitan Naor
|                    |                                        
|                    | Eitan
  Naor                           
|                    | President
  and Chief Executive Officer
|Date: June 28, 2005 |                                         |               



72

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# ECtel Ltd.

# Consolidated Financial Statements As at December 31, 2004



---

---



|ECtel Ltd.                                               
|---------------------------------------------------------
|                                                         
|Consolidated Financial Statements as at December 31, 2004
|                                                         

Contents

|                                                                   | Page
|------------------------------------------------------------------ | ----
|
|
|
|
|Report of Independent Registered Public Accounting Firm            | 2   
|Consolidated Balance Sheets as at                                 
|December 31, 2004 and 2003                                         | 3   
|Consolidated Statements of Income (Loss) for the                  
|years ended December 31, 2004, 2003 and 2002                       | 4   
|Consolidated Statements of Changes in Shareholders' Equity for the
|years ended December 31, 2004, 2003 and 2002                       | 5   
|Consolidated Statements of Cash Flows for the                     
|years ended December 31, 2004, 2003 and 2002                       | 6   
|Notes to the Consolidated Financial Statements                     | 8   



---

---



Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of ECtel Ltd.

We have audited the accompanying
consolidated balance sheets of ECtel Ltd. and its subsidiaries (the Company),
as at December 31, 2004 and 2003 and the related consolidated statements of income (loss),
statement of changes in shareholders equity and consolidated statements of cash
flows for each of the years in the three-year period ended December 31, 2004. These
financial statements are the responsibility of the Companys Board of Directors and
of its management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance
with the Standards of the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. 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 Board of Directors and by 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 consolidated
financial statements referred to above present fairly, in all material respects, the
financial position of the Company and its subsidiaries as of December 31, 2004 and 2003,
and the results of their operations, changes in shareholders equity and their cash
flows for each of the years in the three-year period ended December 31, 2004 in conformity
with generally accepted accounting principles in the United States.

Without qualifying our opinion, we
draw attention to Note 20 to the consolidated financial statement in regard of a class
action lawsuit filed against the Company.

Somekh Chaikin
Certified Public Accountants (Israel)
A member of KPMG International

Tel Aviv, May 15, 2005

F - 2

---

---



|ECtel Ltd.                                   
|---------------------------------------------
|                                             
|Consolidated Balance Sheets as at December 31
|                                             

|                                             |  | 2004 | 2003
|-------------------------------------------- |  | ---- | ----
|
|
|
|Assets                                       |  |      |     
|
|Current assets                               |  |     
|Cash and cash equivalents                    |  |      |     
|Short-term deposit and marketable securities |  |      |     
|Receivables:                                 |  |      |     
|Trade                                        |  |      |     
|Other                                        |  |      |     
|Related parties                              |  |      |     
|Recoverable costs and estimated              |  |     
|earnings - not yet billed                    |  |      |     
|Inventories                                  |  |      |     
|                                             |  |      |     
|                                             |  |      |     
|Total current assets                         |  |      |     
|                                             |  |      |     
|                                             |  |     
|Long-term marketable securities              |  |      |     
|                                             |  |      |     
|Long-term receivables and deposits           |  |      |     
|                                             |  |      |     
|Property, plant and equipment                |  |      |     
|                                             |  |     
|Cost                                         |  |      |     
|Less - Accumulated depreciation              |  |      |     
|                                             |  |      |     
|                                             |  |      |     
|                                             |  |      |     
|                                             |  |     
|Goodwill                                     |  |      |     
|                                             |  |      |     
|                                             |  |     
|Other assets                                 |  |      |     
|                                             |  |      |     
|                                             |  |     
|Assets - held for sale                       |  |      |     
|                                             |  |      |     
|                                             |  |     
|Total assets                                 |  |      |     
|                                             |  |      |     

|
Eitan NaorChief Executive Officer and Director | 
Avi GoldsteinChief Financial Officer
|------------------------------------------------------------- | ---------------------------------------------------

Petach Tikva, May 15, 2005

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



---

---



|ECtel Ltd.                                   
|---------------------------------------------
|                                             
|Consolidated Balance Sheets as at December 31
|                                             

|                                                         |  | 2004 | 2003
|-------------------------------------------------------- |  | ---- | ----
|
|
|
|Liabilities and Shareholders' Equity                     |  |      |     
|                                                         |  |     
|Current liabilities                                      |  |     
|Trade payables                                           |  |      |     
|Related parties                                          |  |      |     
|Advances from customers                                  |  |      |     
|Other payables and accrued liabilities                   |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total current liabilities                                |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Long-term liabilities                                    |  |     
|Liability for employee severance benefits, net           |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Liabilities - held for sale                              |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total liabilities                                        |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Commitments and contingencies                            |  |      |     
|                                                         |  |     
|Shareholders' equity                                     |  |      |     
|Ordinary shares NIS 0.04 par value per share, authorized |  |     
|125,000,000 shares; Issued and outstanding 18,151,172    |  |     
|shares as at December 31, 2004 and 17,995,628 shares     |  |     
|as at December 31, 2003                                  |  |      |     
|Capital surplus                                          |  |      |     
|Accumulated (loss) earnings                              |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total shareholders' equity                               |  |      |     
|                                                         |  |      |     
|                                                         |  |     
|Total liabilities and shareholders' equity               |  |      |     
|                                                         |  |      |     

F - 3

---

---



|ECtel Ltd.                                                              
|------------------------------------------------------------------------
|                                                                        
|Consolidated Statements of Income (Loss) for the years ended December 31
|                                                                        

|                                                                 |  | 2004 | 2003 | 2002        
|---------------------------------------------------------------- |  | ---- | ---- | ------------
|
|
|
|
|Revenues                                                         |  |      |      | 14D         
|Cost of revenues (1)                                             |  |      |      | 10B, 13, 14E
|                                                                 |  |      |      |             
|                                                                 |  |     
|Gross profit                                                     |  |      |      |             
|Research and development costs, net (1)                          |  |      |      | 13, 14F     
|Selling and marketing expenses (1)                               |  |      |      | 13, 14G     
|General and administrative expenses (1)                          |  |      |      | 13, 14H     
|Restructuring and related impairment costs                       |  |      |      | 17          
|Goodwill impairment                                              |  |      |      | 7           
|                                                                 |  |      |      |             
|                                                                 |  |     
|Operating loss                                                   |  |      |      |             
|Financial expenses                                               |  |      |      | 13, 14I     
|Financial income                                                 |  |      |      | 14I         
|Other (expenses) income, net                                     |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |     
|Loss from continuing operations                                  |  |     
|before taxes on income                                           |  |      |      |             
|(Tax benefit) taxes on income                                    |  |      |      | 12          
|                                                                 |  |      |      |             
|                                                                 |  |     
|Net loss from continuing operations                              |  |      |      |             
|Discontinued operations:                                         |  |     
|Income (loss) from discontinued operations (1)                   |  |      |      | 18C         
|                                                                 |  |      |      |             
|                                                                 |  |     
|Net (loss) income for the year                                   |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |     
|(Loss) earnings per share                                        |  |      |      | 11, 14K     
|Basic (loss) earnings per share for:                             |  |     
|Continuing operations                                            |  |      |      |             
|Discontinued operations                                          |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |     
|Weighted average number of shares outstanding                    |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |     
|Diluted (loss) earnings per share for:                           |  |     
|Continuing operations                                            |  |      |      |             
|Discontinued operations                                          |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |     
|                                                                 |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |     
|Weighted diluted average number of shares outstanding            |  |      |      |             
|                                                                 |  |      |      |             
|(1) Stock-based compensation charged in the statements of income |  |     
|is included as follows:                                          |  |     
|                                                                 |  |      |      |             
|Cost of revenues                                                 |  |      |      |             
|Research and development costs                                   |  |      |      |             
|Selling and marketing expenses                                   |  |      |      |             
|General and administrative expenses                              |  |      |      |             
|Discontinued operations                                          |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |      |      |             
|                                                                 |  |      |      |             

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

F - 4

---

---



|ECtel Ltd.                                   
|---------------------------------------------
|                                             
|Statements of Changes in Shareholders' Equity
|                                             

|                               | Ordinary
shares | Share
capital | Capital
surplus | Accumulated
(loss) earnings | Total
Shareholders'
equity
|------------------------------ | --------------- | ------------- | --------------- | --------------------------- | --------------------------
|
|
|
|
|                               |                 |               |                 |                             |                           
|Balance at  December 31, 2001  |                 |               |                 | 17,663,782                  |                           
|                               |                 |              
|Employees stock options        |                 |              
|exercised and paid             |                 |              
|(see Note 11B)                 |                 |               |                 | 254,066                     |                           
|Net income for the year        |                 |               |                 | -                           |                           
|Stock-based compensation       |                 |               |                 | -                           |                           
|                               |                 |               |                 |                             |                           
|                               |                 |              
|Balance at   December 31, 2002 |                 |               |                 | 17,917,848                  |                           
|                               |                 |              
|Employees stock options        |                 |              
|exercised and paid             |                 |              
|(see Note 11B)                 |                 |               |                 | 77,780                      |                           
|Net loss for the year          |                 |               |                 | -                           |                           
|                               |                 |               |                 |                             |                           
|                               |                 |              
|Balance at                     |                 |              
|December 31, 2003              |                 |               |                 | 17,995,628                  |                           
|                               |                 |              
|Employees stock options        |                 |              
|exercised and paid             |                 |              
|(see Note 11B)                 |                 |               |                 | 155,544                     |                           
|Net loss for the year          |                 |               |                 | -                           |                           
|                               |                 |               |                 |                             |                           
|                               |                 |              
|Balance at                     |                 |              
|December 31, 2004              |                 |               |                 | 18,151,172                  |                           
|                               |                 |               |                 |                             |                           

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

F - 5

---

---



|ECtel Ltd.                                                           
|---------------------------------------------------------------------
|                                                                     
|Consolidated Statements of Cash Flows for the years ended December 31
|                                                                     

|                                                              | 2004 | 2003 | 2002
|------------------------------------------------------------- | ---- | ---- | ----
|
|
|
|
|Cash flows from operating activities                          |      |      |     
|                                                              |      |     
|Net (loss) income for the year                                |      |      |     
|                                                              |      |     
|Adjustments to reconcile net income to                        |      |     
|cash provided by operating activities:                        |      |     
|                                                              |      |     
|Depreciation and amortization                                 |      |      |     
|Stock based compensation                                      |      |      |     
|Decrease (increase) in deferred tax                           |      |      |     
|(Gain) loss on sale of property and equipment                 |      |      |     
|Income from discontinued operations                           |      |      |     
|Impairment of fixed assets                                    |      |      |     
|Goodwill impairment                                           |      |      |     
|Inventory write-off                                           |      |      |     
|Decrease (increase) in trade receivables                      |      |      |     
|(Increase) decrease in other receivables                      |      |      |     
|Decrease (increase) in recoverable costs and estimated        |      |     
|earnings - not yet billed                                     |      |      |     
|Decrease (increase) in inventories                            |      |      |     
|Decrease (increase) in long-term receivables                  |      |      |     
|(Decrease) increase in trade payables                         |      |      |     
|Increase (decrease) in advances from customers                |      |      |     
|(Increase) decrease in related parties                        |      |      |     
|(Decrease) increase in other payables and accrued liabilities |      |      |     
|Increase (decrease) in liability for employee severance       |      |     
|benefits, net                                                 |      |      |     
|                                                              |      |      |     
|                                                              |      |     
|Net cash (used in) provided by operating activities           |      |      |     
|                                                              |      |      |     

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

F - 6

---

---



|ECtel Ltd.                                                                    
|------------------------------------------------------------------------------
|                                                                              
|Consolidated Statements of Cash Flows for the years ended December 31 (cont'd)
|                                                                              

|                                                           | 2004 | 2003 | 2002
|---------------------------------------------------------- | ---- | ---- | ----
|
|
|
|
|Cash flows from investing activities                       |      |      |     
|Investment in short-term deposit and marketable securities |      |      |     
|Investment in property, plant and equipment                |      |      |     
|Investment in technology                                   |      |      |     
|Long-term deposit withdrawal (funding)                     |      |      |     
|Proceeds from sale of property, plant and equipment        |      |      |     
|Proceeds from disposal of discontinued operations          |      |      |     
|Employee severance rights withdrawal (funding)             |      |      |     
|Investment in long-term marketable securities              |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Net cash provided by (used in) investing activities        |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|                                                           |      |     
|Cash flows from financing activities:                      |      |     
|                                                           |      |     
|Issuance of ordinary shares, net                           |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Net cash provided by financing activities                  |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Net increase (decrease) in cash and cash equivalents       |      |      |     
|                                                           |      |     
|Cash and cash equivalents at beginning of the year         |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Cash and cash equivalents at end of the year               |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Supplemental disclosures:                                  |      |     
|                                                           |      |     
|Income taxes paid (received), net of tax refunds           |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|Interest received, net                                     |      |      |     
|                                                           |      |      |     
|                                                           |      |     
|                                                           |      |     
|Non-cash transactions                                      |      |     
|                                                           |      |     
|Purchase of property, plant and equipment                  |      |     
|not yet paid                                               |      |      |     
|                                                           |      |      |     

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

F - 7

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 1  General

| | ECtel
Ltd. and its subsidiaries (hereinafter  the Company) provide
telecommunication service providers with comprehensive solutions for their fraud
prevention and interconnect billing needs. The Company was established and commenced
operations in April 1990. In October 1999, the Company completed an initial public
offering of its ordinary shares on the Nasdaq National Market.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | On
February 9, 2004, the Company sold its Government Surveillance Business to Verint Systems
(see Note 18).
| | -----------------------------------------------------------------------------------------------------------

| | The
Companys five subsidiaries are ECtel Inc., ECtel (2000) UK Limited, ECtel B.V.,
Telrad Hawk Net-I Ltd. and ECtel GmbH.
| | ---------------------------------------------------------------------------------------------------------------------------

# Note 2 
Significant Accounting Policies

| | The
financial statements have been prepared in conformity with generally accepted accounting
principles (GAAP) in the United States.
| | ------------------------------------------------------------------------------------------------------------------------------------

| | A. | Principles
of consolidation
| | -- | ---------------------------

| | The
consolidated financial statements include the accounts of the Company and all of its
wholly owned subsidiaries. All significant intercompany accounts have been eliminated in
consolidation.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Financial
statements in U.S. dollars
| | -- | ------------------------------------

| | The
currency of the primary economic environment in which the operations of the Company and
its subsidiaries are conducted is the U.S. dollar (dollar).
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------

| | Most
of the Companys sales are made outside of Israel (see Note 14D regarding
geographical distribution)  and are made primarily in dollars. Most purchases of
materials and components, as well as most selling and other expenses incurred outside
Israel, are in dollars. In view of the foregoing, the dollar has been determined to be
the Companys functional currency.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Transactions
and balances denominated in dollars are presented at their original amounts. Non-dollar
transactions and balances have been translated into dollars in accordance with the
principles set forth in Statement No. 52 of the Financial Accounting Standards Board
(FASB) of the United States.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | All
exchange gains and losses resulting from monetary balance sheet items denominated in
non-dollar currencies are reflected in the income statement when they arise. Such
exchange gains and losses are included in the same income statement items in which the
related transactions are included.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | Cash,
cash equivalents and short-term marketable securities
| | -- | -----------------------------------------------------------

| | The
Company considers all highly liquid investments with maturity of three months or less at
date of purchase, to be cash equivalents. Marketable securities that have an original
maturity of three months or less are considered to be cash equivalents.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Short-term
marketable securities are with maturity date between 91 to 365 days, see also Note 2E.
| | -------------------------------------------------------------------------------------------------

F - 8

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 2 
Significant Accounting Policies (contd)

| | D. | Inventories
| | -- | -----------

| | Inventories
are stated at the lower of cost or market. Cost is determined as follows: Raw materials
(including components)  on the moving average basis. Work in process and finished
products:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Raw
materials and components  on the moving average basis. Labor and overhead
components  on the basis of actual manufacturing costs.
| | ---------------------------------------------------------------------------------------------------------------------------------------

| | E. | Long-Term
marketable securities
| | -- | -------------------------------

| | Long-term
marketable securities at December 31, 2004 consist of corporate and government agencies
debt securities. The Company classifies its debt securities as held-to-maturity.
Held-to-maturity securities are those securities in which the Company has the ability and
intent to hold the security until maturity.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Held-to-maturity
securities are recorded at amortized cost, adjusted for the amortization or accretion of
premiums or discounts.
| | --------------------------------------------------------------------------------------------------------------------------------

| | Any
decline in the market value of any held-to-maturity security below cost, that is deemed
to be other than temporary, results in a reduction in the carrying amount to fair value.
The impairment is charged to earnings and a new cost basis for the security is
established. Premiums and discounts are amortized or accreted over the life of the
related held-to-maturity security as an adjustment to yield using the straight line
method. Interest income is recognized when earned.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | F. | Property,
plant and equipment
| | -- | -----------------------------

| | 1. | These
assets are stated at cost less accumulated depreciation.
| | -- | --------------------------------------------------------------

| | 2. | Depreciation
is computed using the straight-line method, over the estimated           useful life of
the assets as estimated by the Company.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------

| | Annual
rates of depreciation are as follows:
| | --------------------------------------------

|                                   |          |                  
|---------------------------------- | -------- | -----------------
|
|
|
|
|Machinery, equipment and furniture | 6% - 50% | (principally 20%)
|Motor vehicles                     | 15%     

| | Leasehold
improvements are amortized by the straight-line method over the shorter of the useful
lives or the terms of the leases.
| | ---------------------------------------------------------------------------------------------------------------------------------

| | 3. | Major
renewals and improvements are capitalized, while repairs and maintenance           are
expensed as incurred.
| | -- | ------------------------------------------------------------------------------------------------------------------

| | 4. | Upon
the sale or retirement of equipment and leasehold improvements, the cost           and
related accumulated depreciation and amortization are eliminated from the
          respective accounts and the resulting gain or loss is reflected in the
          consolidated statement of income.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 9

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 2 
Significant Accounting Policies (contd)

| | G. | Allowance
for doubtful debts
| | -- | ----------------------------

| | The
financial statements include an allowance which management believes reflects adequately
the loss inherent in receivables for which collection is in doubt. In determining the
fairness of the allowance management bases its determination, among other factors, on
information available about the debtors financial situation, the volume of their
operations and evaluation of the security received from them.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | H. | Amortization
of Goodwill and other intangible assets
| | -- | ----------------------------------------------------

| | According
to SFAS No. 142 goodwill is no longer amortized, but instead tested for impairment at
least annually in accordance with the provisions of SFAS No. 142.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

| | SFAS
No. 142 also requires that intangible assets with definite useful lives be amortized over
their respective estimated useful lives to their estimated residual values, and reviewed
for impairment in accordance with Statement of Financial Accounting Standards No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Change in
basis of valuation
| | ----------------------------

| | The
basis of valuation of the useful live of other purchased technology was accelerated as of
April 2004 from 5 years to 2.5 years. The acceleration was based on managements
decision regarding the development of a replacement solution for the year 2006 and
beyond. Therefore, an amortization period has been adjusted for this change.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | I. | Revenue
recognition
| | -- | -------------------

| | 1. | Revenue
from product sales (which include software) is recognized, in accordance           with
SOP 97-2, Software Revenue Recognition, upon delivery to           customers
and when the following criteria are met: (1) persuasive evidence of an
          arrangement exists, (2) delivery has occurred, (3) the vendors fee is
          fixed or determinable and (4) collectibility is probable.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company includes post contract customer support (PCS) within the price of the product
sale. This PCS is for a one-year period and includes a standard product warranty and
upgrades and enhancements to correct minor bugs or errors in the software. The cost of
providing the PCS is insignificant and the warranty and bug fixes have been infrequent.
Therefore, the PCS revenue is recognized upon delivery of the product in accordance with
SOP 97-2.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | In
certain cases, when the sale contract includes customer acceptance provisions
          with respect to performance guarantees, i.e. installation, revenue is
recognized           when the Company has demonstrated that the criteria specified in the
provisions           have been satisfied.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | Service
revenues from product maintenance contracts and separately priced           extended
warranty contracts are recognized ratably over the contract period.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

10

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 2 
Significant Accounting Policies (contd)

| | I. | Revenue
recognition (contd)
| | -- | ----------------------------

| | 4. | Long-term
contracts are those requiring design, development, engineering and           modification
and are of a significantly longer duration than contracts for           system sales.
Revenue from long-term contracts is recognized using the           percentage of
completion method, which is in accordance with statement of           position (SOP
81-1). The percentage of completion is determined as a ratio of           the extent of
the progress toward completion of the contract using an output           measure method.
In the event that management anticipates a loss on a particular           contract, such
anticipated loss is provided for in full in the period when the           loss is first
anticipated.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
to managements evaluations and assumptions, see Note 2P below.
| | ------------------------------------------------------------------

| | J. | Research
and development costs
| | -- | ------------------------------

| | 1. | Research
and development costs, net of any grants, are charged to the statement           of
income as incurred. Royalties paid and accrued in respect of the said grants
          are classified as cost of goods sold.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Software
development costs are expensed as incurred until the phase where           technological
feasibility has been established, at which time subsequent costs           are
capitalized until the product is available for general release to customers.           To
date, either the establishment of technological feasibility of the           Companys
products and their general release has substantially coincided or           costs
incurred subsequent to the achievement of technological feasibility have           not
been material.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Accordingly,
no software development cost have been capitalized by the Company.
| | -------------------------------------------------------------------------------

| | K. | Liability
for employee severance benefits, net
| | -- | ----------------------------------------------

| | The
increase in value of deposits with severance pay funds during the accounting period is
offset from severance pay expense (see Note 9).
| | ------------------------------------------------------------------------------------------------------------------------------------------

| | L. | Taxes
on income
| | -- | ---------------

| | The
Company accounts for income taxes under Statement of Financial Accounting Standards
(SFAS) No. 109 Accounting for Income Taxes (SFAS 109).
| | --------------------------------------------------------------------------------------------------------------------------------------------------

| | Under
SFAS 109 deferred tax assets or liabilities are recognized in respect of temporary
differences between the tax bases of assets and liabilities and their financial reporting
amounts as well as in respect of tax losses and other deductions which may be deductible
for tax purposes in future years, based on statutory tax rates as these will be
applicable to the periods in which such deferred taxes will be realized. Deferred tax
assets do not include future tax benefits for which the realization of the benefit is
less than more likely than not. Valuation allowances are established when
necessary to reduce deferred tax assets to the amount expected to be realized. Deferred
tax assets and liabilities are presented as current or long-term items in accordance with
the nature of assets or liabilities to which they relate, according to the date of their
realization.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 11

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 2 
Significant Accounting Policies (contd)

| | L. | Taxes
on income (contd)
| | -- | ------------------------

| | Deferred
taxes were not recorded in respect of the following matters 
| | ----------------------------------------------------------------------

| | 1. | Differences
between the rate of change in the Israeli Consumer Price Index           (which serves as
a basis for measurement for tax purposes) and the rate of           change in the NIS/US
dollar exchange rate. This is in accordance with SFAS 109.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Certain
undistributed earnings of a foreign consolidated subsidiary, which are           taxable
upon distribution by way of dividend, as no such dividend distribution
          intention exists.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | Permanent
differences between expenses allowable for tax purposes in respect of           stock
options to employees and expenses included in the Statement of Income.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Income
tax (benefit) expense represents the tax payable for the period and the change during the
period in deferred tax assets and liabilities.
| | -----------------------------------------------------------------------------------------------------------------------------------------------

| | M. | Stock
option plans
| | -- | ------------------

| | The
Company applies the intrinsic value-based method of accounting prescribed by Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations, in accounting for its fixed plan stock options.
As such, compensation expense is determined on the date of grant only if the current
market price of the underlying stock exceeded the exercise price and amortized over the
vesting period.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
October 1995 the Financial Accounting Standards Board (FASB) issued SFAS No. 123 Accounting
for Stock-based Compensation (SFAS 123) which establishes financial
accounting and reporting standards for stock-based compensation plans. The statement
defines a fair value based method of accounting for an employee stock option. The Company
adopted the disclosure provisions of SFAS 123 but opted to remain under the expense
recognition provisions of APB 25.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
following table illustrates the effect on net income and earnings if the Company had
applied the fair value recognition provisions of SFAS 123 ($ in thousands, except per
share data):
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                            | Year ended December 31,
|------------------------------------------- | -----------------------
|
|
|
|
|Net (loss) income as reported               |                        
|Add:  Compensation expenses recorded in     |                        
|statements of income                        |                        
|Less:  Application of compensation expenses |                        
|according to SFAS 123                       |                        
|                                            |                        
|                                            |                        
|Pro forma net (loss) income                 |                        
|                                            |                        
|                                            |                        
|Basic (loss) earnings per share:            |                        
|As reported                                 |                        
|                                            |                        
|Pro forma                                   |                        
|                                            |                        
|Diluted (loss) earnings per share:          |                        
|As reported                                 |                        
|                                            |                        
|Pro forma                                   |                        

F - 12

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 2 
Significant Accounting Policies (contd)

| | N. | Segment
Reporting
| | -- | -----------------

| | The
Company adopted SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information which uses the management approach to designate the internal
information organization that is used by management for making operating decisions and
assessing performance, as the source of the Companys reportable segments (see Note
14D).
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | O. | Derivative
financial instruments
| | -- | --------------------------------

| | The
Company adopted Statement of Financial Accounting Standards No. 133, Accounting for
Derivative Instruments and Hedging Activities, as amended (SFAS 133),
effective January 1, 2001. The Company utilizes derivative financial instruments
principally to manage market risks and reduce its exposure resulting from fluctuations in
foreign currency exchange rates. Derivative instruments include swap agreements, forward
exchange and purchase contracts. Under SFAS 133, the Company is required to recognize all
derivatives on the balance sheet at fair value. Derivatives that are not hedges must be
adjusted to fair value through income. If the derivative is a hedge, depending on the
nature of the hedge, changes in the fair value of derivatives will either be offset
against the change in fair value of the hedged assets, liabilities or firm commitments
through earnings or recognized in other comprehensive income until the hedged item is
recognized in earnings. The ineffective portion of a derivatives change in fair
value will be immediately recognized in earnings.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company does not utilize derivative financial instruments for trading or other
speculative purposes. The Company actively evaluates the creditworthiness of the
financial institutions that are counter parties to derivative financial instruments, and
does not expect counter parties to fail to meet their obligations.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | P. | Estimations
and assumptions in the financial statements
| | -- | -------------------------------------------------------

| | The
preparation of financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and expenses
during the reporting period.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | These
are managements best estimates based on experience and historical data, however
actual results could differ from these estimates.
| | ----------------------------------------------------------------------------------------------------------------------------------------

| | Q. | Transfer
of financial assets
| | -- | ----------------------------

| | The
Company accounts for transfer of financial assets in accordance with the provisions of
SFAS No. 140 Accounting for Transfers and Servicing of Financial Assets.
The Standard requires recognizing the sale of financial instruments when the control over
the financial assets transferred and the consideration from the sale does not include any
beneficial interests in the transferred asset.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 13

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 2 
Significant Accounting Policies (contd)

| | R. | Comprehensive
income
| | -- | --------------------

| | The
Company adopted SFAS No. 130 Reporting Comprehensive Income. It requires that
all items required to be recognized under accounting standards as components of
comprehensive income be reported in a separate financial statement and displayed with the
same prominence as other financial statements. It requires that an enterprise (a)
classifies items of other comprehensive income by their nature in a financial statement
and (b) displays the accumulated balance of other comprehensive income separately from
retained earnings and additional paid in capital in the equity section of the statement
of financial position. In the Companys case, comprehensive income is the same as
net income for all periods presented.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | S. | Impairment
of long-lived assets and assets to be disposed of
| | -- | ------------------------------------------------------------

| | The
Company accounts for long-lived assets under the provisions of FAS No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets (hereinafter SFAS 144). SFAS
144 addresses financial accounting and reporting for the impairment or disposal of
long-lived assets. SFAS 144 requires that long-lived assets be reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of an asset
may not be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected to be
generated by the asset. If the carrying amount of an asset exceeds its estimated future
cash flows, an impairment charge is recognized by the amount by which the carrying amount
of the asset exceeds the fair value of the asset. SFAS 144 requires companies to
separately report discontinued operations and extends that reporting to a component of an
entity that either has been disposed of (by sale, abandonment, or in a distribution to
owners) or is classified as held for sale. See also Note 19.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | T. | Guarantors
accounting and disclosure requirements for guarantees, including indirect
guarantees of indebtedness of others
| | -- | --------------------------------------------------------------------------------------------------------------------------

| | The
Company has adopted the provision of FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees or Indebtedness of
Others (hereinafter the Interpretation). The Interpretation requires the guarantor
to recognize a liability for the non-contingent component of the guarantee i.e. the
obligation to stand ready to perform in the event that specific triggering events or
conditions occur. The initial measurement of this liability is the fair value of the
guarantee at inception. The recognition of the liability is required even if it is not
probable that payments will be required under the guarantee or if the guarantee was
issued with a premium payment or as part of a transaction with multiple elements. The
Company also complies with the disclosure requirements in the Interpretation in regard to
its obligations under guarantees. These disclosure requirements are included in Note 10D
to the consolidated financial statements.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | U. | Accrued
warranty costs
| | -- | ----------------------

| | Accrued
warranty costs are calculated in respect of products sold and work performed (for periods
subsequent to delivery of the products or performance of the work) based on managements
estimation and in accordance with the Companys prior experience, (see also Note
10G).
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 14

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 3  Inventories

| | A. | Inventories
consist of the following:
| | -- | -------------------------------------

|                                                     | December 31
|---------------------------------------------------- | -----------
|
|
|
|
|Raw materials and components                         |            
|Work in process                                      |            
|Finished products, including delivered products that |            
|revenues have not been recognized yet                |            
|                                                     |            
|                                                     |            
|                                                     |            

| | B. | Inventory
write-off
| | -- | -------------------

| | Following
the Companys Board of Directors decision to focus on ECtel core products and
to abandon certain products, the Company wrote off $ 915 thousand of inventories during
the year 2004, (see also Note 14E).
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company believes that this inventory will not be used in the future.
| | ------------------------------------------------------------------------

# Note 4  Marketable
Securities

| | Regarding
Companys marketable securities classification, see Note 2E.
| | ----------------------------------------------------------------------

| | The
Companys investments in marketable securities consist primarily of investments in
US Government Agencies and Corporate bonds. Based on that evaluation and the Companys
ability and intent to hold these investments for a reasonable period of time sufficient
for a forecasted recovery of fair value, the Company does not consider these investments
to be other-than-temporarily impaired at December 31, 2004.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (1) | The
following table summarizes the Companys marketable securities at           December
31, 2004 and 2003 (regarding assumptions used for estimated fair value,           see
Note 16):
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 | December 31, 2004 | 
|-------------------------------- | ----------------- | 
|
|
|
|
|Held to maturity securities      |                   | 
|(carried at amortized cost)      |                   | 
|                                 |                   | 
|US Government Agencies           |                   | 
|Corporate bonds                  |                   | 
|                                 |                   | 
|                                 |                   | 
|Short-term marketable securities |                   | 
|                                 |                   | 
|                                 |                   | 
|                                 |                   | 
|US Government Agencies           |                   | 
|Corporate bonds                  |                   | 
|                                 |                   | 
|                                 |                   | 
|Long-term marketable securities  |                   | 
|                                 |                   | 

F - 15

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 4  Marketable
Securities (contd)

|                            | December 31, 2003 | 
|--------------------------- | ----------------- | 
|
|
|
|
|
|Held to maturity securities |                   | 
|(carried at amortized cost) |                   | 
|US Government Agencies      |                   | 
|Corporate bonds             |                   | 
|                            |                   | 
|                            |                   | 
|                            |                   | 

| | (2) | The
following table summarizes the Companys marketable securities by           maturity
date:
| | --- | ----------------------------------------------------------------------------------------------

|                                                 | Amortized Cost | Fair value
|------------------------------------------------ | -------------- | ----------
|
|
|
|
|Maturity date of long-term marketable securities |                |           
|2006                                             |                |           
|2007                                             |                |           
|                                                 |                |           
|                                                 |                |           

Note 5  Long-Term Receivables and Deposits

| | Consist
of the following :
| | --------------------------

|                                              | December 31
|--------------------------------------------- | -----------
|
|
|
|
|Employee severance rights funded (see Note 9) |            
|Long-term deposits                            |            
|                                              |            
|                                              |            
|                                              |            

F - 16

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

Note 6  Property, Plant and
Equipment

| | Property,
plant and equipment consists of the following:
| | --------------------------------------------------------

|                                             | Machinery
and
equipment | Motor
vehicles | Office
furniture and
equipment | Leasehold
improvements | Total
|-------------------------------------------- | ----------------------- | -------------- | ------------------------------ | ---------------------- | -----
|
|
|
|
|Cost                                         |                         |                |                                |                        |      
|Balance at January 1, 2004                   |                         |                |                                | 8,965                  |      
|Additions                                    |                         |                |                                | 495                    |      
|Disposals                                    |                         |                |                                | -                      |      
|Less - impairment of assets                  |                         |               
|(see Note 17)                                |                         |                |                                | (3,594                 | )    
|                                             |                         |                |                                |                        |      
|                                             |                         |               
|                                             |                         |               
|Balance at December 31, 2004                 |                         |                |                                | 5,866                  |      
|                                             |                         |                |                                |                        |      
|                                             |                         |               
|Accumulated depreciation                     |                         |               
|Balance at January 1, 2004                   |                         |                |                                | 5,488                  |      
|Additions                                    |                         |                |                                | 862                    |      
|Disposals                                    |                         |                |                                | -                      |      
|Less - impairment of assets                  |                         |               
|(see Note 17)                                |                         |                |                                | (2,968                 | )    
|                                             |                         |                |                                |                        |      
|                                             |                         |               
|Balance at December 31, 2004                 |                         |                |                                | 3,382                  |      
|                                             |                         |                |                                |                        |      
|                                             |                         |               
|Undepreciated balance at   December 31, 2004 |                         |                |                                | 2,484                  |      
|                                             |                         |                |                                |                        |      
|                                             |                         |               
|Undepreciated balance at                     |                         |               
|December 31, 2003                            |                         |                |                                | 3,477                  |      
|                                             |                         |                |                                |                        |      

F - 17

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 7 
Acquisition of Telrad Hawk Net-I Ltd.

| | A. | 
| | -- | 

| | 1. | On
October 1, 2001, ECtel acquired 100% of the outstanding shares of Telrad Hawk
          Net-I Ltd. (Net-I). As a result of the purchase of Net-I, goodwill
          in the amount of $ 16,348 thousand was created (as at the date of purchase).
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
June 2003 and 2004, due to significant reduction in Companys revenues, it was
determined that goodwill has been impaired. The Company obtained an independent appraisal
to assess whether goodwill carried on the books need to be written down.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
independent appraisal followed the guidance set forth in paragraphs 19-22 of SFAS 142,
which requires a two-step analysis. The first step used the Discounted Cash flow approach
to measure the fair value of the reporting unit of the Company,
the result of which indicated that the carrying amount of such reporting unit, including
goodwill, exceeded its fair value. The second step was then conducted in order to measure
the amount of impairment loss, by means of a comparison between the implied fair value of
the goodwill and the carrying amount of the goodwill. In the second step, fair value of
the reporting unit of the Company, as determined in the first
step, was assigned to the reporting units individual assets and liabilities. The
excess of the fair value of the reporting unit over the amounts assigned to its assets
and liabilities represented the amount of the implied fair value of the goodwill. The
excess of the current amount of goodwill over the implied fair value of goodwill was
identified as the amount of the impairment loss.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
at June 2003, the Company impaired the goodwill by $ 6,019 to its fair value in the
amount of $ 10,329 thousand.
| | -------------------------------------------------------------------------------------------------------------------

| | As
at June 2004, the Company impaired the goodwill by $ 2,186 to its fair value in the
amount of $ 8,143 thousand.
| | ------------------------------------------------------------------------------------------------------------------

| | 2. | On
December 29, 2004, Net-I shareholders meeting resolved on voluntary
          liquidation process by creditors, under the Companies Law  1983.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------

| | In
addition, Net-I shareholders appointed an attorney to serve as Companys liquidator.
| | ---------------------------------------------------------------------------------------

| | There
is no significant effect on the consolidated financial statements by the aforesaid
process.
| | -------------------------------------------------------------------------------------------------

F - 18

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 7 
Acquisition of Telrad Hawk Net-I Ltd. (contd)

| | B. | Acquired
Intangible Assets
| | -- | --------------------------

| | The
following tables summarize the allocation of acquired intangible assets, estimated
amortization expenses and changes in goodwill, (see also Note 8):
| | --------------------------------------------------------------------------------------------------------------------------------------------------------

|                                              | As at December 31
|--------------------------------------------- | -----------------
|
|
|
|
|Amortized intangible assets:                  |                  
|In process research and development costs (*) |                  
|Current technology                            |                  
|Customer contracts (**)                       |                  
|                                              |                  
|                                              |                  
|Less - accumulated amortization               |                  
|                                              |                  
|Total                                         |                  
|                                              |                  

| | (*) | Fully
amortized at date of purchase.
| | --- | ------------------------------------

| | (**) | As
at December 31, 2004 was fully amortized.
| | ---- | --------------------------------------------

| | Amortization
expenses was $ 48 thousand for each of the years ended December 31, 2004 and 2003,
respectively, as part of research and development cost.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------

| | Future
estimated amortization expenses ($ in thousands):
| | --------------------------------------------------------

|                                                                                              | 
|--------------------------------------------------------------------------------------------- | 
|
|
|
|
|2005                                                                                          | 
|2006                                                                                          | 
|                                                                                              | 
|                                                                                              | 
|Total                                                                                         | 
|                                                                                              | 
|                                                                                              | 
|                                                                                              | 
|The changes in the  carrying  amount of goodwill  for the years ended  December  31, 2004 and | 
|2003 are as follows ($ in thousands):                                                         | 
|                                                                                              | 
|Balance at December 31, 2002                                                                  | 
|                                                                                              | 
|Goodwill impairment during the year 2003                                                      | 
|                                                                                              | 
|                                                                                              | 
|Balance at December 31, 2003                                                                  | 
|                                                                                              | 
|Goodwill impairment during the year 2004                                                      | 
|                                                                                              | 
|                                                                                              | 
|Balance as at December 31, 2004                                                               | 
|                                                                                              | 

F - 19

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 8  Other
Assets

| | Consist
of the following:
| | -------------------------

|                                | December 31
|------------------------------- | -----------
|
|
|
|
|Cost                            |            
|Less - accumulated amortization |            
|                                |            
|                                |            
|                                |            

# Note 9  Liability
for Employee Severance Benefits, Net

| | A. | Employees
of the Israeli Companies
| | -- | ----------------------------------

| | Under
Israeli law and labor agreements, Israeli companies are required to make severance and
pension payments to its retired or dismissed employees and to employees leaving
employment in certain other circumstances.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1. | The
liability in respect of the relevant employees is discharged by           participating
in a defined contribution pension plan and making regular deposits           with a
pension fund. The custody and management of the amounts so deposited is
          independent of any control by the Israeli companies and accordingly such
amounts           funded (included in expenses on an accrual basis) and related
liabilities are           not reflected in the balance sheet.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | In
respect of the liability to other employees, individual insurance policies           are
purchased and deposits are made with recognized severance pay funds.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
liability for severance pay is calculated on the basis of the latest salary paid to each
employee multiplied by the number of years of employment. The liability is covered by the
amounts deposited including accumulated income thereon as well as by the unfunded
provision.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Withdrawals
from the funds may be made only for the purpose of disbursement of severance pay.
| | ---------------------------------------------------------------------------------------------

| | 3. | Expenses
recorded in respect of severance and pension pay for the years ended           December
31, 2004, 2003 and 2002 are $ 661,000, $ 617,000 and $ 513,000,           respectively.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Employees
of U.S consolidated subsidiary
| | -- | ----------------------------------------

| | The
U.S consolidated subsidiary sponsors a 401 (K) defined contribution plan which permits
its employees to make contributions on a pre-tax basis subject to the limits specified in
the Internal Revenue Code. These contributions are not subject to federal income taxes
until distributed to the employees. The subsidiary will match the employees contribution,
to a maximum of the lesser of 5% of the employees earnings or $ 5,000.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
subsidiarys matching contributions with respect to this plan were $ 100,000, $
165,000 and $ 174,000, in 2004, 2003 and 2002, respectively.
| | ------------------------------------------------------------------------------------------------------------------------------------------------

F - 20

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 10 
Commitments and Contingencies

| | A. | Lease
commitments
| | -- | -----------------

| | The
Company and its subsidiaries have entered into operating leases (in respect of premises
and motor vehicles) in Israel and abroad. The agreements expire on various dates from
2005 to 2014 (some have renewal options) and are in US dollar, local currencies or linked
to the US dollar.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Future
minimum annual rental payments which the Company and its subsidiaries are committed to
pay under the above leases, at rates in effect at December 31, 2004, are as follows:
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Year ending December 31: | $ in thousands
|------------------------ | --------------
|
|
|
|
|2005                     |               
|2006                     |               
|2007                     |               
|2008                     |               
|2009                     |               

| | As
to rent expense in connection with the Companys leased premises, see Note 14K.
| | ----------------------------------------------------------------------------------

| | B. | Royalty
commitments
| | -- | -------------------

| | The
Company is committed to pay royalties to the Government of Israel on proceeds from sales
of products in which the Israeli Government participated by way of grants for research
and development. As at December 31, 2004 the Company had received a total of $ 7.7
million in grants and has paid a total of $ 4.4 million in royalties. The royalties are
computed at the rate of 3.5% of the aggregate proceeds from sale of such products, up to
an amount not exceeding 100% of such grants plus interest at the LIBOR rate. Royalties to
the Government of Israel are presented in cost of revenues (see Note 14F).
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | Capital
expenditure commitments
| | -- | -------------------------------

| | The
Company invests in capital expenditures according to Approved Enterpriseprograms.
At December 31, 2004, in order to comply with current approved programs, $ 232 thousand
remain to be invested (see Note 12A.1).
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | D. | Guarantees
| | -- | ----------

| | At
December 31, 2004, the Company has granted guarantees to third parties in the sum of $
4.1 million mainly as performance guarantees that can be demanded in case of material
breach of contracts. The expiration dates of the guarantees are from January 2005 through
December 2006.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 21

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 10 
Commitments and Contingencies (contd)

| | E. | Financial
instruments
| | -- | ---------------------

| | 1. | Forward
exchange contracts
| | -- | --------------------------

| | The
geographical distribution of the Companys operations gives rise to exposure to
market risks mainly from changes in foreign currency exchange rates. Financial
instruments are utilized by the Company to reduce these risks.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company enters into forward exchange contracts to hedge existing non-dollar assets and
liabilities.
| | -------------------------------------------------------------------------------------------------------

| | As
at December 31, 2004, the Company has entered into currency forward contracts, ending
March 2005, as a hedge against sales contracts receivable as follows:
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------

| | a) | Obligation
to sell GBP 500,000 for a total amount of $ 960,875.
| | -- | ---------------------------------------------------------------

| | b) | Obligation
          to sell GBP 500,000 for a total amount of $ 953,715.
| | -- | -------------------------------------------------------------------------

| | Since
the impact of fluctuations in currency exchange rates on foreign exchange contracts
offsets the impact on the underlying items being hedged, these instruments do not expose
the Company to risk that would otherwise result from fluctuations in currency exchange
rates.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Concentrations
of credit risk
| | -- | -----------------------------

| | Financial
instruments, which potentially subject the Company to significant concentrations of
credit risk, consist principally of cash investments and trade accounts receivable. The
Company maintains cash and cash equivalents, forward exchange contracts and certain other
financial instruments with various major financial institutions. These major financial
institutions are located in Israel and the United States, and the Companys policy
is designed to limit exposure to any one institution.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | With
respect to trade account receivables, the Company is subject to a concentration of credit
risk as a majority of its outstanding trade receivables relates to sales to a limited
number of customers.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | F. | Commitments
to indemnify directors and office holders
| | -- | -----------------------------------------------------

| | The
Company has prospectively agreed to indemnify each of its directors and office holders
from time to time (the Directors) to the fullest extent permitted by law and
the Articles of Association of the Company, for:
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (1) | A
financial obligation imposed on the Director in favor of another person by a
          court judgement, including a settlement judgement, or an arbitrators
          award;
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | Reasonable
litigation expenses, including attorneys fees, expended by a           Director or
charged to the Director by a court, in a proceeding instituted           against the
Director by the Company or on its behalf or by another person, or in           a criminal
charge from which the Director was acquitted, or in a criminal           proceeding in
which the Director was convicted of an offense that does not           require proof of
criminal intent.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
total amount of indemnification that the Company has undertaken towards all persons whom
it has resolved to indemnify for the matters and in the circumstances set out in a
standard indemnification letter provided to such directors, jointly and in the aggregate,
shall not exceed an amount of $10 million.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 22

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 10 
Commitments and Contingencies (contd)

| | G. | Liability
for warranty
| | -- | ----------------------

| | The
Company has made provision for its product warranty to its customers, in accordance with
management judgment and based on past experience, see Note 14D.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                             | December 31
2004 | December 31
2003
|-------------------------------------------- | ---------------- | ----------------
|
|
|
|
|Balance outstanding at beginning of the year |                  |                 
|Warranty expenses                            |                  |                 
|Warranties for products sold                 |                  |                 
|Lapsed warranties                            |                  |                 
|                                             |                  |                 
|                                             |                  |                 
|Balance outstanding at end of the year       |                  |                 
|                                             |                  |                 

| | H. | Negative
pledge
| | -- | ---------------

| | In
September 2002, the Company executed a negative pledge to an Israeli Bank in which it
undertook not to perform primarily the following without the Banks prior written
consent:
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (1) | Mortgage,
or undertake to mortgage, in any manner or form, any of its assets in           favor of
any third party.
| | --- | -------------------------------------------------------------------------------------------------------------------

| | (2) | Sell
assets (other than in the ordinary course of business) for consideration
          exceeding $1 million in the aggregate, on an annual basis. On the basis of the
          above mentioned negative pledge, the Bank has agreed to grant various credit
          facilities and/or banking services to the Company. The credit facilities
granted           by the Bank to the Company and outstanding as of December 31, 2004 are
          approximately $ 1,917 thousand for guarantees issued by the Bank in favor of
          third parties, at the request of the Company.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | I. | Contingent
liability
| | -- | --------------------

| | At
the end of November 2003, a customer informed the Company in writing that it deems the
Company to be in breach of various undertakings under an agreement between the parties
for the supply and installation by the Company of a fraud prevention system on the
premises of the customers affiliates; the customer also stipulated steps that it
demands be taken by the Company to remedy such alleged breaches and to avoid a potential
demand for monetary compensation in the future.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
parties are corresponding and holding meetings on the matters in dispute and, at the same
time, the Company is continuing with project activities, based on schedules agreed upon
by the parties. The Company informed the customer that it believes that the remaining
outstanding issues in dispute can be resolved between the parties.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
of December 31, 2004, no provision for cost completion was recorded regarding the above.
| | -------------------------------------------------------------------------------------------

F - 23

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 11 
Shareholders Equity

| | A. | Authorized,
issued and outstanding share capital
| | -- | ------------------------------------------------

|                             | Issued and outstanding shares | Authorized
|---------------------------- | ----------------------------- | ----------
|
|
|
|
|NIS 0.04 par value per share |                               |           
|                             |                               |           

| | B. | Share
incentive and stock option plans
| | -- | --------------------------------------

| | 1.a | The
Companys Share Option Plan (the ECtel Plan) was adopted by the Board of
Directors on June 15, 1998.
| | --- | ----------------------------------------------------------------------------------------------------------

| | The
ECtel Plan provides that options may be granted to senior employees or managers of the
Company or its subsidiary pursuant to (a) one or more sub-plans designed to benefit
Israeli employees from the provisions of Section 102 of the Israeli Income Tax Ordinance
(New Version) 1961 and (b) any other share incentive plan approved by the Board of
Directors of the Company.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Board of Directors initially authorized the Company to grant options for a total of
965,000 shares under the ECtel Plan. The option awards are personal and non-assignable
and terminate automatically upon termination of employment (except for approved
retirement or termination caused by death or disability). The vesting for these options
is in three equal annual installments commencing two years after the date of grant.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
November 1998, the Company granted to employees options to purchase an aggregate of
837,525 ordinary shares. The aggregate amount of compensation expense for this grant was $ 2,604,000.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
May 1999, the Company granted to employees options to purchase an aggregate of 127,475
ordinary shares. The aggregate amount of compensation expense for this grant was $
1,030,000.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
exercise price per share under the option awards was determined based on factors
considered by the Board of Directors. The exercise price per share for these stock
options is $ 1.04 per share.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.b | In
August 1999, the Board of Directors adopted an additional share incentive plan for
non-employee directors. Under the terms of the plan, the Company is authorized to grant
options for a total of 422,200 ordinary shares. In August 1999, the Company granted to
directors options to purchase an aggregate of 422,200 shares. The exercise price is $
4.66 per share. The aggregate amount of compensation expense for this grant was $
2,581,000. These options vest in two equal annual installments commencing March 2001.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
addition, the Board authorized the grant to employees of options to purchase an
additional 180,925 ordinary shares, pursuant to the ECtel Plan. In September 1999, the
Company granted to employees options to purchase an aggregate of 180,925 ordinary shares.
The exercise price is $ 4.66 per share. The aggregate amount of compensation expense for
this grant was $ 1,106,000. These options vest in three equal annual installments
commencing September 2001.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 24

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 11 
Shareholders Equity (contd)

| | B. | Share
incentive and stock option plans (contd)
| | -- | -----------------------------------------------

| | 1.c | In
May 2000, the Board of Directors amended the ECtel Plan (the Amended Plan)
and authorized the Company to grant to employees additional options for a total of
476,760 ordinary shares. In May 2000, the Company granted to employees options to
purchase an aggregate of 476,760 shares. The exercise price is $ 15.75 per share. There
is no compensation expense for this grant as the exercise price is equal to the intrinsic
value of the option at the date of the grant. These options vest in two equal annual
installments commencing at May 2002.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.d | In
January 2001, the Board of Directors authorized, under the above plans, the grant to
employees and directors of options to purchase a total of 832,520 ordinary shares. In
January 2001, the Company granted 812,520 options to employees and 20,000 options to
directors. The exercise price is $ 8.82 per share. There is no compensation expense for
these grants as the exercise price is equal to the intrinsic value of the option at the
date of the grant. These options vest in two equal annual installments commencing at
January 2002.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.e | In
October 2001, the Board of Directors authorized, under the above plans, the grant to
employees and directors of options to purchase a total of 498,000 ordinary shares. In
October 2001, the Company granted 408,000 options to employees and 90,000 options to
Directors. The exercise price is $ 11.55 per share. There is no compensation expense for
these grants as the exercise price is equal to the intrinsic value of the option at the
date of the grant. The employee options vest in two equal annual installments commencing
October 2002. The non-employee director options vest in 12 equal quarterly installments,
commencing January 2002.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.f | In
October 2002, the Board of Directors authorized, under the above plans, the grant to
employees of options to purchase a total of 713,400 ordinary shares. In October 2002, the
Company granted 713,400 options to employees. The exercise price is $ 7.9 per share.
There is no compensation expense for this grant as the exercise price is equal to the
intrinsic value of the option at the date of the grant. These options vest in three equal
annual installments, commencing in October 2003.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.g | In
August 2003, the Board of Directors, authorized two new share option plans for
international and US grantees covering in the aggregate 250,000 shares. Under said 2003
plans, in December 2003, the Company granted 120,000 options to employees. The exercise
price for said options is $ 4.67 per share. There is no compensation expense for this
grant as the exercise price is equal to the intrinsic value of the option at the date of
the grant. These options vest over three years in twelve equal quarterly installments,
commencing on various dates from March 2003 to May 2003.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.h | In
September 2004, the Companys shareholders approved the increase in the number of
ordinary shares underlying the Companys 2003 share option plan for international
grantees from 200,000 ordinary Shares to 1,700,000 ordinary shares and the decrease in
the number of ordinary Shares underlying the Companys other share option plans
(other than the Companys 2003 U.S. stock option plan covering 50,000 ordinary
shares) by an aggregate of (i) 490,266 ordinary shares as of the date of the resolution
and (ii) 437,933 ordinary shares underlying the then outstanding options, which were
scheduled to expire within 60 days following the date of the resolution, upon such
expiration (unless any of such options were exercised prior to such expiration).
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 25

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 11 
Shareholders Equity (contd)

| | B. | Share
incentive and stock option plans (contd)
| | -- | -----------------------------------------------

| | 1.i | In
May 2004, the Board of Directors authorized, under the 2003 Share Option Plan, the grant
to employees of options to purchase a total of 480,000 ordinary shares. In May 2004, the
Company granted 480,000 options to employees. The exercise price is $ 3.14 per share.
There is no compensation expense for this grant as the exercise price was equal to the
intrinsic value of the option at the date of the grant. These options vest 25% after one
year and the rest in 12 equal quarterly installments commencing May 2005.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.j | In
July 2004, the Board of Directors authorized, under the 2003 Plan, the grant to directors
of options to purchase a total of 60,000 ordinary shares. In July 2004, the Company
granted 60,000 options to Directors. The exercise price is $ 2.63-2.77 per share. There
is no compensation expense for this grant as the exercise price was equal to the
intrinsic value of the option at the date of the grant. The options vest 33% after one
year and the rest in 8 equal quarterly installments commencing July 2005.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.k | In
August 2004, the Board of Directors authorized, under the 2003 Plan, the grant to
employees and directors of options to purchase a total of 692,808 ordinary shares. In
August 2004, the Company granted 330,500 options to employees and 362,308 options to
directors. The exercise price ranges between $ 2.43 to $ 2.81 per share. There is no
compensation expense for these grants as the exercise price was equal to the intrinsic
value of the option at the date of the grant. The employee options vest 25% after one
year and the rest in 12 equal quarterly installments, commencing on various dates from
August 2005 to November 2005. The non-employee director options vest 33% immediately, 33%
after 6 months and the rest over 1 year afterwards.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1.l | In
December 2004, the Board of Directors authorized, under the 2003 Plan, the grant to
employees of options to purchase a total of 50,000 ordinary shares. In December 2004, the
Company granted 50,000 options to employees. The exercise price is $ 3.56 per share.
There is no compensation expense for this grant as the exercise price was equal to the
intrinsic value of the option at the date of the grant. These options vest 25% after one
year and the rest in 12 equal quarterly installments commencing December 2005.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Stock
options under all the share incentive and option plans are as follows:
| | -- | ----------------------------------------------------------------------------

|                                             | Year ended December 31
|-------------------------------------------- | ----------------------
|
|
|
|
|Balance outstanding at beginning of the year |                       
|Changes during the year:                     |                       
|Granted                                      |                       
|Exercised *                                  |                       
|Forfeited                                    |                       
|                                             |                       
|                                             |                       
|Balance outstanding at end of the year       |                       
|                                             |                       
|                                             |                       
|*  Average price of options exercised during |                       
|the year (in US$)                            |                       
|                                             |                       

F - 26

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 11 
Shareholders Equity (contd)

| | B. | Share
incentive and stock option plans (contd)
| | -- | -----------------------------------------------

| | 2. | Stock
options under all the share incentive and option plans are as follows:           (contd)
| | -- | -----------------------------------------------------------------------------------------------

|                                     | Year ended December 31
|------------------------------------ | ----------------------
|
|
|
|
|Options may be exercised as follows: |                       
|First year or thereafter             |                       
|Second year or thereafter            |                       
|Third year or thereafter             |                       
|                                     |                       
|                                     |                       
|                                     |                       
|                                     |                       

| | Compensation
expense recorded in statements of income for the relevant years:
| | -----------------------------------------------------------------------------

|Year ended December 31: | $ in thousands
|----------------------- | --------------
|
|
|
|
|2002                    |               
|2003                    |               
|2004                    |               
|                        |               
|                        |               
|                        |               
|                        |               

| | Market
value of the ordinary shares, as determined at the time of issuance by the Board of
Directors (subsequent to the October 1999 public offering, based on market price), was $
4.15 per share for the 1998 grants, $ 9.12 per share for the 1999 grants, $ 10.78 per
share for the 1999 plan for directors and the 1999 plan for employees, $ 15.75 for the
2000 grant, $ 8.82 for the January 2001 grant, $ 11.55 for the October 2001 grant, $ 7.9
for the 2002 grant, $ 4.67 for the 2003 grant and $ 2.9 for the 2004 grant.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Shares
covered by unexercised options have no voting rights or rights to cash dividends.
| | ----------------------------------------------------------------------------------------

| | 3. | In
October 1995 the Financial Accounting Standards Board issued SFAS 123           Accounting
for Stock Based Compensation which establishes financial           accounting and
reporting standards for stock-based compensation plans. The           statement defines a
fair value based method of accounting for an employee stock           option.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
1998, following the adoption of the ECtel Plan, the Company adopted the disclosure
provisions of SFAS 123 but opted to remain under the expense recognition provisions of
Accounting for Stock Issued to Employees in accordance with the methods
prescribed by APB 25.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 27

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 11 
Shareholders Equity (contd)

| | B. | Share
incentive and stock option plans (contd)
| | -- | -----------------------------------------------

| | 3. | (contd)
| | -- | --------

| | As
required by SFAS 123 the Company has determined the fair value of stock-based
arrangements as follows:
| | ---------------------------------------------------------------------------------------------------------

|                          | Fair value
|------------------------- | ----------
|
|
|
|
|1998                      |           
|May 1999                  |           
|August and September 1999 |           
|2000                      |           
|January 2001              |           
|October 2001 (employees)  |           
|October 2001 (directors)  |           
|2002                      |           
|2003                      |           
|May 2004                  |           
|July 2004                 |           
|August 2004 (employees)   |           
|August 2004 (directors)   |           
|December 2004             |           

| | The
fair values of stock-based compensation awards granted were estimated using the Black-Scholes pricing
model with the following assumptions:
| | -------------------------------------------------------------------------------------------------------------------------------------------------

|Year of grant            | Dividend | Expected
option life | Expected
volatility | Risk free
interest rate
|------------------------ | -------- | -------------------- | ------------------- | -----------------------
|
|
|
|
|1998                     |          |                      |                     | -                      
|1999                     |          |                      |                     | -                      
|1999                     |          |                      |                     | -                      
|2000                     |          |                      |                     | -                      
|January 2001             |          |                      |                     | -                      
|October 2001 (employees) |          |                      |                     | -                      
|October 2001 (directors) |          |                      |                     | -                      
|2002                     |          |                      |                     | -                      
|2003                     |          |                      |                     | -                      
|May 2004                 |          |                      |                     | -                      
|July 2004                |          |                      |                     | -                      
|August 2004 (employees)  |          |                      |                     | -                      
|August 2004 (directors)  |          |                      |                     | -                      
|December 2004            |          |                      |                     | -                      

As required by SFAS 123, the Company
has determined the weighted average fair value per option of stock-based arrangements
grants during 2004, 2003 and 2002 to be $ 1.63, $ 2.30 and $ 4.20, respectively. The fair
values of stock-based compensation awards granted were estimated using the
Black-Scholes option pricing model with the following assumptions.

F - 28

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 11 
Shareholders Equity (contd)

| | B. | Share
incentive and stock option plans (contd)
| | -- | -----------------------------------------------

| | Had
compensation expenses for stock options granted under the ECtel Plans been determined
based on fair value at the grant dates consistent with SFAS 123 requirements, the Companys
net (loss) income and (loss) earnings per share would have been reduced to the pro forma
amounts shown below ($ in thousands, except per share data):
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                        | Year ended December 31
|--------------------------------------- | ----------------------
|
|
|
|
|Net (loss) income as reported           |                       
|Add:  Compensation expenses recorded in |                       
|statements of income                    |                       
|Less:  Compensation expenses            |                       
|according to SFAS 123                   |                       
|                                        |                       
|Pro forma net (loss) income             |                       
|                                        |                       
|                                        |                       
|Basic (loss) earnings per share:        |                       
|As reported                             |                       
|Pro forma                               |                       
|                                        |                       
|Diluted (loss) earnings per share:      |                       
|As reported                             |                       
|Pro forma                               |                       

| | C. | Warrants
| | -- | --------

| | In
October 2001, as part of Net-I acquisition, the Company granted to Telrad:
| | -----------------------------------------------------------------------------

| | (1) | Warrants
to acquire 1,000,000 ordinary shares for an exercise price of $ 24 per           share.
| | --- | ------------------------------------------------------------------------------------------------

| | (2) | Warrants
to acquire 250,000 ordinary shares for an exercise price of $ 28 per           share.
| | --- | ----------------------------------------------------------------------------------------------

| | These
warrants were granted for five years expiring October 1, 2006 and were valued at $ 3,922
thousand using the Black  Scholes valuation model with the following
assumptions:
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                        |   |         
|----------------------- | - | --------
|
|
|
|
|Expected volatility     | - | 60%     
|Risk free interest rate | - | 4.57%   
|Warrants terms          | - | 4 years 
|Dividend                | - | 0       
|Stock price             | - | $ 10.997

F - 29

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 12  Taxes on
Income

| | A. | Tax
programs under various Israeli tax laws:
| | -- | --------------------------------------------

| | 1. | Tax
benefits under the Law for the Encouragement of Capital Investments, 1959.
| | -- | ------------------------------------------------------------------------------

| | Pursuant
to the above Law the Company is entitled to tax benefits relating to investments in Approved
Enterprises in accordance with letters of approval received.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | A
major part of the production facilities of the Company has been granted the status of an
Approved Enterprise under the above Law. Income arising from the Companys
Approved Enterprise is subject to zero tax rates under the Alternative
Benefit Method and reduced tax rates based on the level of direct or indirect
foreign ownership, for specified periods.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
period of benefits in respect of most of the Companys production facilities will
terminate in the years 2005  2016. The Companys current investments in
development facilities are made under new approvals.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | At
December 31, 2004, approximately 93% of the cost of the Companys production
facilities represented approved enterprise facilities (2003  45%; 2002  56%).
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
the event of distribution by the Company of a cash dividend out of retained earnings
which were taxed at zero rate due to the Approved Enterprise status, the
Company would be subjected to 20% corporate tax on the amount distributed, and the
recipients would have to pay 15% tax (to be withheld at source) on the amounts of such
distribution received by them.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company has not recorded a deferred tax provision in respect of the above, as there is no
intention to pay a dividend in the foreseeable future and, in any event, there is a tax
strategy available whereby a distribution in liquidation will not create additional taxes
for the Company.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Measurement
of results for tax purposes under the Income Tax Law (Inflationary
          Adjustments), 1985.
| | -- | ------------------------------------------------------------------------------------------------------------

| | Under
this law, operating results for tax purposes are measured in real terms, in accordance
with the changes in the Israeli CPI, or changes in the exchange rate of the dollar for
a Foreign Investors Company, as defined by the Law for the
Encouragement of Capital Investments, 1959. The Company elected to measure its operating
results on the basis of the changes in the Israeli CPI. As a result, the Company is
entitled to deduct from its taxable income an Inflation deduction (which
partially compensates for the decrease in the value of shareholders equity
resulting from the annual rise in the Israeli CPI).
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | Tax
benefits under the Law for the Encouragement of Industry (Taxation), 1969.
| | -- | ------------------------------------------------------------------------------

| | The
Company is an Industrial Company as defined by this Law, and as such is
entitled, among other benefits, to claim accelerated depreciation of machinery and
equipment as prescribed by regulations issued under the inflationary adjustments tax law.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. | Tax
rates applicable to income from other sources in Israel.
| | -- | ------------------------------------------------------------

| | Income
not eligible for Approved Enterprise benefits as mentioned above is taxed at
the ordinary tax rate of 35% (also see Note 12H).
| | ---------------------------------------------------------------------------------------------------------------------------------------

F - 30

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 12  Taxes on
Income (contd)

| | B. | Non-Israeli
subsidiaries
| | -- | ------------------------

| | The
non-Israeli subsidiaries are taxed based upon tax laws in their countries of domicile.
| | ------------------------------------------------------------------------------------------

| | C. | Taxes
on income
| | -- | ---------------

| | Taxes
on income included in the consolidated statements of income are comprised as follows:
| | -------------------------------------------------------------------------------------------

|                                               | Year ended December 31
|---------------------------------------------- | ----------------------
|
|
|
|
|Current and previous years taxes relating to - |                       
|Israeli operations                             |                       
|Foreign operations                             |                       
|                                               |                       
|                                               |                       
|                                               |                       
|                                               |                       
|Deferred taxes relating to -                   |                       
|Israeli operations                             |                       
|Foreign operations                             |                       
|                                               |                       
|                                               |                       
|                                               |                       
|                                               |                       
|                                               |                       
|                                               |                       
|                                               |                       

F - 31

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 12  Taxes on
Income (contd)

| | D. | Reconciliation
of the statutory tax expense to actual tax expense
| | -- | -----------------------------------------------------------------

| | A
reconciliation of the statutory tax expense, assuming all income is taxed at the
statutory rate (see A4 above) applicable to the income of companies in Israel, and the
actual tax expense is as follows:
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                     | Year ended December 31
|---------------------------------------------------- | ----------------------
|
|
|
|
|Loss from continuing operations before               |                       
|taxes on income, as reported in the consolidated     |                       
|statements of income:                                |                       
|                                                     |                       
|                                                     |                       
|Theoretical tax on the above amount                  |                       
|(2004 -35%; 2003 and 2002 - 36%)                     |                       
|Tax effect of differences between the statutory rate |                       
|of tax and tax rate relating to foreign operations   |                       
|Tax benefit arising from the "Approved Enterprise"   |                       
|Differences for which deferred taxes were not        |                       
|recorded                                             |                       
|Taxes in respect of prior years for which deferred   |                       
|taxes were not recorded                              |                       
|Currency revaluation on pre-paid taxes               |                       
|Increase in taxes resulting from permanent           |                       
|differences, net (mainly employee stock option       |                       
|expenses and disallowed expenses)                    |                       
|Adjustments arising from differences in the          |                       
|basis of measurement for tax purposes and            |                       
|for financial reporting purposes and other*          |                       
|                                                     |                       
|                                                     |                       
|Taxes on income for the reported year                |                       
|                                                     |                       

| | * | Resulting
from the difference between the changes in the Israeli CPI (the basis for computation of
taxable income of the Company  (see A2 above) and the changes in the exchange rate
of Israeli currency relative to the dollar.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 32

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 12  Taxes on
Income (contd)

| | E. | Components
of deferred income tax
| | -- | ---------------------------------

| | The
Company recognizes deferred tax benefits based on the managements expectation that
future taxable earnings will be achieved. A valuation allowance has been made because it
is more likely than not that deferred tax assets will not be realized.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Deferred
income tax consists of future tax assets attributable to the following:
| | --------------------------------------------------------------------------------

|                                          | December 31
|----------------------------------------- | -----------
|
|
|
|
|Current deferred tax benefit:             |            
|                                          |            
|Accrued expenses                          |            
|Inventory                                 |            
|Vacation pay accruals                     |            
|Allowance for doubtful debts              |            
|Research and development costs            |            
|Gross current deferred tax benefit        |            
|                                          |            
|                                          |            
|Less - valuation allowance                |            
|                                          |            
|                                          |            
|Net current deferred tax benefit*         |            
|                                          |            
|                                          |            
|Long term deferred tax benefit:           |            
|                                          |            
|Liability for employee severance benefits |            
|Operating and capital loss carryforwards  |            
|Fixed assets                              |            
|Research and development costs            |            
|Others                                    |            
|                                          |            
|                                          |            
|Gross long term deferred tax benefit      |            
|                                          |            
|Less - valuation allowance                |            
|                                          |            
|                                          |            
|Total net deferred tax benefit            |            
|                                          |            

| | * | This
item is included in other receivables in the consolidated balance sheets.
| | - | --------------------------------------------------------------------------------

F - 33

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 12  Taxes on
Income (contd)

| | F. | Tax
assessments
| | -- | ---------------

| | Final
tax assessments have been received by the Israeli company through the 1992 tax year. In
accordance with the provisions of the Income Tax Ordinance tax returns submitted up to
and including the 1998 tax year can be regarded as final.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company has received tax assessments for the years 1999 to 2001 and is in process of
appealing these assessments. The amounts of tax in dispute are approximately $ 2 million,
part of which relate to temporary differences. The Company has made a provision, which in
opinion of management is adequate.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | No
final tax assessments have been received by the Subsidiary Companies since inception. Tax
returns filed up to and including the 1997 tax year for the U.S. subsidiary can be
regarded as final.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Israeli Company has a tax loss carryforward of approximately $ 36 million which can be
carryforward indefinitely.
| | ---------------------------------------------------------------------------------------------------------------------

| | The
UK subsidiary has a tax loss carryforward of approximately $ 2.5 million which can be
carried forward indefinitely. The US subsidiary has a tax loss carryforward of $ 8
million which can be carried forward for 20 years. The GmbH subsidiary has a tax loss
carry forward of approximately $ 250 thousand, which can be carried forward indefinitely.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | G. | Israel
Tax Reform with effect from January 1, þ2003
| | -- | ---------------------------------------------------

| | During
the year 2002, tax reform legislation was enacted with effect from January 1, 2003, which
significantly changed the taxation basis of corporate and individual taxpayers from a
territorial basis to a worldwide basis. From such date an Israel resident taxpayer will
be taxed on income produced and derived both in and out of Israel. The main provisions of
the tax reform that may affect the Company are as follows:
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 1. | Transfer
pricing of international transactions with related parties.
| | -- | --------------------------------------------------------------------

| | The
Income Tax Ordinance was amended to include provisions concerning transfer pricing
between related parties, where one of the parties is situated abroad. Detailed provisions
are to be included in Income Tax Regulations that have yet to be issued. Although the
Company believes that the transfer pricing policy adopted with foreign affiliates is
economically fair, an adjustment may be required following the issue of the said
Regulations.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | Employee
stock incentive plans.
| | -- | -------------------------------

| | The
tax reform codified past practice and determined three alternative tracks for taxing
employee stock option plans. Where a trustee arrangement is in place, the employer can
either claim an expense for tax purposes while the employee will be fully taxed up to the
maximum marginal tax rate of 50% or the Company can waive the tax expense and the
employee will pay a reduced tax rate of 25%. Where there is no trustee arrangement, the
employee is fully taxable and no expense is allowed to the Company. There are detailed
provisions for implementing these tracks. The Company elected the capital gains tax route
of  25%.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 34

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 12  Taxes on
Income (contd)

| | G. | Israel
Tax Reform with effect from January 1, þ2003 (contd)
| | -- | ------------------------------------------------------------

| | 3. | Controlled
foreign company (CFC).
| | -- | ---------------------------------

| | The
amendment to the law introduced Controlled Foreign Company (CFC) provisions, which, in
certain circumstances, will lead to the Israeli company being charged tax on passive
income of foreign affiliates as if it had received a dividend from such companies.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 4. | Capital
gains tax is reduced to 25% from 36%, except with respect to capital           gains from
marketable securities, with transitional provisions for assets           acquired prior
to January 1, 2003.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 5. | The
seven year limit for carrying forward of capital losses has been removed           with
respect to capital losses arising from 1996 and thereafter.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------

| | H. | Reduction
in the company tax rate
| | -- | ---------------------------------

| | On
June 29, 2004, the Israeli Parliament passed Income Tax Ordinance Amendment (No. 140 and
Temporary Order)  2004 (hereinafter  the Amendment).
| | --------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Amendment provides a gradual reduction in the company tax rate from 36% to 30% in the
following manner: in 2004 the tax rate will be 35%, in 2005 the tax rate will be 34%, in
2006 the tax rate will be 32% and from 2007 onwards the tax rate will be 30%.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
effect of the change in the deferred taxes balances required for previous periods, on the
consolidated financial statements, as at December 31, 2004 is immaterial.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Note 13  Related
Party Transactions

| | A. | Related
parties are comprised of principal shareholders (10% or more of the           Companys
share capital) and their subsidiaries and affiliates as well as           other
affiliates of the Company.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Transactions
with related parties are mainly comprised of sales of some of the Companys products
and purchases from related parties in respect of cost of sales.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

| | All
transactions with related parties were in the ordinary course of business and at terms
identical to those applied to transactions with other customers or suppliers.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 35

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 13  Related
Party Transactions (contd)

| | B. | The
Company had various agreements with ECI during the years 2000 to 2004.The
agreements effective throughout 2004 are as follows:
| | -- | ----------------------------------------------------------------------------------------------------------------------------------

| | 1. | An
administrative services agreement for various services including, inter alia,
          security and limited human resources-related services, maintenance, catering
and           transportation, and general and administrative services (all mainly through
          third party providers), as well intellectual property services. For the
          performance of each service the Company pays ECI amounts as agreed upon inthe
          agreement..
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 2. | A
supply agreement with ECI, which replaced an earlier expired supply agreement.
          Under the terms of the new supply agreement, ECI supplies the Company with the
          components (hereinafter: modules) for use in its products. ECI may
          discontinue the production of any modules after giving 12 months prior notice,
          in which case ECI would be obligated to provide the Company with all the
          necessary information to manufacture the modules by the Company and integrate
          them into its products, as well as to supply it with spare parts for such
          modules.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | For
the performance of this agreement the Company pays ECI agreed prices.
| | -------------------------------------------------------------------------

| | 3. | Effective
October 1, 2002, the Company executed an administrative services           agreement with
ECI Telecom GmbH for the provision of certain services to ECtel           GmbH, including
leasing of office space, according to agreed payments.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
term           of the agreement was for an initial period of one year, with automatical
renewal           of additional periods of one year each.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------

| | A
sales representative agreement with ECI Telecom GmbH through September 30, 2002, in which
amounts due to ECI are payment of ECIs cost plus agreed commissions at the balance
sheet date, no open obligations exists.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
connection with the termination of the sales representative agreement with ECI Telecom
GmbH, the Company has undertaken to indemnify ECI Telecom GmbH with regard to any
customer obligations or liabilities in any supply agreements which had been originally
executed by ECI Telecom GmbH with such customers (on behalf of the Company) and which
agreements could not be assigned for any reason to ECtel GmbH.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | At
the balance sheet date, no open obligations exist.
| | -----------------------------------------------------

| | C. | Balances
due to or from related parties:
| | -- | ----------------------------------------

|                  | December 31
|----------------- | -----------
|
|
|
|
|Assets:           |            
|                  |            
|Other receivables |            
|                  |            
|Liabilities:      |            
|                  |            
|Trade payables    |            
|Current account   |            

F - 36

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

Note 13  Related Party Transactions (cont'd)

| | D. | Income
from and expenses to related parties:
| | -- | --------------------------------------------

|                                          | Year ended December 31
|----------------------------------------- | ----------------------
|
|
|
|
|Sales                                     |                       
|Purchase from related parties             |                       
|Research and development costs, net       |                       
|Selling and marketing expenses            |                       
|General and administrative expenses       |                       
|Financial expenses                        |                       
|                                          |                       
|E.  Purchase of fixed assets from related |                       
|parties ($ in thousands):                 |                       

# Note 14 
Supplementary Financial Statement Information

| | Balance
sheet:
| | --------------

| | A. | Cash
and cash equivalents
| | -- | -------------------------

| | Including
short-term deposits and marketable bonds in the amount of $ 33.6 million as at December
31, 2004 (December 31, 2003  $ 27.3 million).
| | ------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Receivables
| | -- | -----------

| | 1. | Net
of provision for doubtful debts of $ 19,262 thousand as at December 31, 2004
          (December 31, 2003 - $ 14,603 thousand).
| | -- | -----------------------------------------------------------------------------------------------------------------------------------

| | The
activity in the allowance for doubtful accounts for the years ended December 31, 2004 and
2003 follows:
| | -----------------------------------------------------------------------------------------------------------

|                                                         | December 31
|-------------------------------------------------------- | -----------
|
|
|
|
|Allowance for doubtful accounts at the beginning of year |            
|Additions charged to doubtful debt expense               |            
|Write-down charged against the allowance                 |            
|Recoveries of amounts previously charged off             |            
|                                                         |            
|                                                         |            
|Allowance for doubtful accounts at the end of year       |            
|                                                         |            

F - 37

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 14 
Supplementary Financial Statement Information (contd)

| | B. | Receivables
(contd)
| | -- | --------------------

| | 2. | Substantially
most of the Companys sales are to large telecommunications           service
providers and government agencies around the world. Typically, the           Company
cannot obtain collateral from such customers.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | 3. | The
Company entered into accounts receivables factoring agreements with number           of
financial institutions (banks). Under the terms of the agreement,
          the Company has the option to factor receivables, with the bank on a
          non-recourse basis, provided that the bank approves the receivable in advance.
          The company continues to be obligated in the event of the commercial disputes,
          (such as product defects) which are not covered under the credit insurance
          policy, unrelated to the credit worthiness of the customer.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
of December 31, 2004, trade receivables in amount of $ 2.8 million were sold (December
31, 2003  $ 2.6 million). The Company accounts for transfer of financial assets in
accordance with the provisions of SFAS No. 140.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | Other
Payables and Accrued Liabilities
| | -- | --------------------------------------

| | Consists
of the following:
| | --------------------------

|                                          | December 31
|----------------------------------------- | -----------
|
|
|
|
|Employees and social benefits             |            
|Tax authorities                           |            
|Commissions payable                       |            
|Verint Purchase agreement (see Note 18)   |            
|Product warranty liability (see Note 10G) |            
|Other payables                            |            
|                                          |            
|                                          |            
|                                          |            
|                                          |            

F - 38

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 14 
Supplementary Financial Statement Information (contd)

| | D. | Disclosures
about segments and related information
| | -- | --------------------------------------------------

| | 1. | The
Company has only one segment, which is divided on geographical basis for
          presentation purpose.
| | -- | ------------------------------------------------------------------------------------------------------------

| | 2. | Information
on sales by geographic distribution:
| | -- | ------------------------------------------------

|              | Year ended December 31
|------------- | ----------------------
|
|
|
|
|Israel        |                       
|Asia Pacific  |                       
|North America |                       
|Europe        |                       
|South America |                       
|Other         |                       
|              |                       
|              |                       
|              |                       
|              |                       

| | Revenues
are attributed to geographic distribution based on the location of the customer.
| | -----------------------------------------------------------------------------------------

| | 3. | Sales
to single customers exceeding 10% of sales :
| | -- | --------------------------------------------------

|           | Year ended December 31
|---------- | ----------------------
|
|
|
|
|Customer A |                       
|Customer B |                       
|Customer C |                       
|           |                       
|           |                       
|           |                       
|           |                       

| | (*) | Less
than 10%.
| | --- | --------------

F - 39

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 14 
Supplementary Financial Statement Information (contd)

| | D. | Disclosures
about segments and related information (contd)
| | -- | -----------------------------------------------------------

| | 4. | Long-lived
assets on a geographical basis :
| | -- | -------------------------------------------

|                  | Israel | United States | Europe | Total 
|----------------- | ------ | ------------- | ------ | ------
|
|
|
|
|December 31, 2004 |        |               |        | 11,215
|December 31, 2003 |        |               |        | 16,235
|December 31, 2002 |        |               |        | 21,997

| | E. | Cost
of revenues:
| | -- | -----------------

|                                            | Year ended December 31
|------------------------------------------- | ----------------------
|
|
|
|
|Materials and components                    |                       
|Salaries, wages and employee benefits       |                       
|Depreciation                                |                       
|Royalties to Chief Scientist (see Note 10B) |                       
|Other manufacturing and service costs       |                       
|Stock-based compensation                    |                       
|                                            |                       
|                                            |                       
|Decrease in inventories                     |                       
|Inventory write off                         |                       
|                                            |                       
|                                            |                       
|                                            |                       

| | F. | Research
and development costs, net:
| | -- | ------------------------------------

|                            | Year ended December 31
|--------------------------- | ----------------------
|
|
|
|
|Expenses incurred           |                       
|Less - grant participations |                       
|                            |                       
|                            |                       
|                            |                       

| | G. | Selling
and marketing expenses :
| | -- | --------------------------------

|                               | Year ended December 31
|------------------------------ | ----------------------
|
|
|
|
|Salaries and employee benefits |                       
|Agents' commissions            |                       
|Advertising and exhibitions    |                       
|Domestic and foreign travel    |                       
|Stock-based compensation       |                       
|Other expenses                 |                       
|                               |                       
|                               |                       
|                               |                       
|                               |                       

F - 40

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

Note 14  Supplementary Financial Statement Information (cont'd)

| | H. | General
and administrative expenses:
| | -- | ------------------------------------

|                                          | Year ended December 31
|----------------------------------------- | ----------------------
|
|
|
|
|Salaries and employee benefits            |                       
|Stock-based compensation                  |                       
|Doubtful debts                            |                       
|Other administrative and general expenses |                       
|                                          |                       
|                                          |                       
|                                          |                       
|                                          |                       

| | I. | Financial
income and expenses:
| | -- | ------------------------------

|                                            | Year ended December 31
|------------------------------------------- | ----------------------
|
|
|
|
|Financial expenses:                         |                       
|Interest and bank charges                   |                       
|Exchange rate differences (see Note 2(B))   |                       
|                                            |                       
|                                            |                       
|                                            |                       
|                                            |                       
|Financial income:                           |                       
|Interest, mainly on bank deposits and other |                       
|receivables                                 |                       
|Exchange rate differences (see Note 2(B))   |                       
|                                            |                       
|                                            |                       
|                                            |                       
|                                            |                       

| | J. | Supplementary
income statement information:
| | -- | -------------------------------------------

|                                              | Year ended December 31
|--------------------------------------------- | ----------------------
|
|
|
|
|Maintenance and repairs                       |                       
|Depreciation of property, plant and equipment |                       
|Taxes (other than income taxes)               |                       
|Rent of premises                              |                       
|Advertising costs                             |                       

F - 41

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 14 
Supplementary Financial Statement Information (contd)

| | K. | (Loss)
earnings per share (EPS)
| | -- | ---------------------------------

| | In
February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 128, Earnings per Share(SFAS
128). Under SFAS 128, basic earnings per share is calculated based upon
the weighted average number of common shares actually outstanding, and diluted
earnings per share is calculated based upon the weighted average number of common
shares, common equivalent shares, and other convertible securities outstanding.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Following
are the details of the basic and diluted EPS:
| | -------------------------------------------------------

|                            | Year ended December 31
|--------------------------- | ----------------------
|
|
|
|
|Basic EPS for:              |                       
|                            |                       
|Continuing operations       |                       
|Discontinued operations     |                       
|                            |                       
|                            |                       
|                            |                       
|                            |                       
|Effect of dilutive options: |                       
|                            |                       
|                            |                       
|Continuing operations       |                       
|Discontinued operations     |                       
|                            |                       
|                            |                       
|                            |                       

| | (*) | Represent
an amount less than $ 0.01
| | --- | ------------------------------------

F - 42

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 15  Balances
in Currencies Other Than the U.S Dollar:

| | A. | Comprised
of:
| | -- | -------------

|                          | December 31, 2004 | December 31, 2003
|------------------------- | ----------------- | -----------------
|
|
|
|
|Assets                    |                   |                  
|Trade receivables         |                   |                  
|Other current assets      |                   |                  
|Long-term receivables     |                   |                  
|                          |                   |                  
|                          |                   |                  
|                          |                   |                  
|Liabilities               |                   |                  
|Trade payables            |                   |                  
|Other current liabilities |                   |                  
|Long-term liabilities     |                   |                  
|                          |                   |                  
|                          |                   |                  
|                          |                   |                  

| | (*) | Linked
to the Israeli CPI.
| | --- | --------------------------

| | B. | Aggregate
exchange rate gains (losses) for the years ended December 31, 2004,           2003 and
2002 are $ 22,000, $ 116,000 and ($ 163,000), respectively.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------

| | As
stated in Note 2(B), exchange gains and losses are included in the same income statement
items in which the related transactions are included.
| | -------------------------------------------------------------------------------------------------------------------------------------------------

F - 43

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 16 
Disclosure Regarding Fair Value of Financial Instruments

| | The
financial instruments of the Parent company and fellow subsidiary companies consist
mainly of cash and cash equivalents, current and non-current receivables, accounts
payable and accruals, and other long-term liabilities.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
view of their nature, the fair value of the financial instruments included in working
capital of the Parent company and fellow subsidiary companies is usually identical or
close to their carrying value.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Considerable
judgment is required to develop the estimates of fair value, thus, the estimates provided
herein are not necessarily indicative of amounts that could be realized in a current
market exchange.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Cash
and cash equivalents, trade receivables, other accounts receivable, parent and fellow
subsidiary companies, net, trade payables, other payables  The carrying amounts
approximate the fair value due to the short maturity of those instruments.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
fair value of long-term marketable securities also approximate the carrying value since
it bear interest at rates closed to the prevailing market rates.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------

# Note 17 
Restructuring and Related Impairment Costs

| | As
a part of the Companys Board of Directors decision to focus on ECtel core
products and to abandon certain products as well as overall cost reductions, the Company
recorded $ 3,358 thousand in reorganization expenses associated with payroll expenses,
disposal of fixed assets and rent contracts termination penalty expenses and others.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | A
reconciliation of the beginning and ending restructuring liability balances are as
follows:
| | ---------------------------------------------------------------------------------------------

|                 | Year ended December 31, 2004
|---------------- | ----------------------------
|
|
|
|
|At the beginning |                             
|of the year      |                             
|Restructuring    |                             
|expenses         |                             
|Realized or paid |                             
|                 |                             
|At the end of    |                             
|the year         |                             
|                 |                             

F - 44

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 18 
Discontinuance of the Government Segment Operation

| | A. | On
February 9, 2004, the Company sold the Government Surveillance Business to
          Verint Systems, an Israeli subsidiary of Verint Systems Inc. The transaction
was           consummated on March 31, 2004.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Pursuant
to the asset purchase agreement, Verint systems purchased certain assets and assumed
certain liabilities relating to our government surveillance business for $ 35 million in
cash. The transferred assets included certain intellectual rights (as more fully
described below), fixed assets, backlog contracts, agreements with subcontractors and
suppliers, third-party software licenses and outstanding customer proposals. The assumed
liabilities included employment-related liabilities in respect of Companys
employees who were hired by Verint Systems, including retention bonuses, severance and
compensation liabilities with respect to the termination of certain of Companys
officers, and an accrual for certain research and development and customization expenses.
The Company has retained its existing government surveillance projects and warranty
obligations and subcontracted the performance thereof to Verint systems upon agreed terms.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | B. | Set
forth below are details of the assets and liabilities held for sale:
| | -- | ------------------------------------------------------------------------

|                                               | December 31
2004 | December 31
2003
|---------------------------------------------- | ---------------- | ----------------
|
|
|
|
|Assets                                         |                  |                 
|Inventories                                    |                  |                 
|Property, plant and equipment, net             |                  |                 
|Other assets                                   |                  |                 
|                                               |                  |                 
|                                               |                  |                 
|                                               |                  |                 
|Liabilities                                    |                  |                 
|Other payables                                 |                  |                 
|Liability for employee severance benefits, net |                  |                 
|                                               |                  |                 
|                                               |                  |                 
|                                               |                  |                 

| | C. | Set
forth below are the results of operations of the discontinued operations:
| | -- | -----------------------------------------------------------------------------

|                                   | Year ended December 31
|---------------------------------- | ----------------------
|
|
|
|
|Revenues                           |                       
|Expenses                           |                       
|Other income*                      |                       
|                                   |                       
|                                   |                       
|Results of discontinued operations |                       
|                                   |                       

| | * | Gain
from sale of government surveillance business.
| | - | ---------------------------------------------------

F - 45

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 19  Recently
Enacted Accounting Standards

| | A. | FASB
Statement No. 151, Inventory Costs
| | -- | -----------------------------------------

| | In
November 2004, the FASB issued FASB Statement No. 151, Inventory Costs,an
amendment to ARB 43, Chapter 4 (SFAS 151). The amendment made by SFAS 151 clarify that
abnormal amounts of idle facility expense, freight, handling costs, and wasted material
(spoilage) should be recognized as current-period charges, and also require the
allocation of fixed production overhead inventory based on the normal capacity of the
production facilities. The guidance is effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. Earlier application is permitted for
inventory costs incurred during fiscal years beginning after November 23, 2004. The
provision of SFAS 151 should be applied prospectively.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company is currently evaluating the possible implications SFAS 151 may have on its
financial statements.
| | ------------------------------------------------------------------------------------------------------------

| | B. | EITF
Issue No. 03-1 The Meaning of Other  Than  Temporary
          Impairment and itsApplication to Certain Investments
| | -- | ----------------------------------------------------------------------------------------------------------------------------

| | In
November 2003, the FASB ratified the consensus reached by the Task Force on EITF Issue
No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
Certain Investments (EITF 03-1) regarding disclosures for certain SFAS
115 investment securities and investments accounted for under SFAS 124. In March 2004,
the FASB ratified other consensus reached by the Task Force on EITF 03-1. The objective
of EITF 03-1 is to provide guidance on determining when an investment is considered
impaired, whether that impairment is other-than-temporary, and the measurement of an
impairment loss. The guidance also includes accounting considerations subsequent to the
recognition of an other-than-temporary impairment and requires certain disclosures about
unrealized losses that have not been recognized as other-than-temporary impairments. In
September 2004, the FASB issued FASB Staff Position (FSP) EITF Issue 03-1-1
that delays the effective date for the measurement and recognition guidance included in
EITF 03-1. The FASB recently announced that it intends on reconsidering in its entirety
EITF 03-1 and all other guidance on disclosing, measuring, and recognizing
other-than-temporary impairments of debt and equity securities Until new guidance is
issued, companies must continue to comply with the disclosure requirements of EITF 03-1
and all relevant measurement and recognition requirements in other accounting literature.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | C. | FASB
Statement No. 123 (Revision 2004) Share-Based Payment (SFAS 123R)
| | -- | --------------------------------------------------------------------------

| | In
December 2004, the Financial Accounting Standards Board (FASB) revised SFAS no. 123 (SFAS
No. 123R), Accounting for Stock-Based Compensation, requiring companies to
record share-based payment transactions as compensation expense at fair market value.
SFAS no. 123R further defines the concept of fair value as it relates to such
arrangements. Based on SEC guidance issued in April 2005, the provision of this Statement
will be effective for the Company as of January 1, 2006. The Company currently
accounts for the Options under the recognition and measurement principles of APB 25 and
related Interpretations using the intrinsic value method. Upon the adoption of SFAS 123R,
the Company will be required to apply the provisions of the statement prospectively for
any newly issued, modified or settled award after the date of initial adoption. As the
Company currently uses the intrinsic value method to value the Options, the fair value
assigned to any newly issued, modified or settled awards after the adoption of SFAS 123R
is expected to be greater due to the differences in valuation methods, (see Note 11B).
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

F - 46

---

---



|ECtel Ltd.                                                            
|----------------------------------------------------------------------
|                                                                      
|Notes to the Consolidated Financial Statements as at December 31, 2004
|                                                                      

# Note 19  Recently
Enacted Accounting Standards (contd)

| | D. | FASB
Statement No. 153 Exchange of Non Monetary Assets  an Amendment to           APB
No.29"
| | -- | ---------------------------------------------------------------------------------------------

| | In
December 2004, the FASB issued SFAS No. 153, Exchanges of Non Monetary Assets an
amendment to APB No. 29". This Statement amends Opinion No. 29 to eliminate the
exception for non monetary exchanges of similar productive assets and replaces it with a
general exception for exchanges of non monetary assets that do not have commercial
substance. A non monetary exchange has commercial substance if the future cash flows of
the entity expected to change significantly as a result of the exchange. Adoption of this
statement in not expected to have any impact on the financial statements of the Company.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

# Note 20 
Subsequent Event

| | In
January 2005, the Company was notified of a class action complaint which had been filed
in the District Court of the State of Maryland against the Company, certain officers and
directors of the Company who served in such positions in the years 2001-2003, as well as
a major shareholder during the referenced period. The complaint alleges violation of U.S.
Federal Securities laws and breach of fiduciary duties in connection with disclosure of
ECtels financial results between April 2001 and April 2003.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
Company believes that the allegations made in the complaint are without merit and that it
intends to vigorously defend against such complaint.
| | --------------------------------------------------------------------------------------------------------------------------------------------------

F - 47

---

---