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                                    FORM 10-K
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
(Mark One)

|X|    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

                   For the fiscal year ended December 31, 1997

                                       OR

|_|    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from ________ to ___________

Commission file number: 000-22327

                             PSW TECHNOLOGIES, INC.
             (Exact name of Registrant as specified in its charter)

Delaware                                                     74-2796054
(State or other jurisdiction of                              (I.R.S. Employer
incorporation or organization)                               Identification No.)

6300 Bridgepoint Parkway,  Building 3, Suite 200, Austin Texas 78730 (Address of
principal executive offices) (Zip code)

                                 (512) 343-6666
               (Registrant's telephone number including area code)

           Securities registered pursuant to Section 12(b) of the Act:
Title of Securities                                Exchanges on which Registered
None.                                              None.

           Securities registered pursuant to section 12(g) of the Act:
                          Common Stock, $.01 par value

         Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of
1934  during  the  preceding  12 months  (or for such  shorter  period  that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ____
         Indicate by check mark if disclosure of delinquent  filers  pursuant to
Item 405 of Regulation S-K is not contained  herein,  and will not be contained,
to the best of  registrant's  knowledge,  in  definitive  proxy  or  information
statements  incorporated  by  reference  in Part  III of this  Form  10-K or any
amendment to this Form 10-K. |_|
         The aggregate  market value of the voting stock held by  non-affiliates
of the Registrant, based upon the closing sale price of Common Stock on March 2,
1998 as reported on the Nasdaq National Market, was approximately $28 million.
         As of March 2, 1998, the Registrant had  outstanding  8,987,874  shares
Common Stock.

                       Documents Incorporated By Reference
     Portions  of the  Proxy  Statement  for  Registrant's  1998  Annual Meeting
of Stockholders are incorporated by reference into Part III of this Form 10-K.

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                                     PART I

Item 1.  Business

         This Business  section and  other  parts  of  this  Form  10-K  contain
forward-looking   statements  that  involve  risk  and  uncertainties  including
statements regarding customer and industry  concentration.  The Company's actual
results   may  differ   significantly   from  the  results   discussed   in  the
forward-looking statements.  Factors that might cause such a difference include,
but are not limited to, those  discussed below and in  "Management's  Discussion
and Analysis of Operations" in Item 7 of this Form 10-K.

         PSW  Technologies,  Inc.  ("PSW"  or the  "Company")  provides  systems
integration and software development  services to information  technology ("IT")
vendors and IT users.  IT vendors  primarily  consist of software  companies who
utilize the Company's services to help bring their products to market faster. IT
users  generally  utilize the  Company's  services to help  define,  develop and
complete high value,  mission critical  enterprise software systems for internal
use.  Services  are  typically  provided  on a  project  or  mission  basis.  In
project-based  engagements,  PSW is retained to complete a specifically  defined
set of tasks,  such as porting a specific  version of client  software  to a new
release of an operating system. In mission-based engagements, PSW is retained to
manage, on an ongoing basis, a specific mission within the client  organization,
such as  responsibility  for all testing  functions  for a client  organization.
Mission  engagements involve multiple projects and releases which generally come
up for renewal on an annual or other periodic basis.

         The  Company  is  flexible  in  structuring  the  terms  of its  client
engagements, often using a time-and-materials  pricing  model  with set  project
milestones,   but   employing   a   fixed-price   model  per  phase  in  certain
circumstances.  The Company works in partnership  with its clients at the client
site or at PSW's facilities,  as appropriate.  This flexible,  joint development
approach,  together with the Company's utilization of proprietary methodologies,
is designed to reduce risks to PSW and its clients, maximize client satisfaction
and allow PSW to transfer expertise to its clients.

         The  Company  was  founded  in 1989 as a  separate  division  of Pencom
Systems  Incorporated,   ("Pencom"),  a  privately  held  corporation,  to  take
advantage of the large numbers of subcontractors placed by Pencom with IBM's AIX
organization in Austin,  Texas. PSW was incorporated in Delaware in August 1996.
In October 1996, Pencom contributed certain assets and associated liabilities of
its software  division and a portion of a software  contract that had previously
been allocated to other  operations of Pencom to the Company in exchange for all
of the  outstanding  Common Stock of the Company and certain  warrants issued to
Pencom and certain of its  employees  to purchase  shares of Common Stock of the
Company. The Company completed an initial public offering of 3,277,500 shares of
Common  Stock  in June  and July of 1997 in which  the  Company  received  $25.7
million in net proceeds.  The Company maintains its principal  executive offices
at 6300 Bridgepoint Parkway, Building 3, Suite 200, Austin, Texas 78730, and its
telephone number at such location is (512) 343-6666.

Industry Background

         The growing  worldwide  demand for IT  services  has been driven by the
increasing  reliance on IT as a strategic tool for addressing  critical business
issues.   Deregulation,   globalization   and   technological   innovation   are
accelerating  the rate of change in  business,  resulting  in a more complex and
intensely   competitive  business   environment.   Organizations  face  constant
pressures to improve the quality of products and services,  reduce cost and time
to market, improve operating efficiencies and strengthen customer relationships.
These  pressures are  increasingly  causing  business  managers to utilize IT to
integrate and streamline business processes with customers and suppliers thereby
decreasing response time,  lowering costs and improving  information flow. These
trends,  together with rapid advances in technology,  are primarily  driving the
move from traditional  host-based  legacy computing systems to more flexible and
functional  technologies,  including  the Internet,  Web based user  interfaces,
client/server  architectures,  object-oriented  programming languages and tools,
distributed   database   management   systems  and  the  latest  networking  and
communications technologies.


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         In order to compete in this business  environment,  IT  departments  of
Fortune 1000 companies often must deploy custom designed  software  applications
composed of multiple operating  systems,  databases,  programming  languages and
networking  protocols throughout the enterprise.  At the same time,  competitive
conditions and cost pressures are  increasingly  forcing such companies to focus
on core competencies and reduce or limit the growth of their IT workforce.

         In addition to the increasing  demand for more responsive  technologies
to address  these  business  challenges,  technology as a whole is becoming more
complex and individual  technology  life-cycles are shortening at a faster rate.
The foregoing has placed increasing pressure on IT vendors to bring new products
and new  versions of proven  products  to market  faster and  simultaneously  to
ensure that those  products  operate with an increasing  number of platforms and
middleware.

         The  convergence  of these  trends is  resulting  in (i) an  increasing
movement of Fortune 1000 companies  toward joint projects with software  service
firms that have a high level of  expertise  in critical  emerging  technologies,
rather  than   relying  on  their   internal   resources   for  the  design  and
implementation of enterprise business systems and (ii) an increasing need within
the research and  development  departments  of key vendors of critical  emerging
technologies   to  outsource  to  software   service  firms  a  portion  of  the
development,   porting  and  testing  of  their   existing  and  new   products.
Accordingly, a growing number of IT users and IT vendors are seeking the help of
software  services firms with strong  technical  expertise in critical  emerging
technologies  and the ability to implement high value  solutions on a prompt and
cost-effective basis.

The PSW Strategy

         PSW  provides  high  value  solutions  to IT  vendors  and IT  users by
mastering  and applying  critical  emerging  technologies,  including  Web based
distributed computing,  object-oriented development,  advanced operating systems
and systems management  technologies.  PSW targets companies that are developing
technologies  which it believes  will be  important  to, and likely to be widely
deployed  by,  its  current  and  potential  IT  user  clients.   Through  these
engagements,  PSW  often  gains  an early  and  comprehensive  understanding  of
critical  emerging  technologies and is therefore well positioned to service the
continued  needs of these and other IT  vendors,  as well as the needs of the IT
user community.  The Company  incorporates  the knowledge and expertise  derived
from each of its client  projects  into its  proprietary  Genova  methodologies,
enabling PSW to retain and distribute its institutional knowledge throughout the
Company  and to  achieve  improvements  in cost,  quality  and  speed on  client
projects.

Services

IT Vendor Clients

         The  Company  provides  software research and development services that
enable its IT vendor clients to improve the quality and speed to market of their
products and, PSW believes,  to achieve an earlier flow of revenue and increased
revenues over the long term.  PSW's  services also enable these clients to focus
on  their  core  competencies,  limit  their  permanent  headcount  and  relieve
temporary workload spikes.

         The Company's  experience with, and knowledge of, IT vendors'  products
often  leads to  significant  follow-on  work in  related  projects  with  these
vendors,  other IT vendors and IT users. At the same time, PSW's experience with
IT users  allows it to  assist  its IT vendor  clients  as they seek to  achieve
wide-spread  adoption of their  technologies  and  enables PSW to give  valuable
feedback to such IT vendors  regarding  the most  appropriate  business  use for
their respective technologies.

The Company offers the following suite of services to its IT vendor clients:

             Development Services

The Company assists clients in the development of products,  the addition of new
capabilities to existing  products and the  development of specialized  software
for  clients'  customers.  PSW's  experience  in computer  architecture,  system

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performance,  operating  systems,  device drivers and middleware, as well as its
software development  methodology, position the Company to enable its clients to
deliver critical software to the marketplace in a timely fashion.

           Porting Services

         The Company assists  clients in the porting of their software  products
to other computing platforms. PSW has extensive operating system experience with
Windows NT, Windows 95,  Solaris,  AIX, HP/UX and NEXTSTEP,  as well as with the
compilers and development tools required to port software.  The Company performs
the porting,  testing and  documentation  of the client product to the specified
operating  environments.  The Company utilizes its Genova porting methodology to
efficiently assess the portability of software to Windows NT and other operating
environments,  to determine the best approach for  completing  ports in a timely
manner and for improving future software portability.

             Testing Services

         The Company  assists clients in test planning,  test suite  development
and test execution.  System verification testing involves the design of tests to
ensure that products adhere to the  specifications and standards demanded by the
client.  Compatibility  testing verifies that specific programs and devices work
with new operating system software.  Standards  compliance  testing involves the
development  of test suites to verify binary or source code  compatibility  with
published standards.

             Advisory Services

         The Company provides advisory services to assess development,  porting,
testing  or support  projects from a technical,  process and project  management
viewpoint.  The Company utilizes its Genova  methodology and prior experience to
identify areas of improvement and make recommendations.  In addition, assessment
services are often used to allow for the  necessary  research and  evaluation to
develop a more extensive proposal for a client.

             Support Services

         The Company provides  customized  technical support for complex systems
to software  developers or users.  Support is provided  on-site,  on-line and by
telephone.  The Company's  services  include help desk,  defect  correction  and
critical situation support.

IT User Clients

         The  Company  also  develops  high  value,  mission critical enterprise
business systems designed to enable  its IT user clients to improve  the quality
of the services they provide to  their customers  through  enhanced  information
capture and  control,  increased accuracy and efficiency and decreased costs and
response times.  The Company offers services ranging from consulting,  to custom
system  development,  to the development of systems  management  solutions.  The
Company   provides  enterprise  solutions  in  a  wide   variety  of   computing
environments  utilizing  leading  technologies,  including Web/Internet, client/
server   architectures,   object-oriented   programming   languages  and  tools,
distributed  database   management  systems  and   the  latest   networking  and
communications technologies.

        The Company focuses on long-term, strategic enterprise solutions  due to
their  greater  value  to  the   client  than  departmental  systems,   and  the
corresponding  potential  for longer-term relationships. In addition, enterprise
system  projects  are  typically  larger  and  more  technically  complex   than
departmental system projects,  thereby   creating a barrier to entry for smaller
services  firms and  increasing the importance of the breadth and depth of PSW's
technical expertise when competing with other firms regardless of their size.


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         The  Company  offers the  following  suite of  services  to its IT user
clients:

            Custom Application Development Services

         PSW provides services to design, construct and deploy custom enterprise
business  systems  utilizing Web,  Internet,  client/server  and object oriented
technologies.  The Genova Business  Systems  Development  Methodology is used to
define business objectives,  gather requirements and perform analysis,  and then
design,  implement,  test and deploy the system.  The project team for a typical
engagement  consists of PSW personnel and client  personnel,  with PSW providing
project  management  and  overall  technical  leadership.  Engagement  durations
may  last  several  years  and  involve  deployment  of multiple versions of the
business system.

             Systems Management Implementation Services

         The Company provides planning,  design and implementation  services for
systems  management.  These services  determine the  availability,  performance,
capacity and servicing requirements of the clients' computing infrastructure and
applications.  Then using industry products primarily associated with the Tivoli
Management Environment,  PSW offers serivces to  design, install,  configure and
test a specific system management solution for the client.

             Enterprise Consulting Services

         The Company  offers  enterprise  consulting  services to assist clients
with the  assessment,  monitoring and  management of projects.  PSW utilizes its
Genova Assessment Methodology, which involves a seven step process to define the
focus of the assessment, conduct the required research, analyze the findings and
provide specific actions and  recommendations to the client. The Genova Business
Systems Development Methodology is also used as a benchmark to determine missing
components or deliverables in the client's  project or process.  The deliverable
in an  enterprise  consulting  engagement  consists  of a report  identifying  a
project's  strengths and weaknesses,  assessing  schedule and resource plans and
recommending  specific actions.  A summary report is typically  presented to the
client's management.

  Genova Methodologies

         Software  development,  testing,  delivery and  deployment is a complex
process. Consequently, PSW employs its Genova methodologies to lower the risk of
project overruns or client dissatisfaction.

         The Company believes that successful  software  projects require a well
designed approach, development process and underlying procedures to organize the
project team to efficiently accomplish numerous interrelated tasks. PSW's Genova
methodologies  achieve this by defining the  specific  deliverables  required at
each phase of the  development  process,  the tasks  required  to develop  them,
examples and templates. In addition,  because the methodologies provide a common
structure  between  projects,  PSW team members can tap the  experience,  ideas,
measurements   and   estimates  of  other  teams  who  have  worked  on  similar
engagements. Technical staff members can often get the latest information  about
technologies being used on the project from PSW professionals who are working on
projects with the IT vendors who develop and support that technology.

         Genova  methodologies  have  several  common  elements  that help align
client expectations with the project objectives.  All the methodologies  consist
of a thorough  definition phase where client  objectives and user or marketplace
requirements  are  defined.   The  definition  phase  of  a  project  emphasizes
specifications which can be positively verified during the testing phase. Genova
methodologies  also emphasize proper up front design prior to  implementation to
minimize the risk of design flaws. The implementation  phase of each methodology
includes a complete testing plan, one of the frequently  underestimated parts of
a project.

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Marketing and Sales

  Marketing

         Strategic  market  planning is performed by the executive  staff of the
Company,  which  actively  seeks  guidance  from a  number  of  sources  to make
strategic decisions.  These sources include PSW clients,  senior technical staff
members,   sales  personnel  and  numerous  executive  contacts  throughout  the
industry.  The executive  staff meets  off-site  quarterly to discuss  strategic
issues and actions.  Action items are identified and tracked  between  meetings.
Senior  technical staff members meet twice a year at the PSW Technology Forum to
share their views and produce a set of strategic  actions for themselves and for
the executive staff to pursue business  opportunities  resulting from changes in
the technology landscape.

         The marketing  department controls and promotes key corporate messages,
consistent  marketing programs and materials and ongoing public relations.  This
is accomplished by working in coordination with Company  initiatives and through
a program of regular communication of newsworthy items to key press and industry
analysts.  Public  relations is the primary  vehicle  used to promote  corporate
image through the use of client case studies and placement of technical articles
by senior technical staff.

         Service  marketing  supports the sales  process by producing  qualified
leads.  The Company  focuses on implementing a "value chain" that seeks to align
the  communication  and delivery of the highest value  services  possible to the
client.  This includes  marketing,  sales,  project  management,  methodologies,
recruiting,  training and any other initiatives  required to deliver consistent,
high quality service.  The marketing  emphasis is on communicating  the value of
the service to the client and  demonstrating  PSW's  capabilities to deliver the
service effectively.

         The  Company's  marketing  programs  emphasize  relationships  with  IT
vendors,  clients and other key partners to shorten the sales cycle and increase
the  productivity  of PSW's  sales  resources.  PSW  works  closely  with  these
companies  during the sales process to present a unified proposal to the client.
At the same time, PSW does not resell hardware or software products of any other
IT vendor, maintaining its independence to recommend the appropriate solution to
each of its clients.

Sales

         PSW's sales force consists of Business  Development Managers and Senior
Account Managers.  Business  Development  Managers identify appropriate business
opportunities  and client needs.  Senior members of the technical  staff provide
high level technical  consulting early in the client  relationship to thoroughly
explore the  client's  needs and to propose  solutions.  These  solutions  often
result in PSW projects  involving project managers and technical  professionals,
in which case a Senior  Account  Manager will be assigned to oversee the project
and serve as the primary account manager.

         Senior  Account   Managers  are  experienced   professionals   in  both
relationship  management  and in  understanding  the business needs of either IT
vendors or IT users. They are responsible for achieving high client satisfaction
and growing additional business in their assigned accounts. Business Development
Managers  are  paid a  commission based on  the  gross  margin of  business they
obtain.  Commissions  are also  structured  to incent finding new clients and to
incent  the  sale  of  larger engagements.  Senior Account  Managers   are  also
commissioned  but  have a  higher  base  salary  and  lower commission  leverage
than a  Business  Development  Manager.

         The sales  and  marketing  organization utilizes  a   formal   proposal
process to identify  engagements  in  which the Company's  technical  skills and
project management capabilities are well suited to meet the needs of prospective
clients.  The proposal  process also involves  reviews  with the  client,  which
are  designed  to  ensure that the engagement is  based upon a jointly developed
proposal. In some cases, the client  pays  for  an  assessment  to  analyze  the
project  and  make  a  detailed proposal. Time schedules and cost  estimates are
prepared by the  technical  staff.  A pricing model is used to determine whether
the  engagement  will meet or exceed Company margin  targets  for new  business.
Pricing for fixed  price  projects  must be approved by a Senior Vice President.

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         PSW serves clients  throughout the United States.  The Company seeks to
establish  sites in those  areas that have a high  concentration  of IT vendors.
Current sites include Austin,  Boston, and Seattle. Each site has a site manager
and sales  resources  to grow the  Company's  business  and base of clients.  In
addition,  the Company has  established  a sales office in Chicago,  Illinois in
order to focus on IT user  opportunities.  Once an  engagement  is started,  key
personnel  travel or relocate to the project site and new personnel are added by
both local and national recruiting efforts.

Employees

         PSW's  workforce  has grown  significantly  over the past three  years,
increasing  from 167  full-time  employees at December 31, 1994 to 461 full-time
employees at December  31, 1997.  PSW believes  that  attracting  and  retaining
superior and innovative technical professionals,  project managers and executive
management is a critical element in its ability to deliver high quality services
to its clients.  Accordingly,  PSW focuses on identifying and recruiting  highly
qualified technical  professionals at all levels within the Company. In order to
retain  these  professionals,  the Company  maintains  a culture and  implements
numerous  programs that  emphasize the  importance of its  employees,  including
training, career development and incentive programs.

         None of the Company's  employees is covered by a collective  bargaining
agreement.  Substantially  all of  the  Company's  employees  have  executed  an
invention  assignment and confidentiality  agreement.  In addition,  the Company
requires  that all new  employees  execute  such  agreements  as a condition  of
employment by the Company.
Management considers its relations with its employees to be good.

  Selection and Recruiting

         Prior to  October  1995,  the  Company  relied  significantly  upon the
recruiting  services of Pencom for its technical  staff hires.  Since that time,
the Company has  decreased  its  reliance  on Pencom by  building  its  internal
recruiting  infrastructure for technical staff hires, with Pencom accounting for
less  than 15% and 4% of the  Company's  hires in 1996 and  1997,  respectively.
Currently,  the Company is a party to recruiting  agency  agreements with Pencom
and several other outside recruiting firms.

         The Company  utilizes  dedicated  recruiters  to support  management in
identifying,  staffing and building  pipelines  for the skill types  required to
meet  the  Company's  sales  efforts.  PSW  has a  comprehensive  interview  and
evaluation process, which typically includes a full day of technical interviews.
The Company utilizes a sophisticated  on-line  recruiting system from Resumix to
quickly capture candidate resumes,  allow for specific skill searches and manage
the work flow associated with a specific search.

         In addition,  PSW has established an employee referral program pursuant
to which existing  employees receive a cash incentive for each person they refer
who becomes a PSW employee.  This referral program has provided the Company with
a cost-effective means of identifying and recruiting high quality employees.  In
addition to agencies and employee  referals,  the Company utilizes  advertising,
job fairs and its Website to identify potential employees.

  Career Development and Training

         The  Company  has   developed  a  separate   Professional   Development
department  within Human  Resources  which is designed,  among other things,  to
ensure that project assignments and training are consistent with each employee's
career  aspirations  and that each employee  receives  meaningful  quarterly and
annual performance reviews. In addition, the Company's "technical career ladder"
enables  highly  qualified  technical   professionals  to  reach  the  level  of
Architect, a position which entails substantial professional authority. Finally,
the Company  typically offers  redeployment  and/or relocation to employees upon
business changes, such as the expiration of an engagement.

         The Company has developed  strong  internal  training  programs for its
technical  employees,   including  its  Windows  NT  certification  program  for
technical  professionals working with the Windows NT operating environment,  and
the  Genova  Business  Systems  Development  Academy  coursework,  which  trains

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employees  in  object-oriented  business  systems  development  using the Genova
methodology.  In  addition,  the  Company  offers  several  management  training
programs  to  its  senior  employees,  including  Communications  &  Leadership,
Overview  of  Management,  Interviewing  Effectively  and  Legally,  Performance
Reviews,  and  Progressive  Discipline and  Termination.  Finally,  PSW conducts
semi-annual Technology Forums and Business Forums to increase communications and
sharing  among both  business  units and across all  locations  and  disciplines
within the Company.

Incentives

         The Company  implements a number of  compensation  and other  incentive
programs  designed to promote employee  retention.  Technical  professionals are
compensated in accordance with the Company's  merit pay program,  which is based
on competitive  salary ranges and is designed to reward employees based on their
individual job level and their  performance in that job level. In addition,  the
Company  implements a "battle pay" program to compensate  employees for extended
on-site work away from home. The Company also issues Common Stock options to all
PSW employees,  with senior management and technical personnel receiving options
at levels  intended  to build a  significant  and  long-term  commitment  to the
Company.  Finally, the Company provides a competitive and comprehensive benefits
program which includes health care, escalating vacation time and life insurance.
Executives and other key employees participate in an annual bonus program. Other
employees  receive  discretionary  bonuses upon  recommendation  and approval by
management.

Competition

         The markets for the  Company's  services  are highly  competitive.  The
Company  believes that it currently  competes  principally  with  consulting and
software integration firms and the professional service organizations of certain
hardware and application  software vendors.  In addition,  there are a number of
systems  integrators who serve similar markets or provide similar  services with
whom the Company competes or may compete in the future.  Many of these companies
have significantly greater financial, technical and marketing resources than the
Company,  generate  greater  revenues and have greater name recognition than the
Company.  There are relatively low barriers to entry into the Company's  markets
and the Company has faced and expects to continue to face additional competition
from new entrants into its markets.

         The Company  believes  that the  principal  competitive  factors in its
markets include reputation,  project management  expertise,  industry expertise,
speed of  development  and  implementation,  technical  expertise and ability to
deliver on a  fixed-price  as well as a time and  materials  basis.  The Company
believes  that its  ability  to  compete  also  depends  in part on a number  of
competitive factors outside its control, including the ability of its clients or
competitors  to hire,  retain and  motivate  project  managers  and other senior
technical  staff;  the  ownership by  competitors  of software used by potential
clients; the development by others of products and services that are competitive
with  the  Company's  services;  the  price  at which  others  offer  comparable
services; the ability of its clients to perform the services themselves; and the
extent  of its  competitors'  responsiveness  to client  needs.  There can be no
assurance  that the Company  will be able to compete  effectively  on pricing or
other  requirements  with  current and future  competitors  or that  competitive
pressures faced by the Company will not cause the Company's revenue or income to
decline  or  otherwise  materially  adversely  affect  its  business,  financial
condition  and results of  operations.  The Company has entered into  employment
agreements  with  each  of its  executive  officers.  These  agreements  contain
provisions  which,  among  others,  prohibit the  employee  from  disclosing  or
otherwise  using  certain  confidential  information,   assign  to  the  Company
inventions or ideas conceived by the employee  during his  employment,  prohibit
solicitation  by the employee of clients and other  employees of the Company and
prohibit the employee  from  accepting any  opportunity  (whether by contract or
full-time  employment) with the Company's  clients.  Furthermore,  the Company's
employment  agreement with Dr. W. Frank King, the Company's  President and Chief
Executive  Officer,  contains  provisions,  which  for a  period  of two  years,
restrict Dr. King's ability to provide  services to, or solicit the business of,
the Company's  clients and prospective  clients.  There can be no assurance that
any of the foregoing measures will prevent a former employee of the Company from
enhancing the prospects of one of the Company's competitors.

                                       8
<PAGE>

Customers

         The  Company has derived a  significant  portion of its revenue  from a
limited number of large clients.  The Company's five largest  clients in each of
1994, 1995, 1996 and 1997,  accounted for  approximately  77%, 88%, 82% and 63%,
respectively, of its revenues in each such period. The Company's largest client,
International   Business   Machines  Corp.,   together  with  its   subsidiaries
(collectively, "IBM"), accounted for approximately 52% and 39% of its revenue in
1996 and 1997,  respectively.  The Company expects a decline in the level of IBM
business in 1998 due to the completion of several projects for IBM nd the growth
in non-IBM business. The volume of work performed for specific clients is likely
to  vary  from  year  to  year,  and a  major client in one year may not use the
Company's services  in a  subsequent  year.  The loss of,  or  reduction  in PSW
services required  by, any large client  could have a  material  adverse  effect
on the Company's business, financial condition and results of operations.

         Most of the Company's  contracts are terminable by the client following
limited  notice  and  without  penalty  to the  client.  Further,  the  level of
investment by the Company's clients in IT projects can be adversely  affected by
a number of factors, including changes or developments in the general technology
landscape and the internal budget cycles of such clients.  The cancellation of a
large project or a significant  reduction in the scope of any such project could
have a material adverse effect on the Company's  business,  financial  condition
and results of operations,  and in the past the  cancellation  of large projects
has adversely impacted the Company's earnings.

Intellectual Property Rights

         The Company's  future success is dependent in part upon the maintenance
and protection of its intellectual property rights and, to a lesser extent, upon
its ability to license  technology  from its  clients.  The Company  relies on a
combination  of  copyrights,   trade  secrets  and  trademarks  to  protect  its
intellectual  property.  There can be no  assurance  that the steps taken by the
Company to protect  its  intellectual  property  rights will be  adequate,  that
competitors  will not be able to  develop  similar  or  functionally  equivalent
methodologies or products or that the Company will be able to license technology
from its  clients in the  future.  Furthermore,  effective  copyright  and trade
secret  protection may be unavailable or limited in certain  foreign  countries,
and no assurance can be given that foreign  copyright and trade secret laws will
adequately protect the Company's intellectual property rights. Litigation may be
necessary to enforce the Company's  intellectual property rights, to protect the
Company's trade secrets, to determine the validity and scope of the intellectual
property rights of others, including the Company's clients, or to defend against
claims of infringement.  Such litigation  could result in substantial  costs and
diversion of resources and could have a material adverse effect on the Company's
business,  financial  condition and results of  operations.  No assurance can be
given that  infringement  or  invalidity  claims (or claims for  indemnification
resulting from infringement claims against third parties,  such as clients) will
not be asserted against the Company or that any such assertions would not have a
material  adverse  effect on the  Company's  business,  financial  condition  or
results of operations. If infringement or invalidity claims are asserted against
the Company or any of its  licensees,  litigation may be necessary to defend the
Company or such licensees against such claims, and in certain  circumstances the
Company  may  choose  to seek to  obtain  a  license  under  the  third  party's
intellectual  property rights. There can be no assurance that such licenses will
be available on terms acceptable to the Company, if at all.

Additional Factors That Affect Future Results

         In addition to the other  information  in this Form 10-K, the following
factors should be considered in evaluating the Company and its business.

         Industry  Concentration;  Dependence on Large Projects. The Company has
derived and  believes it will  continue to derive a  significant  portion of its
revenue  from  the  technology  vendor  industry.  As a  result,  the  Company's
business,  financial  condition  and results of  operations  are  influenced  by
economic  and  other  conditions  affecting  such  industry,  such  as  economic
downturns  which could lead to a reduction in spending on IT projects,  which in
turn could lead to fewer new research and development outsourcing projects being
undertaken. Further, several of the Company's client contracts limit its ability

                                       9
<PAGE>

to provide  services to competitors  of such clients,  thereby  restricting  the
field of  potential  future  clients.  In  addition,  as a result of the dynamic
nature  of the IT vendor  industry,  the  Company  may lose  clients  due to the
acquisition, merger or consolidation of existing clients with entities which are
not current clients of the Company. The occurrence of any of the foregoing could
have a material adverse effect on the Company's  business,  financial  condition
and results of operations.

         Fixed-Price  Contracts and Other Project  Risks.  During 1996 and 1997,
approximately 12% and 20%, respectively,  of the Company's revenue was generated
on a fixed price,  fixed-delivery-schedule ("fixed price") basis, rather than on
a  time-and-materials  basis. The Company's  failure to accurately  estimate the
resources  required  for a fixed price  project or its  failure to complete  its
contractual obligations in a timely manner consistent with the project plan upon
which its fixed price contract is based could have a material  adverse effect on
the Company's business,  financial  condition and results of operations.  In the
past,  the  Company  has  found it  necessary  to  revise  project  plans  after
commencement  of the project and commit  unanticipated  additional  resources to
complete certain projects,  which have negatively  affected the profitability of
such  projects.  The Company may  experience  similar  situations in the future,
which could have a material adverse effect on the Company's business,  financial
condition  and results of  operations.  In addition,  the Company may  establish
contract prices before the project design  specifications  are finalized,  which
could result in a fixed price that proves to be too low and therefore  adversely
affects the Company's business, financial condition and results of operations.

         Many of the Company's  engagements  involve projects which are critical
to the operations of its clients' businesses and which provide benefits that may
be difficult to quantify.  The Company's failure to meet a client's expectations
in the  performance  of its services  could damage the Company's  reputation and
adversely  affect its ability to attract new  business,  and may have a material
adverse effect upon its business, financial condition and results of operations.
The Company has undertaken,  and may in the future undertake,  projects in which
the Company guarantees  performance based upon defined operating  specifications
or  guaranteed  delivery  dates.  Unsatisfactory  performance  or  unanticipated
difficulties  or  delays  in  completing  such  projects  may  result  in client
dissatisfaction  and a  reduction  in payment to, or payment of damages by, PSW,
any of which could have a material  adverse  effect on the  Company's  business,
financial  condition and results of  operations.  There can be no assurance that
the Company will be able to limit its liability to clients,  including liability
arising  from  the  Company's  failure  to  meet  clients'  expectations  in the
performance of services, through contractual provisions, insurance or otherwise.

         Management  of Growth.  The  Company's  growth  has placed  significant
demands on its management and other resources.  For example, the Company's staff
increased  from 167  full-time  employees at December 31, 1994 to 461  full-time
employees  at December  31,  1997.  The  Company's  ability to manage its growth
effectively  will require it to continue to develop and improve its operational,
financial  and  other  internal  systems,  as well as its  business  development
capabilities, and to continue to attract, train, retain, motivate and manage its
employees.  In addition,  the Company's future success will depend in large part
on its ability to continue to maintain high rates of employee  utilization,  set
fixed price fees  accurately,  maintain project quality and meet delivery dates,
all as the  Company  seeks to  increase  the number of  projects  in which it is
engaged. If the Company is unable to manage its growth and projects effectively,
such  inability  would  have a  material  adverse  effect on the  quality of the
Company's  services,  its  ability to retain  key  personnel  and its  business,
financial  condition and results of  operations.  No assurance can be given that
the  Company's  growth will  continue to be achieved,  or if  achieved,  will be
maintained or that the Company will be successful in managing any such growth.

         Recent  Organization;  Absence of Operating  History as an  Independent
Business;  Limited  Relevance  of  Historical  Financial  Information.  Prior to
October 1996, the Company  conducted its business and operations as the software
division of Pencom.  Accordingly,  the  Company  has only a limited  independent
operating  history upon which an evaluation of the Company and its prospects can
be based.  Prior to  October  1996,  the  Company  also had  limited  accounting
capability and depended upon Pencom for most accounting functions. By October 1,
1996,  the Company  had  assumed  responsibility  for most  internal  accounting
functions, but continued to depend upon Pencom for limited accounting support in
connection  with the Company's  1996 year-end  audit.  There can be no assurance
that the Company will be successful in taking  control of these  functions  from
Pencom. The Company has also relied upon, and will continue to rely upon, Pencom

                                       10
<PAGE>

for certain legal services and recruiting  functions.  The Company's  management
has only limited  experience  operating  the Company as a  stand-alone  company,
separate and apart from Pencom. Pencom has no obligation to provide financial or
management assistance to the Company and has no plans to do so. The inability of
the Company to operate  successfully as an entity  independent from Pencom would
have a material adverse effect on the Company's  business,  financial  condition
and results of operations.

         The  information  presented for 1996 and prior periods herein  reflects
the  financial  position, results of  operations  and cash  flows of the Company
and its  predecessor, the software division of Pencom, and such information does
not necessarily  reflect what the financial position,  results of operations and
cash flows of the Company would  have  been had the  Company  been  operated  as
a  separate,  stand-alone business for the periods presented prior to October 1,
1996.

         Variability of Quarterly  Operating Results.  The Company's revenue and
operating  results may  fluctuate  from quarter to quarter  based on a number of
factors,  including the number,  size and scope of projects in which the Company
is engaged, the contractual terms and degree of completion of such projects, any
delays incurred in connection with a project,  the Company's  success in earning
bonuses or other contingent payments, employee hiring and utilization rates, the
adequacy of  provisions  for losses,  the  accuracy of  estimates  of  resources
required to complete ongoing projects and general  economic  conditions.   Other
factors may  affect  operating  results  includes  customer  budget  cycles  and
customer spending priorities such as the Year 2000 issue.  A high percentage  of
the Company's operating expenses, particularly personnel and rent, are fixed  in
advance of any particular quarter. For example, while the number of professional
staff the  Company  employs  may be  adjusted  to reflect  active projects, such
adjustments take time and the Company  must  maintain  a  sufficient  number  of
senior  professionals  to oversee  existing client  engagements and to focus  on
securing new client engagements. As a result,  unanticipated variations  in  the
number or progress  toward  completion  of the Company's projects or in employee
utilization rates may cause significant variations in operating results  in  any
particular  quarter  and  could  result  in  adverse  changes  to  the Company's
business, financial condition  and results of  operations.  In the first quarter
of 1998, revenues may be adversely impacted by the Company's lenghy sales cycle,
among other matters, which may cause the Company's revenues and earnings  to  be
below  the expectations of securitites analysts. Any  shortfall  in  revenue  or
earnings  from  expected  levels  or  other  failures  to  meet  expectations of
securities  analysts  or  the market in general  regarding results of operations
could have an immediate and material  adverse  effect on the market price of the
Company's Common Stock. Given the possibility of such quarterly  fluctuations in
revenue or earnings,  the Company  believes  that  comparisons  of its quarterly
results of operations are not  necessarily  meaningful and that such results for
one quarter should not be relied upon as an indication of future performance.

         Need to Attract and Retain  Professional  Staff. The Company's  success
will depend in large part upon its ability to attract,  train, retain,  motivate
and manage highly skilled  employees,  particularly  project  managers and other
senior technical  personnel.  Significant  competition exists for employees with
the skills  required to perform the  services  offered by the  Company,  and the
Company  requires that a significant  number of such employees  travel to client
sites to perform  services  on its  behalf,  which may make a position  with the
Company less  attractive to potential  employees.  Qualified  project  managers,
software  architects and senior  technical and  professional  staff are in great
demand worldwide and are likely to remain a limited resource for the foreseeable
future.  Furthermore,  there is a high rate of attrition  among such  personnel.
There can be no assurance that a sufficient  number of highly skilled  employees
will continue to be available to the Company,  that potential  employees will be
willing to travel to client  sites,  or that the Company will be  successful  in
training,  retaining and motivating  current or future employees.  The Company's
inability  to  attract,  train and retain  skilled  employees  or the  Company's
employees'  inability to achieve expected levels of performance could impair the
Company's  ability to adequately  manage and staff its existing  projects and to
bid for or obtain new  projects,  which in turn  would  have a material  adverse
effect on the Company's business, financial condition and results of operations.

     Rapid Technological Advances; Risk of Targeting Emerging Technologies.  The
Company has derived,  and will continue to derive, a substantial  portion of its
revenue from projects based on client/server  systems.The  client/server systems
market is  continuing to develop and is subject to rapid  technological  change.
The Company's  future success will also depend in part on its ability to develop

                                       11
<PAGE>

IT solutions which keep pace with continuing  changes in information  processing
technology,  evolving industry standards and changing client preferences.  There
can be no assurance  that the Company will be  successful  in  addressing  these
developments  in a timely  manner  or that, if addressed,  the  Company  will be
successful in the  marketplace.  The Company's delay or failure to address these
developments  could have a material  adverse  effect on the Company's  business,
financial  condition  and results of  operations.  In addition,  there can be no
assurance that products or technologies developed, or services offered, by third
parties will not render the Company's services  noncompetitive or obsolete.  The
Company's Software Technology Unit also seeks to identify emerging  technologies
which it believes will develop into critical technologies with broad application
and longevity. Once identified,  the Company may commit substantial resources to
provide  services to the  developers of such  technologies.  No assurance can be
given that the technologies identified by the Company will develop into critical
technologies with broad application and longevity. The failure of the Company to
align  itself with such  critical  emerging  technologies  would have a material
adverse affect on its business, financial condition and results of operations.

         Dependence on Key Personnel.  The Company's  future success will depend
in part upon the  continued  services of a number of key  management  employees,
particularly Dr. W. Frank King, Patrick D. Motola,  Brian E. Baisley,  Dennis P.
Thompson and William C. Cason, and a number of key technical employees. The loss
of the  services of any of the  Company's  key  personnel  could have a material
adverse  effect on the Company's  business,  financial  condition and results of
operations.  In addition,  the  Company's  credit  facility  prohibits  material
changes in management.  The Company does not maintain  key-person life insurance
on any of its  employees.  In  addition,  if one or  more of the  Company's  key
employees  resigns from the Company to join a competitor  or to form a competing
company,  any  resulting  loss of  existing  or  potential  clients  to any such
competitor  could  have a material  adverse  effect on the  Company's  business,
financial  condition and results of operations.  In the event of the loss of any
such  personnel,  there can be no  assurance  that the Company  would be able to
prevent the unauthorized disclosure or use of its technical knowledge, practices
or procedures by such personnel.

         System  Interruption and Security Risks.  The Company's  operations are
dependent on its ability to protect its  intranet  from  interruption  by damage
from  telecommunications  failure,  fire, earthquake,  power loss,  unauthorized
entry or other  events  beyond  the  Company's  control.  Most of the  Company's
computer equipment,  including its processing equipment, is currently located at
a single site.  There can be no assurance that  unanticipated  problems will not
cause any significant  system outage or data loss. Despite the implementation of
security  measures,  the  Company's  infrastructure  may also be  vulnerable  to
computer  viruses,  hackers or similar  disruptive  problems  caused by Internet
users.  Persistent problems continue to affect public and private data networks.
For example,  it is common for Internet service  providers to experience  system
interruptions which cause the Company to lose access to the Internet,  the means
by which the Company posts  internal  information  and provides  e-mail and time
sheet query and entry.  Any damage or failure that causes  interruptions  in the
Company's  operations  could have a  material  adverse  effect on the  Company's
business, financial condition or results of operations.

         Potential  Volatility  of Stock  Price.  The market for  securities  of
early-stage  companies  has been highly  volatile in recent years as a result of
factors  often  unrelated to a company's  operations.  In addition,  the Company
believes   factors  such  as   quarterly   variations   in  operating   results,
announcements  of  technological  innovations or new products or services by the
Company  or its  competitors,  general  conditions  in the  IT  industry  or the
industries in which PSW's clients  compete and changes in earnings  estimates by
securities  analysts,  could  contribute  to the  volatility of the price of the
Company's Common Stock.  These factors,  as well as general economic  conditions
such as  recessions or changes in interest  rates,  could  adversely  affect the
market price of the Company's Common Stock. Furthermore,  in the past, following
periods of volatility in the market price of a company's securities,  securities
class action claims have been brought against the issuing company.  There can be
no assurance that such  litigation  will not occur in the future with respect to
the Company.  Such litigation could result in substantial  costs and a diversion
of management's  attention and resources,  and any adverse determination in such
litigation  could also subject the Company to  significant  liabilities,  all of
which could have a material adverse effect on the Company's business,  financial
condition and results of operations.

                                       12
<PAGE>

         Effect of  Certain  Antitakeover  Provisions.  The  Company's  Board of
Directors has the authority to issue shares of Preferred  Stock and to determine
the designations,  preferences and rights and the qualifications or restrictions
of those  shares  without any further  vote or action by the  stockholders.  The
rights of the holders of Common  Stock will be subject to, and may be  adversely
affected by, the rights of the holders of any Preferred Stock that may be issued
in the future.  The issuance of Preferred  Stock could have the effect of making
it more  difficult  for a third party to acquire a majority  of the  outstanding
voting  stock of the  Company.  In  addition,  the  Company  is  subject  to the
antitakeover  provisions of Section 203 of the Delaware General  Corporation Law
(the  "DGCL").  In general,  this  statute  prohibits a publicly  held  Delaware
corporation  from  engaging  in a  "business  combination"  with an  "interested
stockholder"  for a period of three years after the date of the  transaction  in
which  the  person  became  an  interested  stockholder,   unless  the  business
combination  is approved in a  prescribed  manner.  Furthermore,  certain  other
provisions of the Company's  Amended and Restated  Certificate of  Incorporation
and Amended and Restated Bylaws may have the effect of discouraging, delaying or
preventing a merger, tender offer or proxy contest, which could adversely affect
the market price of the Company's Common Stock.

                                       13
<PAGE>

Item 2.  Properties

          The Company's  executive  offices and primary  facility are located in
Austin,  Texas,  in a leased  facility of 36,319 square feet.  The lease for the
Austin  facility  includes  an  additional  11,072  square  feet of  space in an
adjoining  building  which the  Company  assumed in  February  1998.  This lease
expires on December 31, 2003 with  respect to both  premises and is renewable at
the option of the Company for an additional five-year term. The Company also has
a right of first  refusal on  additional  space in such  facilities  exercisable
during the primary term of the lease. The Austin facility is located in the high
tech  center of  Austin  near  other  leading  technology  firms,  and  includes
sophisticated  laboratory,  network  and  server  facilities  to  support  PSW's
operations and project work on a variety of computing platforms.

         PSW  has  8,957  square  feet  of additional  office space in Bellevue,
Washington,  strategically  located  near   Microsoft   and   the  IBM  Kirkland
Programming Center. This facility primarily provides office and laboratory space
for the Company's  Windows NT porting center,  and also supports sales. PSW also
has space in  Jersey  City,  New  Jersey,  Boston,  Massachusetts  and  Chicago,
Illinois.

         PSW  employees are also located at client sites  throughout  the United
States,  including Chicago,  Raleigh,  Atlanta, Costa Mesa, Dallas and Stamford.
Additional  office  expansion is anticipated in 1998. The Company  believes that
its existing facilities are adequate to meet its current needs and that suitable
additional or alternative  space will be available in the future on commercially
reasonable terms, if and as needed.


Item 3.  Legal Proceedings

         None.


Item 4.  Submission of Matters to a Vote of Security Holders

         No matters were submitted  during the fourth quarter of the fiscal year
covered by this report to a vote of security  holders,  through the solicitation
of proxies or otherwise.

                                       14
<PAGE>

                                     PART II

Item 5.  Market for Registrant's Common Equity and Related Stockholder Matters

         The  Company's  Common Stock has traded on the Nasdaq  National  Market
under the symbol "PSWT" since its initial public offering on June 5, 1997. Prior
to the initial public  offering,  there had been no public market for the Common
Stock. The following table lists the high and low sales by quarter subsequent to
the initial public offering:

                                            High              Low
Fourth quarter of 1997                      $19.63            $10.31
Third quarter of 1997                       $15.63            $11.38

         As of March 2,  1998,  there  were  8,987,874  shares of the  Company's
Common Stock  outstanding held by 53 stockholders of record.  The Company paid a
cash dividend to its stockholders of record  immediately prior to the completion
of the initial public  offering in an amount  estimated to approximate  the 1997
income tax that such stockholders are required to pay on the 1997 taxable income
allocated to them as a result of the Company's prior S Corporation  status.  The
Company  currently  intends  to  retain  any  earnings  for the  operations  and
expansion of the  Company's  business  and does not  anticipate paying  any cash
dividends  in  the  foreseeable  future.  Future  dividends,  if  any,  will  be
determined by the  Company's  Board  of  Directors  and  will  depend  upon  the
Company's earnings,  financial condition,  cash requirements,  future prospects,
contractual  restrictions  and other  factors  deemed  relevant  by the Board of
Directors.

Use of Proceeds From Registered Securities

         On June 5, 1997 (the  "Effective  Date"),  the  Company's  Registration
Statement  on Form S-1  (Registration  No.  333-21565)  relating  to its initial
public  offering  (the  "IPO") was  declared  effective  by the  Securities  and
Exchange  Commission and the offering of up to 3,277,500 shares of the Company's
Common Stock covered by such Registration  Statement  commenced.  The IPO, which
has been  completed,  was managed by Alex,  Brown & Sons  Incorporated  and J.P.
Morgan  &  Co.,  as  the  representatives  of  the  several   underwriters  (the
"Underwriters")  of the IPO. All of the securities  registered were sold for the
account of the Company at an aggregate  offering price of $29.5 million.  Of the
shares of Common Stock sold by the Company,  2,850,000  shares were sold on June
5, 1997,  and 427,500  shares  (which were  subject to an  overallotment  option
granted by the Company to the Underwriters) were sold on July 2, 1997.

         In  connection  with the IPO,  total  expenses  of  approximately  $3.8
million were  incurred by the Company,  which  expenses  consisted  of: (i) $2.1
million  representing   underwriting  discounts  and  commissions  paid  to  the
Underwriters;  and (ii) other offering expenses,  including without  limitation,
attorney's  fees,   accountants'  fees,   printing  costs  and  filing  fees  of
approximately $1.7 million. Of the other offering expenses, $101,000 were direct
or indirect payments to directors or officers of the Company or their associates
or to persons owning ten percent (10%) or more of any class of equity securities
of the Company or to  affiliates  of the Company.  The net offering  proceeds of
such shares,  after  deducting  such total  expenses,  was  approximately  $25.7
million,  of which $3.0 million was used to repay  indebtedness  of the Company,
$654,000  was used to satisfy  certain  federal  income tax  obligations  of the
Company,  $1.4 million was used to pay a dividend to the Company's  stockholders
of  record  just  prior to the IPO in  respect  of the  estimated  tax that such
stockholders  are required to pay on the estimated 1997 taxable income allocated
to them, and the remaining  $20.7 million was invested in  short-term,  interest
bearing accounts pending application of such proceeds by the Company. Other than
the amounts paid as a dividend to the  stockholders  of record just prior to the
IPO, no other net proceeds  were paid directly or indirectly to any directors or
officers of the  Company or their  associates  or to persons  owning ten percent
(10%) or more of any class of equity  securities of the Company or to affiliates
of the Company.

                                       15
<PAGE>

Item 6.  Selected Financial Data

         PSW commenced  operations as a corporation  effective  October 1, 1996.
Prior to that date,  the Company  conducted  its business and  operations as the
software  division of Pencom.  The selected  financial data presented below have
been  derived  from the  audited  financial  statements  of the  Company and its
predecessor  and include the portion of a software  contract that had previously
been  allocated  to Pencom.  The  statements  of income data for the years ended
December 31, 1995,  1996 and 1997 and the balance  sheet data as of December 31,
1996 and 1997 are derived  from  financial  statements,  appearing  herein.  The
statements of income data for the years ended December 31, 1993 and 1994 and the
balance  sheet data as of  December  31, 1993,  1994 and 1995 are  derived  from
audited  financial  statements not included  herein.  The information  presented
below reflects the financial  condition and results of operations of the Company
and its  predecessor,  and  does not  necessarily  reflect  what  the  financial
position  and  results  of  operations  of the  Company  would have been had the
Company  been  operated  as a  separate,  stand-alone  company  for the  periods
presented prior to October 1, 1996, nor is it necessarily indicative  of  future
results.  The following  should  be  read  in  conjunction  with   "Management's
Discussion and Analysis of Financial Condition and Results  of  Operations"  and
the  financial  statements  and  notes  thereto appearing elsewhere in this Form
10-K.

<TABLE>
<CAPTION>
                                                                                             Year ended December 31,
                                                                              1993        1994        1995        1996        1997
                                                                            --------    --------    --------    --------    --------
                                                                                     (in thousands, except per share data)
<S> ......................................................................    <C>        <C>         <C>         <C>         <C>
Statements of Income Data:
Revenue ..................................................................  $  8,725    $ 12,318    $ 21,147    $ 31,274    $ 44,118
Operating expenses:
   Technical staff .......................................................     6,167       7,385      11,193      16,444      22,479
   Selling and administrative staff ......................................     1,873       2,320       3,755       5,622       8,405
   Other expenses ........................................................     1,899       2,317       3,976       5,684       7,979
   Special compensation expense(1) .......................................      --          --          --         2,193         268
                                                                             --------    --------    --------    --------    -------
      Total operating expenses ...........................................     9,939      12,022      18,924      29,943      39,131
                                                                             --------    --------    --------    --------    -------
Income (loss) from operations ............................................    (1,214)        296       2,223       1,331       4,987
Interest income (expense), net ...........................................      (329)        (74)        (84)       (170)        431
                                                                             --------    --------    --------    --------    -------
Income (loss) before provision
  for income taxes .......................................................    (1,543)        222       2,139       1,161       5,418
                                                                             --------    --------    --------    --------    -------

Provision for income taxes:
   Nonrecurring charge for termi-
    nation of Subchapter S election ......................................      --          --          --          --         1,200
    C Corporation taxes...................................................      --          --          --          --         1,000
                                                                             --------    --------    --------    --------    -------
Net income (loss) ........................................................  $ (1,543)   $    222    $  2,139    $  1,161    $  3,218
                                                                             ========    ========    ========    ========    =======

Unaudited pro forma information:
   Historical income (loss) before
     provision for income taxes ..........................................  $ (1,543)   $    222    $  2,139    $  1,161    $  5,418
   Pro forma provision (benefit)
     for income taxes(2) .................................................      (586)         84         813         441       1,900
                                                                             ========    ========    ========    ========    =======
Pro forma net income (loss) ..............................................  $   (957)   $    138    $  1,326    $    720    $  3,518
                                                                             ========    ========    ========    ========    =======
   Pro forma diluted earnings
     (loss) per share(3) .................................................  $  (0.14)   $   0.02    $   0.20    $   0.11    $   0.41
                                                                             ========    ========    ========    ========    =======

Shares used in pro forma diluted
   earnings (loss) per share
   calculation(3) ........................................................     6,635       6,635       6,635       6,689       8,517
                                                                             ========    ========    ========    ========    =======
</TABLE>

                                       16
<PAGE>


Item 6.  Selected Financial Data (continued)
<TABLE>
<CAPTION>
                                                                                                      December 31,
                                                                                      1993      1994      1995      1996      1997
                                                                                     -------   -------   -------   -------   -------
                                                                                                     (in thousands)
      <S>                                                                             <C>       <C>       <C>      <C>       <C>
       Balance Sheet Data:
       Working capital ...........................................................   $ 1,526   $ 1,933   $ 2,756   $ 1,648   $28,074
       Total assets ..............................................................     2,533     3,538     4,982    11,943    35,420
       Total stockholders' equity ................................................     2,302     2,675     3,684     3,444    31,859

</TABLE>
(1)  See Note 13 of Notes to Financial  Statements for an explanation of special
     compensation expense.
(2)  Computed  on the basis  described  in Notes 2 and 12 of Notes to  Financial
     Statements.
(3)  Computed on the basis described in Note 2 of Notes to Financial Statements.

Item 7.  Management's Discussion and Analysis of Financial Condition and Results
 of Operations

         The discussion and analysis below contains  forward-looking  statements
that involve risks and uncertainties. These forward-looking statements and other
statements made elsewhere in this document are made in reliance upon safe harbor
provisions of the Private Securities  Litigation Reform Act of 1995. The section
below  entitled  "Certain  Factors  That May Affect  Future  Results,  Financial
Condition  and  Market  Price of  Securities"  sets  forth and  incorporates  by
reference  certain factors that could cause actual future results of the Company
to differ materially from those statements.

Overview

         PSW  Technologies,  Inc. is a software services firm that provides high
value  solutions to IT vendors and IT users by mastering  and applying  critical
emerging  technologies.   These  critical   technologies   include  Web/Internet
distributed computing,  object-oriented development,  advanced operating systems
and systems management technologies.  IT vendors  primarily  consist of software
companies  that utilize  the  Company's services to help bring their products to
market  faster. IT users  generally  utilize  the  Company's  services  to  help
define,  develop and complete high value,  mission critical  enterprise software
systems for internal use.

         The  Company  was  founded as a separate  division of Pencom in 1989 to
take advantage of the large number of subcontractors placed by Pencom with IBM's
AIX  organization  in Austin,  Texas.  As these  subcontractors  completed their
assignments,  the most talented  were  recruited to become part of the permanent
technical   staff  of  the   Company.   The   Company's   mission  was  to  seek
project-oriented  assignments  to complement  Pencom's  existing  recruiting and
staff supplementation business.

         Dr. W. Frank King was hired in 1992 as the  President of the Company to
continue its growth, establish profitability and develop the infrastructure that
would eventually  enable it to operate as a separate  company.  In addition,  in
1993, Dr. King focused resources to provide application  development services to
address the needs of IT users.  The Company  established a formal sales function
in 1994,  and began the  Genova  initiative  with an  emphasis  on the  business
development  methodology.  The Company first became profitable in 1994. In 1995,
the Company initiated its own recruiting function independent of Pencom.

         In 1996, the Company  formalized the Genova  initiative,  completed the
licensing of the Genova Object  Libraries  and  established  the Genova  Academy
training. On October 1, 1996, the Company was formed as PSW Technologies,  Inc.,
at which time the Company  assumed  responsibility  for its own  accounting  and
finance  operations  but continued to depend upon Pencom for limited  accounting
support in connection with the Company's year-end audit.

         The Company completed an initial public offering of its Common Stock in
1997. Including the underwriters  exercise of their  over-allotment  option, the
Company sold  3,277,500  shares of its Common Stock and raised $25.7  million in

                                       17
<PAGE>

net proceeds from the offering.  In 1997, the Company completed business systems
projects for major IT users  including  U.S.  Bancorp,  MCC Behavior Care/ Cigna
Health Care Systems and a multi-year  engagement  with Canon  Computer  Systems,
Inc.  Major IT  vendor  projects  completed  during  1997  included projects for
Novell,  Inc., Cadence Design Systems,  Inc. and Tivoli Systems. The Company was
also named a Lotus Notes Qualified Business partner  and a  member  of  Tivoli's
10/Plus Association Business Partner in 1997.

         To date, revenue has been generated principally from time-and-materials
contracts for the Company's software services.  Revenue from  time-and-materials
contracts is  recognized  during the period in which the services are  provided.
The Company also enters into fixed price  contracts  for its software  services.
Revenue    from   fixed    price    contracts    is    recognized    using   the
percentage-of-completion  method over the term of the client contract,  measured
by the labor  incurred  as a  percentage  of the  estimated  total labor used at
completion.  Fixed price contract revenue represented  approximately 12% and 20%
of the Company's revenue in 1996 and 1997,  respectively.  The cumulative impact
of revisions in percentage of completion estimates is reflected in the period in
which the revisions are made.  Provisions  for estimated  losses on  uncompleted
contracts  are made on a contract-by-contract  basis and are  recognized  in the
period in which such losses are  determined.  There can be no  assurance  of the
accuracy  of the  Company's  future work  completion  estimates,  and  operating
results may be adversely  affected by inaccurate  estimates of contract  related
labor.

         The  Company has derived a  significant  portion of its revenue  from a
limited number of large clients.  One client,  IBM, accounted for 52% and 39% of
revenue in 1996 and 1997,  respectively.  The  Company  expects a decline in the
level of IBM  business in 1998.  The  Company's  relationship  with IBM includes
engagements  with IBM Kirkland,  IBM Austin,  Tivoli Systems,  Inc.  ("Tivoli"),
Lotus Development  Corporation ("Lotus") and Transarc. The technologies involved
in these  engagements  include  Windows 95, Windows NT, AIX,  system  management
software  and  Lotus  Notes  workgroup   software.   None  of  these  individual
engagements  accounted  for more than 20% of the  Company's  revenue  in 1996 or
1997. The Company  believes that future revenue  growth and  profitability  will
principally depend on its ability to further diversify its client base away from
IBM. During 1997, the Company's non-IBM revenue grew  approximately 80% compared
to 1996.

         The  information  presented  herein  reflects the  financial  position,
results of  operations  and cash flows of the Company and its  predecessor,  the
software division of Pencom,  and such information does not necessarily  reflect
what the financial position, results of operations and cash flows of the Company
would  have  been had the  Company  been  operated  as a  separate,  stand-alone
business  for  the  periods  presented  prior  to  October  1,  1996,  nor is it
necessarily indicative of future operations.

Year 2000 Compliance

         Many currently  installed  computer  systems and software  products are
coded to accept only two-digit entries in the date code field.  Beginning in the
Year 2000,  these date code  fields  will need to accept  four digit  entries to
distinguish  21st century dates from 20th century dates.  As a result,  computer
systems and  software  used by many  companies  may need to be updated to comply
with  such  "Year  2000"  requirements.  Significant  uncertainty  exists in the
consulting and software  development  services industry concerning the potential
effects associated with such compliance.  Although all of the services currently
offered by the Company are designed to be Year 2000  compliant,  there can be no
assurance  that the  Company's  services  will be  compatible  with  third-party
software  that may be  integrated  or used in  conjunction  with  the  Company's
services. The Company believes that its internal and financial reporting systems
will be  operational  through  and  beyond  the year  2000  without  significant
additional expense to the Company.

Net Charge Resulting from S Corporation Termination

         From  commencement  through the  completion  of the  Company's  initial
public  offering on June 5, 1997,  the Company had elected to be treated as an S
Corporation under Subchapter S of the Internal Revenue Code of 1986, as amended.
As such,  federal  income  taxes  attributable  through  June 5,  1997  were the
responsibility of the individual stockholders. As a result of the initial public

                                       18
<PAGE>

offering,  the  Company's  Subchapter  S status was  terminated  and the Company
recorded a deferred tax charge against income of approximately  $1.2 million for
the cumulative  differences between the financial reporting and income tax basis
of certain  assets and  liabilities  existing  at that date.  Additionally,  the
Company was required to change its method of  accounting  from the cash basis to
the accrual basis for income tax reporting purposes.  The Company's stockholders
are  obligated to pay the 1997 income  taxes  related to the period prior to the
completion  of the  offering.  The Company  declared and paid a dividend of $1.4
million  to the S  Corporation  stockholders  of record  immediate  prior to the
completion  of the offering for the amount  estimated  to  approximate  the 1997
income  taxes  payable by the  stockholders. (See Note 12 of Notes to  Financial
Statements.)

Special Compensation Expense

         Special   compensation   expense  in  1996   consisted  of  stock-based
compensation  in  connection  with the  grants  of  replacement  options  to the
Company's  employees  who  participated  in the  Pencom  stock  option  plan and
compensation  related to the  cancellation of a note issued by an officer of the
Company to Pencom,  which,  in the  aggregate,  totaled  $2.2  million.  Special
compensation expense in 1997 consisted of stock-based compensation in connection
with grants of replacement  options to the Company's  employees who participated
in the Pencom stock option plan, which, in the aggregate, totaled $268,000. (See
Notes 9, 12 and 13 of Notes to Financial Statements.)

Pro Forma Income Taxes

         Pro forma  income  taxes  reflect the  estimated  corporate  income tax
expense that the Company would have  recognized had it not elected S corporation
status  prior  to  the  completion  of  its  IPO (see Notes 2 and 12 of Notes to
Financial Statements).

Results of Operations

         The  following  table sets forth the  percentage  of revenue of certain
items included in the Company's statements of income for the periods indicated:
<TABLE>
<CAPTION>
                                                                                               Year ended December 31,
                                                                                                1995    1996     1997
                                                                                                ----    ----     ----
<S> .........................................................................................    <C>     <C>      <C>
Revenue .....................................................................................    100%    100%     100%
Operating Expenses:
     Technical staff ........................................................................     53      53       51
     Selling and administrative staff .......................................................     18      18       19
     Other expenses .........................................................................     19      18       18
     Special compensation expense ...........................................................     --       7        1
                                                                                                ----    ----     ----
Total operating expenses ....................................................................     90      96       89
                                                                                                ----    ----     ----
Income from operations ......................................................................     10       4       11
Interest income (expense), net ..............................................................     --      (1)       1
Pro forma provision for income taxes ........................................................      4       1        4
                                                                                                ----    ----     ----
Pro forma net income ........................................................................      6%      2%       8%
                                                                                                ----    ----     ----
</TABLE>
Results of Operations for 1997 Compared with 1996

         Revenue

         Revenue  consists  primarily  of fees for software  services  provided.
Revenue was $44.1 million in 1997, an increase of 41% over 1996 revenue of $31.3
million,  principally  due to  increases  in the  scope  and  number  of  client

                                       19
<PAGE>

projects.  Revenue  attributable to software services rendered to IT vendors was
$27.3 million and $20.4 million in 1997 and 1996,  respectively,  an increase of
34% in 1997 compared to 1996. Revenue attributable to software services rendered
to IT users was $16.8 million and $10.9 million in 1997 and 1996, respectively,
an increase of 54% in 1997 compared to 1996.

         One customer,  including its wholly owned  subsidiaries,  accounted for
52% and 39% of revenue in 1997 and 1996,  respectively.  The  Company  expects a
decline in the level of business  from this customer in 1998.  Another  customer
accounted for  approximately  14% of total  revenue for 1996. No other  customer
accounted for more than 10% of revenue in 1997 or 1996.

         Technical Staff

         Technical  staff  expenses  consist  of the cost of  salaries,  payroll
taxes, health insurance and workers'  compensation for technical staff personnel
assigned to client projects and unassigned  technical staff personnel,  and fees
paid to any  subcontractors  for  work  performed  in  connection  with a client
project. Technical staff expenses were $22.5 million in 1997, an increase of 37%
over 1996 technical  staff expenses of $16.4 million.  The increase in technical
staff  expenses was  primarily  due to the  addition of  personnel  necessary to
service  growth in the number and scope of customer  projects.  Technical  staff
expenses  declined  to 51% of  revenue in 1997 from 53% in 1996  primarily  as a
result of improved pricing and productivity of the technical staff.

         Selling and Administrative Staff

         Selling  and  administrative  staff  expenses  consist  of the  cost of
salaries,  payroll taxes, health insurance and workers' compensation for selling
and  administrative  personnel,  all  commissions  and bonuses,  and the cost of
technical staff salaries for technical  staff personnel  assigned to methodology
development  projects or performing  selling or training related tasks.  Selling
and administrative  staff expenses were $8.4 million in 1997, an increase of 50%
from $5.6  million in 1996.  The  increase in selling and  administrative  staff
expenses  was  primarily  due  to  the  addition  of  sales  and  administrative
personnel,  and  technical  staff  training  necessary to support the  Company's
growth. Selling and administrative staff expenses increased to 19% of revenue in
1997 from 18% of revenue in 1996.  The  increase in selling  and  administrative
staff  expenses  as a  percentage  of  revenue is due  primarily  as a result of
increases  in the  costs  and  number  of  sales  and  marketing  staff.

         Other Expenses

         Other  expenses  consist  of  all  non-staff  related  costs,  such  as
occupancy costs, travel, business insurance,  business development,  recruiting,
training and depreciation. Other expenses were $8.0 million in 1997, an increase
of 40% over other  expenses of $5.7 million in 1996.  Other expenses were 18% of
revenue in both 1997 and 1996.

         Special Compensation Expense

         Special  compensation  expense in 1997  consisted  of  amortization  of
stock-based compensation  originating in 1996, which, in the aggregate,  totaled
$268,000  or less  than 1% of  revenue.  Special  compensation  expense  in 1996
consisted  of  stock-based   compensation  and   compensation   related  to  the
cancellation of a note payable,  which, in the aggregate,  totaled $2.2 million,
or 7% of revenue. See Notes 9, 12 and 13 of Notes to Financial Statements.

         Income from Operations

         Income  from  operations  increased  to $5.0  million in 1997 from $1.3
million in 1996.  If income from  operations  was  adjusted  to exclude  special
compensation  expense,  referred  to above,  income from  operations  would have
increased to $5.3 million in 1997,  up 49% from $3.5 million in 1996.  Excluding
special compensation expense,  income from operations was 12% of revenue in 1997
and 11% of revenue in 1996.

                                       20
<PAGE>

Results of Operations for 1996 Compared with 1995

         Revenue

         Revenue was $31.3 million in 1996, an increase of 48% over 1995 revenue
of $21.1 million, principally due to increases in the scope and number of client
projects.  Revenue  attributable to software services rendered to IT vendors was
$20.4 million and $14.0 million in 1996 and 1995,  respectively,  an increase of
45% in 1996 compared to 1995. Revenue attributable to software services rendered
to IT users was $10.9  million and $7.1 million in 1996 and 1995,  respectively,
an increase of 54% in 1996 compared to 1995.

         Two clients, including their subsidiaries, accounted for 66% and 76% of
revenue in 1996 and 1995, respectively.  No other client accounted for more than
10% of revenue in 1996 or 1995.

         Technical Staff

         Technical staff expenses were $16.4 million in 1996, an increase of 47%
over 1995 technical  staff expenses of $11.2 million.  The increase in technical
staff  expenses was  primarily  due to the  addition of  personnel  necessary to
service  growth in the  number  and scope of client  projects.  Technical  staff
expenses were 53% of revenue in both 1996 and 1995.

         Selling and Administrative Staff

         Selling and administrative staff expenses were $5.6 million in 1996, up
50% from $3.8 million in 1995. The increase in selling and administrative  staff
expenses was primarily due to the addition of personnel necessary to support the
Company's growth,  including  increases in sales and recruiting  personnel,  and
increases in personnel working on the Company's Genova  initiative.  Selling and
administrative staff expenses were 18% of revenue in both 1996 and 1995.

         Other Expenses

         Other expenses were $5.7 million in 1996, an increase of 43% over other
expenses of $4.0 million in 1995.  Other expenses  declined to 18% of revenue in
1996 from 19% in 1995,  primarily  as a result of the  significant  increase  in
revenue in 1996.

         Special Compensation Expense

         Special   compensation   expense  in  1996   consisted  of  stock-based
compensation  and  compensation  related to the  cancellation of a note payable,
which, in the aggregate, totaled $2.2 million, or 7% of revenue. See Notes 9, 12
and 13 of Notes to  Financial  Statements.  There  was no  special  compensation
expense in 1995.

         Income from Operations

         Income from operations  decreased $892,000 to $1.3 million in 1996 from
$2.2 million in 1995. If income from  operations was adjusted to exclude special
compensation expense, referred to above, income from operations would have grown
59% in 1996 compared with 1995. Income from operations declined to 4% of revenue
in 1996 from 10% in 1995 primarily as a result of special  compensation  expense
in 1996. If income from operations was adjusted to exclude special  compensation
expense, income from operations would have been 11% of revenue in 1995 and 1996.

Liquidity and Capital Resources

         Since  commencement of its operations as a separate  company on October
1, 1996, the Company has  maintained  its own cash accounts.  Before the  IPO in
June  1997,  available  cash  balances  were used to reduce  bank borrowings and
amounts due to Pencom.  Prior to its  incorporation, the Company participated in
Pencom's centralized cash management system while it conducted its business  and

                                     21
<PAGE>

operations as the software  division of Pencom.  In 1995, cash was used to repay
$1.1 million of  contributions  by  Pencom.  In 1996, the  Company  repaid  $2.9
million of contributions from Pencom.

         Cash flows from  operations  were $3.0  million,  $2.1 million and $1.6
million  in  1997, 1996  and 1995, respectively.  Total repayments of borrowings
were $5.1 million in 1997.  The Company  purchased  approximately  $2.7 million,
$1.2 million and  $450,000 of computer and office  equipment in  1997,  1996 and
1995, respectively. At December 31, 1997, the Company did not have any  material
commitments for capital expenditures.

         At December 31,  1997,  the Company had cash and cash  equivalents  and
investments  totaling $23.3  million,  an increase from $3.2 million at December
31, 1996,  primarily as a result of the completion of the IPO, pursuant to which
the Comp6any issued and sold 3,277,500 shares of its Common  Stock at a price to
the public of $9.00 per share.  Of the $25.7 million  of  net  proceeds from the
IPO, approximately  $3.0 million was used  to  repay  the  principal  amount and
accrued interest  outstanding  under the  Company's  credit facility, as amended
(the "Credit Facility"). In connection with the  completion  of  its  IPO,   the
Company also recorded liabilities for the payment of an  estimated  $1.8 million
income tax  obligation  payable over two years  resultant  from  the  conversion
from a cash basis to accrual basis method of tax accounting upon the termination
of its  Subchapter  S election  and the  payment of a $1.4  million dividend  to
stockholders of the Company prior to the offering in  respect of  the  estimated
tax that such  stockholders  are required to pay on the estimated  1997  taxable
income allocated to them.

         The Company's  revolving credit agreement with a bank which was amended
and extended until May 1, 1999, is unsecured and contains customary  restrictive
covenants,  including  covenants requiring the Company to maintain a minimum net
worth and certain financial ratios. The revolving credit agreement is subject to
a borrowing base requirement and bears interest at the greater of (a) the bank's
prime rate or (b) the federal  funds rate plus 0.25  percent.  At the  Company's
election,  borrowings  can be converted  to loans which bear  interest at a rate
computed  based on the London  Interbank  Offered Rate  ("LIBOR") . The weighted
average borrowing rate on the line of credit was 8.4%  for 1997. At December 31,
1997,  there was no amount  outstanding and the available  borrowing  amount was
$7.5 million.

         The Company  anticipates that its existing capital resources  described
above,  including  cash  provided by operating  activities  and  available  bank
borrowings  will be adequate to fund the Company's  operations  for at least the
next 12 months. There can be no assurance that changes will not occur that would
consume  available  capital  resources  before such time. The Company's  capital
requirements depend on numerous factors,  including potential acquisitions,  the
timing  of  the  receipt  of  accounts  receivable,  employee  growth,  and  the
percentage of projects  performed at PSW  facilities.  There can be no assurance
that additional funding, if necessary,  will be available on favorable terms, if
at all.

Certain Factors That May Affect Future Results, Financial Condition and Market
Price of Securities

         Numerous  factors may affect the Company's  business and its results of
operations.  These  factors  include  the  client and  industry  concentrations;
management's  ability to accurately  estimate resources required for fixed-price
contracts;  the Company's  ability to meet client  expectations  and deliverable
dates,  the Company's  ability to manage the substantial  growth of the Company;
potential  for  significant  fluctuations  in  quarterly  results;  management's
ability  to  attract  and  retain  professional staff;  the Company's ability to
develop IT  solutions  with rapid technological advances; and  general  economic
and business conditions. For a discussion of these and other  factors  that  may
affect the Company's future results, see "Business" in Item 1 of this Form 10-K.

                                       22
<PAGE>

Item 8.  Financial Statements and Supplementary Data



                             PSW TECHNOLOGIES, INC.

                          INDEX TO FINANCIAL STATEMENTS




                                                                            Page

Report of Independent Auditors.............................................  F-2
Balance Sheets as of December 31, 1996 and 1997............................  F-3
Statements of Income for the years ended December 31, 1995, 1996 and 1997..  F-4
Statements of Stockholders' Equity for the years ended December 31, 1995, 1996
and  1997 ...................................................................F-5
Statements of Cash Flows for the years ended December 31, 1995, 1996
and 1997...................................................................  F-6
Notes to Financial Statements..............................................  F-7




<PAGE>

                         Report of Independent Auditors




   The Stockholders and Board of Directors
   of PSW Technologies, Inc.

   We have audited the accompanying balance sheets of PSW Technologies,  Inc. as
   of  December  31,  1996  and  1997  and the  related  statements  of  income,
   stockholders'  equity,  and cash  flows  for each of the  three  years in the
   period ended December 31, 1997.  These statements are the  responsibility  of
   the Company's  management.  Our  responsiblility  is to express an opinion on
   these financial statements based on our audits.

   We conducted  our audits in  accordance  with  generallly  accepted  auditing
   standards.  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 management,  as well as evaluating the overall
   finanacial  statement  presentation.  We believe  that our  audits  provide a
   reasonable basis for our opinion.

   In our opinion, the financial statements referred to above present fairly, in
   all material respects,  the financial  position of PSW Technologies,  Inc. at
   December 31, 1996 and 1997,  and the results of its  operations  and its cash
   flows for each of the three years in the period ended  December 31, 1997,  in
   conformity with generally accepted accounting principles.

                                                   /s/ ERNST & YOUNG LLP


   Austin, Texas
   January 19, 1998


                                      F-2
<PAGE>

                             PSW Technologies, Inc.
                                 Balance Sheets
                 (in thousands, except share and per share data)
<TABLE>
<CAPTION>
                                                                        December 31,
                                                                     1996         1997
                                                                   --------     --------
<S>                                                                  <C>         <C>
Assets
Current assets:
   Cash .........................................................   $  3,182    $    835
   Short-term investments .......................................       --        22,470
   Accounts receivable, net of allowance for doubtful
     accounts of $120 and $165 in 1996 and 1997,
     respectively ...............................................      6,118       7,429
   Due from related party .......................................        323        --
   Unbilled revenue under customer contracts ....................        244         418
   Prepaid expenses and other current assets ....................        280         483
                                                                    --------    --------
Total current assets ............................................     10,147      31,635

Property and equipment, net .....................................      1,796       3,551
Deferred income taxes ...........................................       --           234

Total assets ....................................................   $ 11,943    $ 35,420
                                                                    ========    ========

Liabilities and stockholders' equity 
Current liabilities:
   Note payable to bank .........................................   $  5,125    $   --
   Due to related party .........................................        581        --
   Accounts payable and accrued expenses ........................      2,566       2,834
   Deferred revenue .............................................        227        --
   Deferred income taxes ........................................       --           727
                                                                    --------    --------
Total current liabilities .......................................      8,499       3,561

Commitments

Stockholders' equity:
   Preferred stock, par value $.01 per share, 1,000,000 shares
     authorized and none issued and outstanding .................       --          --
   Common stock, par value $.01 per share, 34,000,000 shares
     authorized, 5,538,463 and 8,960,935 shares issued and
     oustanding at December 31, 1996 and 1997, respectively .....         55          90
   Additional paid-in capital ...................................      4,187      29,484
   Deferred compensation ........................................       (641)       (243)
   Unrealized loss on investments ...............................       --           (27)
   Retained earnings (accumulated deficit) ......................       (157)      2,555
                                                                    --------    --------
Total stockholders' equity ......................................      3,444      31,859
                                                                    --------    --------
Total liabilities and stockholders' equity ......................   $ 11,943    $ 35,420
                                                                    ========    ========
</TABLE>

                                                See accompanying notes.

                                                         F-3
<PAGE>

                                                 PSW Technologies, Inc.
                                                  Statements of Income
                                         (in thousands, except per share data)

<TABLE>
<CAPTION>
                                                                                                      Year ended December 31,
                                                                                                   1995         1996         1997
                                                                                                 --------   ----------   ----------
<S>                                                                                               <C>         <C>         <C>
Revenue .......................................................................................   $ 21,147    $ 31,274    $ 44,118

Operating expenses:
   Technical staff ............................................................................     11,193      16,444      22,479
   Selling and administrative staff ...........................................................      3,755       5,622       8,405
   Other expenses .............................................................................      3,976       5,684       7,979
   Special compensation expense ...............................................................       --         2,193         268

Total operating expenses ......................................................................     18,924      29,943      39,131


Income from operations ........................................................................      2,223       1,331       4,987

Interest income (expense), net ................................................................        (84)       (170)        431
                                                                                                  --------    --------    --------
Income before provision for income taxes ......................................................      2,139       1,161       5,418
                                                                                                  --------    --------    --------
Provision for income taxes:
   Nonrecurring charge for termination
      of Subchapter S election ................................................................       --          --         1,200
   C Corporation taxes.........................................................................       --          --         1,000
                                                                                                  --------    --------    --------
Total provision for income taxes ..............................................................       --          --         2,200
                                                                                                  --------    --------    --------

Net income ....................................................................................   $  2,139    $  1,161    $  3,218
                                                                                                  ========    ========    ========


Unaudited pro forma information:
Historical income before provision for
   income taxes ...............................................................................   $  2,139    $  1,161    $  5,418
Pro forma provision for income taxes ..........................................................        813         441       1,900
                                                                                                  --------    --------    --------

Pro forma net income ..........................................................................   $  1,326    $    720    $  3,518
                                                                                                  ========    ========    ========

Pro forma basic earnings per share ............................................................   $   0.24    $   0.13    $   0.48
                                                                                                  ========   =========   =========

Pro forma diluted earnings per share ..........................................................   $   0.20    $   0.11    $   0.41
                                                                                                  ========   =========   =========

Shares used in pro forma basic earnings
    per share calculation .....................................................................      5,538       5,538       7,384
                                                                                                  ========    ========    ========

Shares used in pro forma diluted earnings
    per share calculation .....................................................................      6,635       6,689       8,517
                                                                                                  ========    ========    ========
</TABLE>
                                                         See accompanying notes.

                                                                   F-4
<PAGE>

<TABLE>
<CAPTION>

                                                                       PSW Technologies, Inc.
                                                                 Statements of Stockholders' Equity
                                                                   (in thousands, except shares)

                                                                                                            Retained
                                               Common Stock       Additional                  Unrealized    Earnings      Total
                                              $.01 Par Value        Paid-in     Deferred       Loss on    (Accumulated Stockholders'
                                            Shares      Amounts     Capital   Compensation    Investments    Deficit)      Equity
                                           ---------   ---------   ---------    ---------    -------------  ----------  ------------
<S> ......................................<C>          <C>        <C>          <C>          <C>              <C>          <C>
 Balance at December 31, 1994 ............5,538,463    $     55   $   6,077    $    --      $        --      $  (3,457)   $   2,675
 Distributions, net ......................     --          --        (1,130)        --               --           --         (1,130)
 Net income ..............................     --          --          --           --               --          2,139        2,139
                                          ---------   ---------   ---------    ---------    -------------     ---------    ---------
 Balance at December 31, 1995 ........... 5,538,463          55       4,947         --               --         (1,318)       3,684
 Distributions, net .....................      --          --        (2,939)        --               --           --         (2,939)
 Deferred compensation related
    to stock options ....................      --          --         2,179       (2,179)            --           --           --
 Amortization of deferred
    compensation ........................      --          --          --          1,538             --           --          1,538
 Net income .............................      --          --          --           --               --          1,161        1,161
                                           ---------   ---------   ---------    ---------    -------------    ---------    ---------
 Balance at December 31, 1996 ........... 5,538,463          55       4,187         (641)            --           (157)       3,444
 Issuance of common stock, net
    of issuance costs of $3,816 ......... 3,285,500          33      25,698         --               --           --         25,731
 Employee stock purchase plan
    issuance of stock ...................    53,732           1         410         --               --           --            411
 Exercise of stock options ..............    83,240           1          31         --               --           --             32
 Reclassification  upon termi-
    nation of S Corporation status ......      --          --          (894)        --               --            894         --
 Tax benefit related to stock
    option exercises ....................      --          --           182         --               --           --            182
 Forfeiture of stock options ............      --          --          (130)         130             --           --           --
 Dividend ...............................      --          --          --           --               --         (1,400)      (1,400)
 Amortization of deferred
    compensation ........................      --          --          --            268             --           --            268
 Net unrealized loss on investments .....      --          --          --           --                (27)        --            (27)
 investments
 Net income .............................      --          --          --           --               --          3,218        3,218
                                          =========    =========   =========    =========    =============    =========    =========
 Balance at December 31, 1997 ........... 8,960,935   $      90   $  29,484    $    (243)   $         (27)   $   2,555    $  31,859
                                          =========    =========   =========    =========    =============    =========    =========

                                                                         See accompanying notes.

                                                                                  F-5
</TABLE>
<PAGE>
                             PSW Technologies, Inc.
                            Statements of Cash Flows
                                 (in thousands)
<TABLE>
<CAPTION>
                                                                1995        1996        1997
                                                              --------    --------    --------
<S> .......................................................     <C>         <C>         <C>
Operating activities
     Net income ...........................................   $  2,139    $  1,161    $  3,218
     Adjustments to reconcile net income to net
         cash  provided  by  operating
         activities:
       Special compensation ...............................       --         2,193         268
       Depreciation and amortization ......................        288         424         825
       Bad debt expense ...................................         52          75          45
       Changes in operating assets and liabilities:
         Accounts receivable ..............................     (1,181)     (2,344)     (1,367)
         Due from related party ...........................       --          (323)       (258)
         Unbilled revenue under customer contracts ........       (100)       (144)       (174)
         Prepaid expenses and other current assets ........        (45)       (864)       (203)
         Due to related party .............................       --           581        --
         Accounts payable and accrued expenses ............        648       1,154         299
         Deferred revenue .................................       (214)        227        (227)
         Deferred taxes ...................................       --          --           675
                                                              --------    --------    --------
                  Net cash provided by operating activities      1,587       2,140       3,101
                                                              --------    --------    --------


Investing activities
     Purchase of short-term investments ...................       --          --       (22,497)
     Acquisition of property and equipment ................       (444)     (1,247)     (2,646)
                                                              --------    --------    --------
                  Net cash used in investing activities ...       (444)     (1,247)    (25,143)
                                                              --------    --------    --------


Financing activities
     Proceeds from (repayments on) line of credit, net ....       --         5,125      (5,125)
     Capital distributions, net ...........................     (1,130)     (2,870)       --
     Proceeds from issuance of common stock, net of
        issuance costs ....................................       --          --        26,220
     Dividend paid to S corporation stockholders ..........       --          --        (1,400)
                                                              --------    --------    --------
                Net cash provided by (used in) financing
                  activities ..............................     (1,130)      2,255      19,695
                                                              --------    --------    --------


Net increase (decrease) in cash ...........................         13       3,148      (2,347)
Cash, beginning of year ...................................         21          34       3,182
                                                              ========    ========    ========
Cash, end of year .........................................   $     34    $  3,182    $    835
                                                              ========    ========    ========


Supplemental disclosure of cash flow information
     Interest paid ........................................   $     84    $    154    $    137
     Income taxes paid ....................................   $   --      $   --      $  1,571

Supplemental schedule of non-cash activities
     Unrealized loss on investments .......................   $   --      $   --      $     27
     Reduction of income taxes payable associated
        with the exercise of stock options ................   $   --      $   --      $    182

</TABLE>
                             See accompanying notes.


                                      F-6
<PAGE>

                             PSW Technologies, Inc.
                        Notes to the Financial Statements

 1.   Nature of Business

PSW  Technologies,  Inc.  ("PSW" or the "Company") is a software  services firm,
operating in one industry  segment,  that  provides  high value  solutions to IT
vendors and IT users by mastering and applying critical  emerging  technologies.
These  critical  technologies  include  distributed  computing,  object-oriented
development, advanced operating systems and systems management technologies. PSW
provides  joint  project-based  development,  porting  and  testing  services to
selected IT vendor  clients and applies the technical  expertise  learned to the
design and  development  of high value,  mission  critical  enterprise  business
systems for its Fortune 1000 end-user clients.

 2.   Summary of Significant Accounting Policies

Basis of Presentation

Pencom Systems Incorporated ("Pencom") provided software services via a separate
division (the "Software Division") that commenced operations in October 1989. In
addition,  a portion of a software  services  contract was allocated between the
other operations of Pencom and the Software Division. Effective October 1, 1996,
Pencom contributed to PSW the business of the Software  Division,  including the
portion of the software contract that had previously been allocated to the other
operations  of Pencom (see Note 3). In exchange for the net assets  contributed,
Pencom  received  all of the then issued and  outstanding  shares of PSW and PSW
issued  warrants  to Pencom and to  certain  Pencom  employees  to  purchase  an
aggregate of 507,654 shares of PSW's common stock at $.04 per share.  The shares
and warrants issued to Pencom were immediately  thereafter distributed to Pencom
shareholders.  This  exchange has been  accounted  for in a manner  similar to a
pooling of interests and  accordingly,  the  accompanying  financial  statements
include the operations of the Software Division and the  aforementioned  portion
of the software  services  contract  allocated to other operations of Pencom for
all periods presented.

Use of Estimates

The preparation of financial  statements in conformity  with generally  accepted
accounting  principles  requires  management to make estimates and  assumptions,
including estimates to complete  contracts,  that affect the reported amounts in
the financial  statements and  accompanying  notes.  Actual results could differ
from those estimates.

New Accounting Pronouncements

In June 1997, the Financial Accounting Standards Board issued Statement No. 130,
Reporting  Comprehensive  Income ("SFAS No. 130").  This  statement  establishes
standards for reporting and display of  comprehensive  income and its components
in a full set of  general-purpose  financial  statements.  Comprehensive  income
includes all revenues,  expenses, gains, and losses recognized during the period
regardless  of whether they are  considered  to be results of  operations of the
period.  This statement is effective for fiscal years  beginning  after December
15, 1997. The Company does not expect SFAS No. 130 to have a material  impact on
the financial statements.

In June 1997, the Financial Accounting Standards Board issued Statement No. 131,
("SFAS No.  131"),  Disclosures  about  Segments  of an  Enterprise  and Related
Information.  SFAS No. 131  establishes  standards  to address  the way in which
public business  enterprises  report  information  about  operating  segments in
annual financial  statements and requires that those enterprises report selected
information  about  operating  segments in interim  financial  reports issued to
shareholders.  It also  establishes  standards  for  related  disclosures  about
products and services,  geographic  areas and major  customers.  SFAS No. 131 is
effective for financial statements for fiscal years beginning after December 15,
1997. The Company does not expect SFAS No. 131 to have a material  impact on its
financial statements.

                                      F-7
<PAGE>


                             PSW Technologies, Inc.
                  Notes to the Financial Statements (continued)

2.   Summary of Significant Accounting Policies (continued)

Share Information

All outstanding share amounts included in the  accompanying financial statements
have been  adjusted to reflect an  11,250-for-1  forward stock split on December
18, 1996 and the 8-for-13 reverse stock split effected described in Note 3.

Revenue Recognition

Revenue from time and materials  contracts is  recognized  during the period for
which the services are provided.

Revenue    from   fixed    price    contracts    is    recognized    using   the
percentage-of-completion  method,  measured by the  percentage of units of labor
incurred to the date of  measurement  relative to the  estimated  total units of
labor at  completion.  The  cumulative  impact of  revisions in estimates of the
percentage  to complete is  reflected in the period in which the  revisions  are
made.  Provisions for estimated  losses on  uncompleted  contracts are made on a
contract-by-contract basis and are recognized in the period in which such losses
are  determined.  Revenue earned in excess of billings is classified as unbilled
revenue  under  customer  contracts.  Billings  in excess of earned  revenue are
classified as deferred revenue. Revenue excludes reimbursable expenses.

Costs and Expenses

Technical  staff expense  consists of the cost of (i) salaries,  payroll  taxes,
health  insurance  and  workers'  compensation  for  technical  staff  personnel
assigned to client projects, (ii) unassigned technical staff personnel and (iii)
fees  paid to  subcontractors  for work  performed  in  connection  with  client
projects.

Selling and  administrative  staff expense consists of (i) the cost of salaries,
payroll  taxes,  health  insurance  and  workers'  compensation  for selling and
administrative  personnel,  (ii) all commissions and bonuses and (iii) technical
staff  personnel  assigned  to  development   projects  or  performing  selling,
recruiting or training related tasks.

Pencom allocated certain expenses to the Software Division,  including corporate
and officers' salaries, interest and rent. Corporate and officers' salaries were
allocated  based upon the percentage of time expended by certain  individuals on
Software Division  matters.  Interest was allocated based upon interest incurred
by Pencom on its secured debt (see Note 7). Rent was  allocated  based on square
footage  and/or  employee  head  count.  It is  management's  opinion  that  the
estimated  cost of the  allocated  expenses  on a stand  alone  basis  would not
produce  materially  different results than those reflected in the 1995 and 1996
financial statements.

Concentration of Credit Risk

Financial  instruments that potentially  subject the Company to concentration of
credit risk consist  principally of cash balances,  short term  investments  and
trade accounts receivable.  The Company invests its excess cash in highly liquid
investments  (short-term  bank  deposits)  and  places its  investments  in high
quality  securities  with financial  institutions of high credit  standing.  The
Company does not require  collateral from its customers.  The Company  maintains
allowances for potential credit losses and such losses were not material for any
of the periods presented. The Company's customers are headquartered primarily in
North America.

Cash and Cash Equivalents

The Company considers all highly liquid investments with original  maturities of
three months or less to be cash equivalents.


                                      F-8
<PAGE>

2.   Summary of Significant Accounting Policies (continued)

Depreciation and Amortization

Depreciation  and  amortization  are  computed  based on the cost of the related
assets,  using the  straight-line  method over the estimated useful lives of the
assets  which  range  from  five to  seven  years.  Leasehold  improvements  are
amortized  over the term of the related lease or estimated life of the leasehold
improvements, whichever is shorter.

Advertising Expense

The Company expenses  advertising  costs when the  advertisement  occurs.  Total
advertising  expense  amounted to  approximately  $175,000 in 1997.  Advertising
costs were not material for 1995 and 1996.

Stock Based Compensation

The Company  has adopted the  disclosure  provisions  accounts  for  stock-based
compensation in accordance with Statement of Financial  Accounting Standards No.
123, "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 123 prescribes
accounting  and reporting  standards  for all  stock-based  compensation  plans,
including  employee stock  options,  restricted  stock,  employee stock purchase
plans and stock appreciation  rights. SFAS 123 requires  compensation expense to
be  recorded  (i)  using  the new  fair  value  method  or (ii)  using  existing
accounting  rules  prescribed  by  Accounting  Principles  Board Opinion No. 25,
"Accounting   for  Stock   Issued  to   Employees"   ("APB   25")  and   related
interpretations  with pro forma  disclosure  of what net income and earnings per
share would have been had the Company  adopted  the new fair value  method.  The
Company intends to continue to account for its stock based compensation plans in
accordance with the provisions of APB 25 as permitted by SFAS 123.
Income Taxes

Upon formation in August 1996, the Company elected to be treated as a Subchapter
S  corporation,  under the  Internal  Revenue  Code of 1986 as amended,  whereby
federal  income taxes are the  responsibility  of the  individual  stockholders.
Accordingly,  the Company did not provide  for federal  income  taxes.  With the
closing of the Company's  initial public  offering,  the Company's  Subchapter S
status was terminated and the Company became subject to federal corporate income
taxes.

In  accordance  with  Statement of Financial  Accounting  Standards,  ("SFAS No.
109"),  Accounting for Income Taxes, deferred income taxes were provided for all
temporary  differences existing at the date of the Company's  termination of its
Subchapter S status.  This statement  prescribes the use of the liability method
whereby  deferred tax asset and liability  account balances are determined based
on  differences  between  financial  reporting  and  tax  bases  of  assets  and
liabilities  and are measured  using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse.

Pro Forma Earnings Per Share

The  unaudited pro forma  adjustments  on the  statements  of income  reflect an
adjustment to record a provision for income taxes as if the Company had not been
an S corporation.

In 1997,  the Financial  Accounting  Standards  Board issued  Statement No. 128,
Earnings per Share ("SFAS 128").  SFAS 128 replaced the  calculation  of primary
and fully diluted  earnings per share with basic and diluted earnings per share.
Unlike  primary  earnings  per share,  basic  earnings  per share  excludes  any
dilutive  effects of  options,  warrants  and  convertible  securities.  Diluted
earnings  per share is very similar to the  previously  reported  fully  diluted
earnings per share.  All  earnings  per share  amounts for all periods have been
presented,  and where  appropriate,  restated to conform to the  requirements of
SFAS 128 and Securities and Exchange Commission Staff Accounting Bulletin 98.

                                      F-9
<PAGE>

3.   Stockholders' Equity

Effective  October 1, 1996, in connection with the  contribution of the business
of the Software  Division,  the Company issued  5,538,463 shares of common stock
and warrants to purchase an aggregate of 507,654  shares of common stock at $.04
per share.  All warrants were  exercisable  upon issuance and expire in October,
2006. In exchange for the shares and warrants issued, PSW received an assignment
of a 26.67% interest in the proceeds to be received from the accounts receivable
as of September 30, 1996 and  substantially all the other assets and liabilities
of the Software Division.  The net assets contributed  amounted to approximately
$2,100,000 (see also note 2).

On February 3, 1997, the Company's  Board of Directors  approved 1.) an 8-for-13
reverse stock split, which was effected on April 2, 1997, 2.) an increase in the
Company's  authorized  common stock from 11,250,000 to 34,000,000 shares and 3.)
an authorization of 1,000,000 shares of preferred stock of $.01 par value, which
was effected prior to the completion of the Company's initial public offering.

In June 1997,  the Company  completed  an initial  public  offering of 2,850,000
shares of its authorized  but unissued  Common Stock at a price to the public of
$9.00 per share.  In connection  with the initial public  offering,  the Company
granted  the  underwriters  of the  offering an option to purchase up to 427,500
shares  of  Common  Stock  to  cover  over-allotments.  On  July  2,  1997,  the
underwriters exercised their option,  purchasing 427,500 shares of the Company's
Common  Stock.  The above  transactions  resulted in total net proceeds from the
initial public offering of $25.7 million (after deducting  offering expenses and
the underwriters  discount of approximately  $3.8 million).  The proceeds of the
offering were used to repay  indebtedness,  to pay certain  corporate income tax
obligations of the Company and to pay dividends to existing  stockholders of the
Company in amounts  estimated  to  approximate  certain of their 1997 income tax
obligations,  and for working capital and other general  corporate  purposes.  A
portion of the remaining funds may be used to fund acquisitions of complementary
businesses or technologies.

As  discussed  in Note 12, the  Company's S  corporation  status was  terminated
immediately  upon completion of its initial public offering.  Additionally,  the
Company  was  required to change its method of tax  accounting  from the cash to
accrual method.  The stockholders of the Company prior to the termination of the
S corporation  status are obligated to pay the income taxes for the 1997 taxable
earnings of the Company allocated to them. During 1997, the Company declared and
paid a dividend of $1.4 million to these stockholders.  The dividend payment was
an  estimate  based  upon  numerous   assumptions,   including   taxable  income
attributable to the conversion from the cash to the accrual method of accounting
upon the termination of the Company's S corporation status.

At December 31, 1997,  the Company has reserved  507,654  shares of Common Stock
for issuance in connection  with warrants  outstanding  and 1,978,000  shares of
Common Stock for issuance  under the Company's  stock  purchase and stock option
plans.

4. Property and Equipment

Property and equipment consist of the following (in thousands):
<TABLE>
<CAPTION>
                                                  1996     1997
                                                 ------   ------
<S> ..........................................      <C>      <C>
Furniture and fixtures .......................   $  521   $1,192
Computer equipment ...........................    2,251    3,480
Computer software ............................      266      603
Leasehold improvements .......................       59      379
                                                 ------   ------
                                                  3,097    5,654

Less accumulated depreciation and amortization    1,301    2,103
                                                 ======   ======
                                                 $1,796   $3,551
                                                 ======   ======
</TABLE>
                                      F-10
<PAGE>

5.    Short-Term Investments

The Company determines the appropriate classification of investments at the time
of purchase and  re-evaluates  such  designation at each balance sheet date. The
short-term  investments  have  been  classified  as  available-for-sale  and are
carried at fair value (quoted market prices),  with unrealized holding gains and
losses reported as a separate  component of  stockholders'  equity.  The cost of
debt  securities  is adjusted  for  amortization  of premiums  and  accretion of
discounts to maturity.  Such amortization,  interest income,  realized gains and
losses and declines in value judged to be other than  temporary  are included in
net interest and other income.

Information  related to the  Company's  investments  at December  31, 1997 is as
follows (in thousands):
<TABLE>
<CAPTION>
                                                  Amortized         Unrealized     Unrealized     Market
                                                     Cost              Gains         Losses       Value
                                                ---------------   --------------   ------------   -------
<S> .........................................   <C>               <C>              <C>                <C>
Money market funds ..........................   $         1,801   $         --     $       --     $ 1,801
Municipal obligations .......................            16,391               17             29    16,379
Corporate securities ........................             4,305               20             35     4,290
                                                ===============   ==============   ============   =======
                                                $        22,497   $           37   $         64   $22,470
                                                ===============   ==============   ============   =======
</TABLE>
Gross gains and gross losses on the sale of investments  were not significant in
1997. Short-term investments are generally comprised of variable rate securities
that  provide for  optional or early  redemption  within  twelve  months and the
contractual maturities are generally greater than twelve months.

6.   Accounts Payable and Accrued Expenses

Accounts payable and accrued expenses consist of the following (in thousands):
<TABLE>
<CAPTION>
                                               1996     1997
                                              ------   ------
<S> .......................................      <C>      <C>
Trade payables ............................   $  945   $  532
Accrued vacation ..........................      307      442
Accrued bonuses ...........................      600      455
Payroll and other taxes payable ...........      216      437
Other accounts payable and accrued expenses      498      968
                                              ======   ======
                                              $2,566   $2,834
                                              ======   ======
</TABLE>

7.     Note Payable to Bank

In November 1996,  the Company  obtained a revolving line of credit from a bank,
providing for borrowings of up to $6.5 million.  In November  1997, the line  of
credit  expired and was replaced with a revolving  line of credit which provides
for borrowings of up to $10 million,  subject to a borrowing  base  requirement.
Borrowings  under the line of credit  bear  interest  at the  greater of (a) the
bank's  prime  rate or (b) the  federal  Funds  Rate plus 0.25  percent.  At the
Company's election,  borrowings can be converted to loans which bear interest at
a rate  computed  based on the London  Interbank  Offered  Rate  ("LIBOR").  The
weighted  average  borrowing  rate on the line of credit was 8.4% for 1997.  The
line of credit  contains  certain  restrictive  convenants  which,  among  other
things,  require the Company to maintain a minimum net worth and to meet certain
financial ratios. At December 31, 1997, there was no amount  outstanding and the
available borrowing amount was $7.5 million.

Interest expense  includes  interest  allocated by Pencom through  September 30,
1996.  The  allocation  represented  the Software  Division's  share of interest
payments  paid by Pencom  under its line of credit and was based on the ratio of
the monthly  balance of the Software  Division's  accounts  receivable  to total
accounts receivable of the Software Division and Pencom. This line of credit was
collateralized  by all accounts  receivable and fixed assets for Pencom and bore
interest at a rate based on the bank's prime rate or alternative  LIBOR pricing,
based on LIBOR plus 2.5%.

                                      F-11
<PAGE>

8.  Significant Customers

One  customer  and  two  of  its   wholly-owned   subsidiaries   accounted   for
approximately 56%, 52% and 39% of total revenue for the years ended December 31,
1995, 1996 and 1997, respectively. This customer accounted for approximately 26%
of accounts  receivable  at December 31, 1997.  Another  customer  accounted for
approximately 17% and 14% of total revenue for the years ended December 31, 1995
and 1996, respectively. No other customer accounted for more than 10% of revenue
in 1995, 1996 or 1997.

9.   Employee Benefit Plans

Stock Option Plan

Effective  October 1, 1996,  the Company's  Board of Directors and  stockholders
approved  and  adopted  the PSW  Technologies,  Inc.  1996 Stock  Option/  Stock
Issuance Plan (the "1996 Plan").  The aggregate  number of shares issuable under
the 1996 Plan has been  increased to 1,715,000  shares of the  Company's  common
stock for  issuance to  employees,  directors  and  consultants  of the Company.
Incentive stock options as defined in Section 422A of the Internal  Revenue Code
of 1986 and  nonqualified  stock options may be issued under the 1996 Plan.  The
exercise  price for  incentive  stock  options  may not be less than fair market
value on the date of grant,  or such greater  amount  necessary to qualify as an
incentive stock option.  The options  outstanding  under the 1996 Plan generally
vest in four equal annual  installments  commencing on the first  anniversary of
the grant and expire 10 years after the date of grant.  Certain of these options
are subject to acceleration clauses.

Pursuant to the  organization of the Company and the  contribution of net assets
of the Software Division,  the Company granted replacement options for shares of
its common stock under the 1996 Plan to its  employees who  participated  in the
Pencom Option Plan and the Pencom Option Plan was  terminated.  The  replacement
options  were  granted  for the same  number of shares and at the same  exercise
price as those options  granted to the  employees  under the Pencom Option Plan.
The grant date determining  vesting was the original grant date under the Pencom
Option Plan.  Under APB 25, the  difference  between the  estimated  fair market
value of the Company's common stock and the options' exercise prices on the date
of issuance was determined to be approximately $2,179,000.  This charge is being
amortized  for  financial  reporting  purposes  over the  vesting  period of the
options and the amount recognized as expense during the years ended December 31,
1996 and 1997 amounting to approximately $1,538,000 and $268,000,  respectively,
is included in special compensation  expense. A deferred tax benefit is recorded
for the amortized compensation expense.

                                      F-12
<PAGE>

                             PSW Technologies, Inc.
                  Notes to the Financial Statements (continued)

9.   Employee Benefit Plans (continued)

The following table summarizes stock option activity under the 1996 Plan:
<TABLE>
<CAPTION>
                                                         Range of Exercise Prices
                                     ------------------------------------------------------------------
                                        $0.04 - $2.60         $3.90 - $9.00         $11.50 - $15.25                  Total
                                     --------------------  --------------------- ----------------------       ----------------------
                                                 Weighted               Weighted               Weighted                    Weighted
                                                  Average                Average                Average                    Average
                                      Number     Exercise   Number      Exercise  Number       Exercise        Number      Exercise
                                     of shares     Price   of shares      Price  of shares       Price        of shares     Price
                                     ---------   --------  ---------    -------- --------    ----------      -----------    --------

<S>                                       <C>         <C>       <C>         <C>      <C>            <C>             <C>          <C>
Balance at December 31, 1995 .....         --    $     --        --   $      --       --     $       --              --    $      --
Granted during the year ..........    632,907        0.42   452,804        4.23       --             --       1,085,711         2.00
Exercised during the year ........         --          --        --          --       --             --              --           --
Forfeited during the year ........     (6,957)       0.72    (1,846)       4.12       --             --          (8,803)        1.44
                                      --------      -----   --------      -----  --------         -----       ----------      ------
Balance at December 31, 1996 .....    625,950        0.41   450,958        4.23       --             --       1,076,908         2.00
Granted during the year ..........         --          --   306,784        8.87  177,826          12.36         484,610        10.15
Exercised during the year ........    (77,391)       0.12    (5,849)       3.92       --             --         (83,240)        0.39
Forfeited during the year ........    (41,987)       0.77   (34,136)       5.38   (2,025)         13.22         (78,148)        3.10
                                      ========      =====   ========      =====   =======         =====       ==========      ======
Balance at December 31, 1997 .....    506,572    $   0.43   717,757    $   6.16  175,801   $      12.35       1,400,130         4.86
                                      ========      =====   ========      =====   =======         =====       ==========      ======

Exercisable at December 31, 1996 .    360,464    $   0.09     3,076    $   3.90       --   $         --         363,540    $    0.12
                                      ========      =====   ========      =====   =======         =====       ==========      ======

Exercisable at December 31, 1997 .    380,883    $   0.20   130,693    $   4.19    4,723   $      13.08         516,299    $    1.33
                                      ========      =====   ========      =====   =======         =====       ==========      ======

Weighted average fair value of
    options granted during 1997 ..               $     --              $   5.10                  $ 7.00                    $    5.79
                                                    =====                 =====                   =====                       ======

Weighted average remaining
    contractual life in years,
    at December 31, 1997 .........                   5.49                  7.38                    8.38                         6.82
                                                    =====                 =====                   =====                        =====
</TABLE>

                                                                           F-13
<PAGE>

                             PSW Technologies, Inc.
                  Notes to the Financial Statements (continued)


9.   Employee Benefit Plans  (continued)

Employee Stock Purchase Plan

On February 3, 1997, the Board of Directors adopted the Company's Employee Stock
Purchase Plan (the "Purchase  Plan") that allows eligible  employees to purchase
shares of Common Stock,  at  semi-annual  intervals,  through  periodic  payroll
deductions  under the Purchase Plan; a reserve of 400,000 shares of common stock
has been established for this purpose.  The stockholders of the Company approved
the Purchase Plan on March 17, 1997.

The Purchase Plan  incorporates a series of successive  offering  periods,  each
generally with a duration of six months.  The initial  purchase  period began on
the date of the initial  public  offering  (see Note 3) and ended on October 31,
1997.  Thereafter,  purchase periods begin on the first business day in November
and May of each  year and end on the last  business  day of April  and  October,
respectively.  Shares of Common Stock are purchased for each  participant at the
end of each purchase period. On October 31, 1997, the Company sold 53,732 shares
of Common Stock to employees through the Purchase Plan.

Payroll  deductions  may not exceed 15% of base salary for each purchase  period
and each employee's purchases are limited to 500 shares per purchase period. The
purchase  price per share is  eighty-five  percent  of the lower of (i) the fair
market  value of the Common  Stock on the start date of the  purchase  period or
(ii) the fair market value at the end of the semi-annual  purchase  period.  The
Purchase Plan will terminate on the last business day of April, 2007.

As specified  in APB No. 25, the sale of Common  Stock under the  Purchase  Plan
does not result in compensation expense to the Company. Under SFAS 123, however,
expense would be  recognized,  and  accordingly,  approximately  $408,000 of pro
forma  compensation  expense  relating  to the sale of  Common  Stock  under the
Purchase  Plan is  included in the  calculation  of pro forma net income and pro
forma  basic  earnings  per  share  and pro  forma  diluted  earnings  per share
resulting from the grant of stock options during 1997,  below.  The  assumptions
used to value the  compensation  expense  resulting  from the issuance of shares
under the Purchase Plan do not differ  materially from the  assumptions  used to
value the 1997 stock options.

 Employee Retirement Plan

The  Company  maintains a defined  contribution  plan (the  "Plan")  pursuant to
Section  401(k) of the Internal  Revenue Code for  employees who are at least 21
years of age. Eligible employees can elect to reduce their current  compensation
up to the  statutory  prescribed  limit and have the  amount  of such  reduction
contributed  to the  Plan.  The  Plan  also  allows  for  the  Company  to  make
contributions on behalf of eligible employees. A similar plan in which employees
of the Software  Division were eligible to participate was maintained by Pencom.
No  contributions  were made to the plan in 1995,  1996 or 1997 by the  Software
Division or PSW.

Pro forma Information

Pro forma information regarding net income and earnings per share is required by
SFAS 123, and has been  determined  as if the Company had  accounted  for option
grants under the 1996 Plan and purchases of Common Stock under the Purchase Plan
using the fair value method of that Statement. The fair value of the options was
estimated at the date of grant using a  Black-Scholes  option pricing model with
the following weighted average assumptions:
<TABLE>
<CAPTION>
                                                                   1996 Option Grants
                                                               ----------------------------
                                                                 Vested at    Non-vested at      1997
Assumption                                                       Grant Date     Grant Date   Option Grants
----------                                                     -------------  -------------  -------------
<S>                                                                    <C>            <C>         <C>
Risk-free interest rate ....................................           5.93%          6.23%       6.34%
Dividend yield .............................................              0%             0%          0%
Volatility factor of the expected
  market price of the Company's
  common stock .............................................           0.374          0.374       0.521
Average life ...............................................         3 years        6 years     6 years
</TABLE>
                                      F-14
<PAGE>

The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded  options which have no vesting  restrictions  and are fully
transferable.  In addition,  option valuation models require the input of highly
subjective  assumptions  including the expected stock price volatility.  Because
the  Company's  employee  stock  options  have   characteristics   significantly
different from those of traded  options,  and because  changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion,  the  existing  models do not  necessarily  provide a  reliable  single
measure of the fair value of its employee stock options.

For purposes of pro forma  disclosures,  the estimated fair value of the options
under SFAS 123 is amortized to expense over the options' vesting period. For the
years  ended  December  31, 1996 and 1997,  pro forma net income  under SFAS 123
amounted to approximately $658,000 and $2.7 million,  respectively and pro forma
basic earnings per share and pro forma diluted earnings per share under SFAS 123
amounted to  approximately  $.012 and $0.09 in 1996 and $0.36 and $0.32 in 1997,
respectively.

10.   Related Party Transactions

The  Company  utilizes  non-exclusive  recruiting  services  provided by Pencom.
Management  believes  that the  terms  and fees  paid in  connection  with  such
recruiting services are comparable to agreements  maintained by the Company with
other  unrelated  recruiting  firms and will  continue  to use these  recruiting
services on a  non-exclusive  basis  pursuant to an agreement  entered into with
Pencom.  In addition,  certain expenses were allocated by Pencom to the Software
Division.  Management  believes that the allocations were  reasonable.  Services
provided and expenses allocated to PSW were as follows (in thousands):
<TABLE>
<CAPTION>
                                                    Year ended December 31,
                                                    1995     1996     1997
                                                  ------   ------   ------
<S> ...........................................      <C>      <C>      <C>
Services performed by related party:
   Recruiting services ........................   $  447   $  316   $   60
   Contracted technical services ..............       --       --        9
   Legal and accounting .......................       --       21       28
Allocated expenses:
   Rent .......................................      329      448       37
   Corporate and officers' salaries ...........      242      125       --
                                                  ------   ------   ------
      Total expenses included in other expenses    1,018      910      134
   Interest ...................................       84      104       --
                                                  ------   ------   ------
Total related party expenses ..................   $1,102   $1,014   $  134
                                                  ======   ======   ======
</TABLE>

The Company also entered  into an agreement  with Pencom for certain  accounting
and legal  services for the period  October 1, 1996 through  April 30, 1997 at a
fee of $7,000 per month.

In recognition of establishing an independent  profitable  company, in 1996, the
Software Division  cancelled a note receivable,  including unpaid interest,  due
from an officer and shareholder of the Company that resulted in a charge against
income of $655,000 which has been included in special compensation expense.

Assets  contributed  by Pencom on October 1, 1996  included an  assignment  of a
26.67%  interest in the proceeds to be received from the accounts  receivable of
the Software  Division as of September 30, 1996. At December 31, 1996, "Due from
related  party"  includes  approximately  $309,000  that  relates  to a  payment
received  on behalf of Pencom  which was  transferred  to Pencom  subsequent  to
December 31,  1996.  Other  amounts  denoted  "due to related  party"  represent
expenses that were paid on the Company's behalf by Pencom.

                                      F-15
<PAGE>

11.  Commitments

The Company  leases its office  space  through  noncancellable  operating  lease
arrangements including a lease for its office in Texas which was entered into on
October 31, 1996.  Other than the lease related to the Texas  office,  the other
leases are held by Pencom and will be assigned  to PSW.  Future  minimum  rental
commitments  (including  amounts  payable  under  leases  held by Pencom) are as
follows:
<TABLE>
<CAPTION>
Years ending December 31 (in thousands):
<S> ....................................      <C>
1998 ...................................   $1,264
1999 ...................................    1,244
2000 ...................................    1,143
2001 ...................................    1,078
2002 ...................................    1,077
Thereafter .............................    1,077
                                           ------
Total ..................................   $6,883
                                           ======
</TABLE>
The premises  previously occupied by the Company in Texas were leased by Pencom.
In connection  with the office  relocation,  the Company  transferred  leasehold
improvements  with a net book value of approximately  $69,000 to Pencom.  Pencom
has sub-leased  these premises.  However,  the Company entered into an agreement
with Pencom to guarantee  Pencom's  sublease  income.  Future minimum  sub-lease
rental income that the Company has guaranteed is as follows:
<TABLE>
<CAPTION>
Years ending December 31 (in thousands):
<S> ....................................      <C>
1998 ...................................   $  376
1999 ...................................      380
2000 ...................................      285
                                           ------
Total ..................................   $1,041
                                           ======
</TABLE>
Rent expense,  including rent allocated by Pencom,  for the years ended December
31, 1995,  1996 and 1997 was  approximately  $329,000,  $601,000 and $1,258,000,
respectively.

12.  Income Taxes

From commencement through June 5, 1997, the Company had elected to be treated as
an S  Corporation  under  subchapter S of the Internal  Revenue Code of 1986, as
amended.  As such,  federal income taxes  attributable to income through June 5,
1997, were the responsibility of the individual stockholders.

As a result  of the  initial  public  offering  in June of 1997,  the  Company's
Subchapter  S status was  terminated  for federal and state tax purposes and the
Company   recorded  a  deferred  tax  charge  against  income  of  approximately
$1,200,000 for the cumulative  differences  between the financial  reporting and
income  tax basis of  certain  assets  and  liabilities  existing  at that date.
Additionally,  the Company was required to change its method of accounting  from
the cash basis to the accrual basis for income tax reporting purposes.

The Company's stockholders are obligated to pay the 1997 income taxes related to
the period up to the completion of the offering. The Company declared and paid a
dividend of $1,400,000 to its  stockholders of record  immediately  prior to the
completion of the public  offering for the amount  estimated to approximate  the
1997 income taxes payable by the stockholders.

The pro forma  disclosures on the  statements of income  reflect  adjustments to
record  provisions  for  income  taxes  as if the  Company  had  not  been  an S
Corporation.  The pro forma  provisions  for  income  taxes for the years  ended
December 31, 1995 and 1996, of $813,000 and $441,000, respectively, are computed
using an effective  tax rate of 38%,  which  differs from the federal  statutory
rate of 34%  primarily  due to state taxes.  The pro forma  provision for income
taxes of  $1,900,000  attributable  to December 31, 1997,  is computed  using an
effective tax rate of 35%, which differs from the federal  statutory rate of 34%
as a result of state taxes and tax-exempt income.

                                      F-16
<PAGE>

12.  Income Taxes (continued)

Significant components of the provision for income taxes are as follows:
<TABLE>
<CAPTION>
                                                   1997
                                                  ------
Current:
<S> ...........................................      <C>
Federal .......................................   $1,526
State .........................................      180
                                                  ------
Total Current .................................    1,706
Deferred:
Federal .......................................      442
State .........................................       52
                                                  ------
Total Deferred ................................      494
                                                  ======
                                                  $2,200
                                                  ======
</TABLE>
The Company's  effective tax rate from  continuing  operations  differs from the
U.S. statutory income tax rate as set forth below:
<TABLE>
<CAPTION>
                                                         Pro forma   Pro forma    Pro forma  Historical
                                                           1995        1996         1997        1997
                                                         ---------   ----------   ---------  ----------
<S> ..................................................   <C>          <C>          <C>        <C>
U.S. statutory income tax rate .......................        34.0%        34.0%       34.0%      34.0%
State taxes, net of federal income tax
   benefit ...........................................         4.0%         4.0%        4.0%       3.8%
Permanent differences, primarily
   tax-exempt income .................................          --           --        (3.0%)     (0.7%)
Nonrecurring charge due to
   Subchapter S termination ..........................          --           --           --      22.1%
S Corporation income not subject to
   tax ...............................................          --           --           --     (20.7%)
Other ................................................          --           --           --       2.1%
                                                         =========    =========       ======   =========
Effective tax rate ...................................        38.0%        38.0%       35.0%      40.6%
                                                         =========    =========    =========   =========
</TABLE>

Deferred  income  taxes  reflect  the net tax effects of  temporary  differences
between the carrying  amounts of assets and liabilities for financial  reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred taxes as of December 31 are as follows:
<TABLE>
<CAPTION>
                                         1997
                                       -------
<S>                                       <C>
Deferred tax assets:
   Allowances and reserves .........   $   183
   Accrued expenses ................       246
   Stock option compensation expense       575
                                       -------
Total deferred tax assets ..........     1,004
Deferred tax liabilities:
   Fixed assets ....................       (84)
   Cash to accrual adjustment ......    (1,151)
   Other ...........................      (262)
                                       -------
Total deferred tax liabilities .....    (1,497)
                                       =======
Net deferred tax liabilities .......   $  (493)
                                       =======
</TABLE>
The  exercise  of  certain  stock  options  which  have been  granted  under the
Company's stock option plan give rise to compensation which is includable in the
taxable income of the applicable option holder and deductible by the Company for
federal and state income tax  purposes.  Any  realized tax benefit  arising from
exercised options in excess of the benefit previously recorded,  as discussed in
Notes 9 and 13, is credited to additional paid-in capital.

                                      F-17
<PAGE>

13.  Special Compensation Expense

As  described  in Notes 9 and 12,  charges  to income  were made  related to the
replacement  options issued to employees and the  cancellation of a note from an
officer and  stockholder  of the Company which totaled  $2,193,000  for the year
ended December 31, 1996.  Amortization of deferred  compensation of $268,000 was
recognized  for the year ended  December 31, 1997.  These  transactions  reduced
income from operations,  pro forma net income and pro forma diluted earnings per
share for the years ended  December 31, 1996 and 1997 as follows (in  thousands,
except per share data):
<TABLE>
<CAPTION>
                                        1996     1997
                                       ------   ------
<S> ................................      <C>      <C>
Operating income ...................   $2,193   $  268
Pro forma net income ...............    1,360      169
Pro forma diluted earnings per share     0.19     0.02
</TABLE>
Deferred compensation as of December 31, 1997 of approximately  $243,000 will be
amortized over the remaining vesting periods in 1998, 1999 and 2000.


14.    Earnings per Share

The following table sets forth the computation of basic and diluted earnings per
share (in thousands, except per share data):
<TABLE>
<CAPTION>
                                           1995     1996     1997
                                          ------   ------   ------
<S>                                       <C>      <C>      <C>
Numerator:
  Pro forma net income ................   $1,326   $  720   $3,518
                                          ======   ======   ======

Denominator:
  Shares used in pro forma basic
    earnings per share calculation(1) .    5,538    5,538    7,384

  Effect of dilutive securities:
    Employee stock options ............      592      646      627
    Warrants ..........................      505      505      506
                                          ------   ------   ------
  Shares used in pro forma diluted
    earnings per share calculation(1) .    6,635    6,689    8,517
                                          ======   ======   ======

Pro forma basic earnings per share(1) .   $ 0.24   $ 0.13   $ 0.48
                                          ======   ======   ======

Pro forma diluted earnings per share(1)   $ 0.20   $ 0.11   $ 0.41
                                          ======   ======   ======
</TABLE>
(1)      The pro forma basic and pro forma  diluted  earnings per share  amounts
         prior to the Company's  initial public offering,  which occurred during
         the second  quarter of 1997,  have been  restated as required to comply
         with SFAS No. 128 and the  Securities  and  Exchange  Commission  Staff
         Accounting Bulletin 98 ("SAB 98"). The adoption of SFAS 128 and SAB  98
         resulted  in  an  increase to pro forma diluted earnings per share  for
         1995 and 1996 of $.01 per share.

                                      F-18
<PAGE>

15.   Quarterly Information (Unaudited)

Summarized  quarterly financial  information for 1996 and 1997 is as follows (in
thousands, except per share amounts):
<TABLE>
<CAPTION>
                                                                  Quarter ended
                                       ---------------------------------------------------------------------
                                         March 31          June 30         September 30        December 31
                                       -------------    --------------    ---------------     --------------
<S>                                             <C>               <C>                <C>                <C>
1996
  Total revenues                       $      6,537     $       6,950      $       7,737        $    10,050
  Operating income                              633               712                 79                (93)
  Pro forma net income                          376               431                 12                (99)
  Pro forma diluted earnings
    per share(1)                       $        .06     $         .06      $           -        $      (.02)
  Shares used in diluted earnings
    per share calculation(1)                  6,635             6,635              6,635              5,538

1997
  Total revenues                       $     10,307     $      10,702      $      11,258        $    11,851
  Operating income                            1,057             1,177              1,417              1,336
  Pro forma net income                          600               721              1,111              1,086
  Pro forma diluted earnings
    per share(1)                       $        .09     $         .10      $         .11        $       .11
  Shares used in diluted earnings
    per share calculation(1)                  6,740             7,290              9,973             10,063
</TABLE>
(1)      The pro forma diluted earnings per share amounts prior to the Company's
         initial public  offering,  which occurred  during the second quarter of
         1997,  have been  restated  as required to comply with SFAS No. 128 and
         the Securities  and  Exchange  Commission Staff Accounting Bulletin  98
         ("SAB 98"). The  adoption  of  SFAS  128  and  SAB 98  resulted  in  an
         increase to pro  forma  diluted  earnings  per share  for 1995 and 1996
         of $.01 per share.

                                      F-19
<PAGE>

Item 9.  Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure

None.

                                    PART III

Certain information  required by Part III is omitted from this Form 10-K because
the Company will file a definitive  Proxy  Statement  pursuant to Regulation 14A
(the "Proxy Statement") not later than 120 days after the end of the fiscal year
covered by this Form 10-K,  and certain  information  to be included  therein is
incorporated herein by reference.

Item 10.  Directors and Executive Officers of the Registrant

The information  required by this Item is incorporated by reference to the Proxy
Statement under the headings "Proposal 1 - Election of Directors," and Executive
Compensation  - Executive  Officers" and  "Compliance  with Section 16(a) of the
Exchange Act".

Item 11.  Executive Compensation

The information  required by this Item is incorporated by reference to the Proxy
Statement under the heading "Executive Compensation".

Item 12.  Security Ownership of Certain Beneficial Owners and Management

The information  required by this Item is incorporated by reference to the Proxy
Statement under the heading "Principal Stockholders".

Item 13.  Certain Relationships and Related Transactions

The information  required by this Item is incorporated by reference to the Proxy
Statement under the heading "Executive  Compensation - Certain Transactions with
Management".

<PAGE>

Item 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K

(a)   1.  Financial Statements:
     The  financial  statements  listed  in ITEM  8:  Financial  Statements  and
Supplementary Data, above are filed as part of this Annual Report on Form 10-K.

      2.  Financial Statement Schedules:
     All schedules are omitted  because they are not  applicable or the required
information is shown in the financial statements or notes thereto.
<TABLE>
<CAPTION>
     3.  Exhibits
<C>               <S>
Number            Description

   **3.1 Amended and Restated Certificate of Incorporation of the Registrant.
   **3.2 Amended and Restated Bylaws of the Registrant.
   **4.1 Specimen Common Stock Certificate.
   **4.2 See  Exhibits  3.1  and  3.2  for  provisions  of  the  Certificate  of
         Incorporation  and Bylaws of the Registrant  defining rights of holders
         of Common Stock of the Registrant.
  **10.1 Bridgepoint Lease Agreement dated October 31, 1996 between the
         Registrant and Investors Life Insurance Company of North America.
  **10.2 Lease Guarantee effective January 31, 1997 between the Registrant and
         Pencom Systems Incorporated.
  **10.3 Office Lease dated April 25, 1996 between G&W Investment Partners and
         Pencom Systems Incorporated, as amended.
  **10.4 Agreement of Lease dated May 13, 1996 between Newport L.G.-I, Inc. and
         Pencom Systems Incorporated.
 #**10.5 Software Development Agreement having an effective date of March 9,
         1994 between the Registrant and Canon Computer Systems, Inc., as
         amended.
 #**10.6 Software Licensing Agreement having an effective date of June 13, 1996
         between the Registrant and Canon Computer systems Incorporated.
  **10.7 Service Agreement No. 200.504 dated November 26, 1990 between the
         Registrant and International Business Machines Corporation, as amended
         to date.
    10.8 Software Task Order Agreement dated November 20, 1995 between the
         Registrant and Tivoli Systems, Inc., as amended.
    10.9 Credit Agreement dated November 8, 1997 between the Registrant and
         Texas Commerce Bank National Association.
   10.10 Promissory Note dated November 8, 1997 from the Registrant to Texas
         Commerce Bank National Association.
 **10.11 Accounts Receivable Agreement dated October 1, 1996 between the
         Registrant and Pencom Systems Incorporated.
 **10.12 Letter Agreement dated October 2, 1996 between the Registrant and
         Pencom Systems Incorporated.
 **10.13 Recruiting Services Agreement dated January 20, 1997 between the
         Registrant and Pencom Systems Incorporated.
 **10.14 Stockholders Agreement dated October 1, 1996 between the Registrant and
         certain stockholders of the Registrant.
 **10.15 Registration Rights Agreement dated October 1, 1996 between the
         Registrant and certain stockholders and warrantholders of the
         Registrant.
 **10.16 Employment Agreement dated October 19, 1992 between Dr. William Frank
         King and Pencom Systems Incorporated.
 **10.17 Employment Agreement dated October 1, 1996 between Dr. W. Frank King
         and the Registrant.
 **10.18 Employment  Agreement dated July 1, 1993 between the Registrant and
         Patrick Motola.
 **10.19 Employment  Agreement dated September 27, 1993 between the Registrant
         and William Cason. **10.20 Employment Agreement dated October 19,
         1993 between the Registrant and Brian Baisley.
   10.21 Employment  Agreement dated September 15, 1994 between the Registrant
         and Dennis Thompson.
 **10.22 1996 Stock Option/Stock Issuance Plan.
 **10.23 Employee Stock Purchase Plan.
 **10.24 PSW Profit Sharing Plan.
 **10.25 Description of Executive Bonus Plan.
 **10.26 Stock Purchase Agreement dated as of January 1, 1997 between Michael J.
         Maples and the Registrant.
</TABLE>

<PAGE>
<TABLE>
<CAPTION>
<C>      <S>
**10.27  Stock Subscription dated October 1, 1996 between Pencom Systems
         Incorporated and  the Registrant.
**10.28  Asset Contribution Agreement dated October 1, 1996 between Pencom
         Systems Incorporated and the Registrant.
**10.29  Assignment and Assumption Agreement dated October 1, 1996 between the
         Registrant and Pencom Systems Incorporated.
**10.30  Warrant dated October 1, 1996 issued by the Registrant to Pencom
         Systems Incorporated.
**10.31  Warrant  dated  October  1, 1996  issued by the  Registrant  to Stephen
         Markman.
**10.32  Warrant  dated  October 1, 1996 issued by the  Registrant  to
         Thomas Pallister.
**10.33  Warrant dated October 1, 1996 issued by the Registrant
         to Joy Venegas.
   23.1  Consent of Ernst & Young L.L.P.
   27.1  Financial Data Schedule
---------
</TABLE>

**       Incorporated herein by reference to the Company's Registration
         Statement on Form S-1 (File No. 333-21565).
#        The Company has been  granted  confidential  treatment  with respect to
         certain  portions of these  documents.  The portions of these documents
         which have been  omitted  are  denoted by an  asterisk[*].  The omitted
         portions of these  documents  have been filed with the  Securities  and
         Exchange  Commission  pursuant to Rule 406 under the  Securities Act of
         1933.

     Reports on Form 8-K:
     During the quarter ended December 31, 1997, no current  reports on Form 8-K
     were filed.


<PAGE>

                                   SIGNATURES

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

                             PSW TECHNOLOGIES, INC.

March 27, 1998                       By: /s/ W. Frank King 
--------------                       -------------------------------------------
Date                                 Dr. W. Frank King, President, Chief
                                     Executive Officer and Director
                                     (Principal Executive Officer)


March 27, 1998                       By:  /s/ Patrick D. Motola
--------------                       -------------------------------------------
Date                                 Patrick D. Motola, Senior Vice President of
                                     Operations, Chief Financial Officer and
                                     Secretary (Principal Financial Officer)

March 27, 1998                       By: /s/ Keith D. Thatcher
--------------                       -------------------------------------------
Date                                 Keith D. Thatcher, Vice President of
                                     Finance and Treasurer
                                     (Principal Accounting Officer)

         Pursuant to the  requirements  of the Securities  Exchange Act of 1934,
this  report has been  signed  below by the  following  persons on behalf of the
registrant and in the capacities and on the dates indicated.

March 27, 1998                       By: /s/ Wade E. Saadi
--------------                       -------------------------------------------
Date                                 Wade E. Saadi,
                                     Chairman of the Board of Directors

March 27, 1998                       By: /s/ Edward C. Ateyeh, Jr.
--------------                       -------------------------------------------
Date                                 Edward C. Ateyeh, Jr., Director

March 27, 1998                       By: /s/ Thomas A. Herring
--------------                       -------------------------------------------
Date                                 Thomas A. Herring, Director

March 27, 1998                       By: /s/ Kevin B. Kurtzman
--------------                       -------------------------------------------
Date                                 Kevin B. Kurtzman, Director

March 27, 1998                       By: /s/ Michael J. Maples
--------------                       -------------------------------------------
Date                                 Michael J. Maples, Director

March 27, 1998                       By: /s/ Jonathan D. Wallace, Esq.
--------------                       -------------------------------------------
Date                                 Jonathan D. Wallace, Esq., Director