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, 1998

                                       OR

o    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 Each Class                Name of Each Exchange 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. o
         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 February
26, 1999 as reported on the Nasdaq  National  Market,  was  approximately  $13.4
million  (affiliates  being,  for  these  purposes  only,  directors,  executive
officers and holders of more than 5% of the Registrant's Common Stock).

         As of February 26,  1999,  the  Registrant  had  outstanding  9,351,301
shares Common Stock.

                       Documents Incorporated By Reference
          Portions of the Proxy Statement for  Registrant's  1999 Annual Meeting
of Stockholders are incorporated by reference into Part III of this Form 10-K.

<PAGE>

                                     PART I

Item 1.  Business

         In  addition  to  the  historical  information  contained  herein,  the
discussion in this Form 10-K contains certain forward-looking statements, within
the meaning of Section 27A of the  Securities Act of 1933 and Section 21E of the
Securities  Exchange Act of 1934, that involve risks and uncertainties,  such as
statements concerning:  growth and future operating results, developments in the
Company's  markets  and  strategic  focus;  and  future  economic  and  business
conditions.  The cautionary  statements made in this Form 10-K should be read as
being applicable to all related forward-looking  statements whenever they appear
in this Form 10-K. The Company's actual results could differ materially from the
results discussed in the forward-looking statements. Factors that could cause or
contribute to such differences  include, but are not limited to, those discussed
under the section captioned  "Additional Factors That May Affect Future Results"
in Item 1 of this Form  10-K as well as those  cautionary  statements  and other
factors set forth elsewhere herein.

         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 are
subject to 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
and completed an initial public offering in June of 1997. 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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<PAGE>

         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 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 and (ii) 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.  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.




                                       3
<PAGE>

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  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, in the following areas:

 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.

                                       4
<PAGE>

         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.

         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 services 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, and
to deliver  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.

                                 
                                       5
<PAGE>

         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.

Marketing and Sales

  Marketing

         Strategic  market  planning is performed by the executive  staff of the
Company,  which  actively  seeks input and guidance  from a number of sources to
make strategic  decisions.  These sources include PSW clients,  senior technical
staff members,  marketing and sales  personnel and numerous  executive  contacts
throughout  the  industry.  The  executive  staff  meets  regularly  to  discuss
strategic issues and actions. Senior technical staff members meet once 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 corporate marketing  department develops and promotes key corporate
messages,  consistent  marketing  programs  and  materials  and  ongoing  public
relations.  This is accomplished by coordinating  the execution of the Company's
strategic marketing  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 developing a "value  proposition" for its services
that  clearly  defines  the  benefits  of  engaging  PSW and  seeks to align the
communication  of the value  proposition  with the delivery of the highest value
services   possible   to  the  client.   This   includes   project   management,
methodologies,  recruiting,  training  and any  other  initiatives  required  to
deliver  consistent,   high  quality  service.  The  marketing  emphasis  is  on
communicating  the value  proposition  to the  client  and  demonstrating  PSW's
capabilities to deliver the service effectively.

         The Company's  marketing  programs  emphasize its 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 certain key
partners during the sales process to present a unified proposal to the client.

Sales

         PSW's sales force  consists of Regional  Sales  Directors and Managers.
The Company's executive  management,  project managers and senior members of the
technical staff also assist with the sale of the Company's  services.  The sales
force identifies  appropriate  business  opportunities and client needs.  Senior
members of the technical  staff provide high level technical  review,  typically
involving  members of the client's  staff,  early in the client  relationship to
thoroughly explore the client's needs and to propose  solutions.  In some cases,
the  client  pays for an  assessment  to  analyze  the  requirements  and make a
detailed  proposal.  Large project proposals  typically involve project managers
and other technical professionals.

         The sales force is responsible  for achieving high client  satisfaction
and growing additional  business in their assigned  accounts.  They are assigned
revenue  quotas and are paid a commission  based on the revenue of business they
obtain.  Time schedules and cost  estimates are prepared by the technical  staff
with input from the responsible  salesperson.  These schedules and estimates are
used to determine  the financial  structure  and proposed  pricing for a project
based on gross  margin  targets  for new  business.  All  pricing is approved by
operating management,  whose performance and compensation is not based primarily
on revenue.

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<PAGE>

         PSW serves clients  throughout the United States.  The Company seeks to
establish  offices in those areas that have a high  concentration of IT vendors.
Current  office  sites  include  Austin,  Boston,  Seattle  and  Mountain  View,
California. Each office has a site manager and salespersons assigned to grow the
Company's base of clients and revenue.  Once an engagement is started,  work may
be conducted on PSW's premises or the Company's and technical  personnel  travel
or relocate to the client site.

Employees

         PSW's  workforce  has grown  significantly  over the past  four  years,
increasing  from 167  full-time  employees at December 31, 1994 to 391 full-time
employees at December  31, 1998.  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%,  4% and 1% of the  Company's  hires  in 1996,  1997  and  1998,
respectively.  Currently, the Company is a party to recruiting agency agreements
with Pencom as well as 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 extensive telephone and in-person
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 referrals,  the Company utilizes  advertising,
job fairs,  internet  recruiting  sites,  its  Website and  research  and direct
sourcing to identify and attract potential employees.

 Career Development and Training

         The Company has developed a Resource Management group that is designed,
among other things, to build strong,  long-term relationships with the technical
staff. These relationships are critical in ensuring that project assignments and
training are consistent  with each employee's  career  aspirations and that each
employee receives meaningful project and annual performance reviews.

         The  Company  has placed a focus on  creating  career  ladders  for the
technical  staff that are  equivalent to that of the  management  career ladder.
Career ladders exist for software consultants, software developers, and software
quality specialists as well as for technical management.

                                       7
<PAGE>

         The Company has developed  strong  internal  training  programs for its
employees,  including technical  training,  management  training,  and knowledge
management. Technical training includes Java and Microsoft Developer and Systems
Engineering certification programs. Employees gain classroom as well as hands-on
experience  with  Genova  methodologies  created  and  refined by each  business
practice,  including object-oriented business systems, porting,  UNIX-to-Windows
NT migration, software quality assurance, and project management.

         The  Company  offers  several  management   training  programs  to  its
employees,   including   overall   management   skills,   effective   and  legal
interviewing,  effective  performance  reviews,  and progressive  discipline and
termination.

         To effectively leverage the Company's intellectual assets, PSW embraces
the knowledge management approach to learning.  Employees contribute information
to an  ever-growing  knowledge  base  that  includes  technology  and  products,
methodologies,  project web sites, and corporate information.  PSW also conducts
annual  technology  forums and  business  forums to increase  communication  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 stock  options to all key
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,
other than the enterprise system projects, 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

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<PAGE>

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 for which the employee has had
direct contact.  Furthermore, the Company's employment agreement with Timothy D.
Webb, the Company's President and Chief Executive Officer,  contains provisions,
which for a period of two years, restrict Mr. Webb's ability to provide services
to, or solicit the business of, the Company's clients and prospective clients in
a  competitive  manner.  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.

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
1995, 1996, 1997 and 1998,  accounted for  approximately  88%, 82%, 63% and 57%,
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 39% and 35% of its revenue in
1997 and 1998, respectively. The Company may experience a decline in the percent
of revenue and level of IBM  business in 1999 due to the  completion  of several
projects  for IBM  and 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 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.

                                       9
<PAGE>

Additional Factors That May 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
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,  1997 and
1998, approximately 12%, 20% and 16%, 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. The Company has also undertaken projects in which
a material  portion  of total  revenue is earned  based upon  meeting  specified
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, the  Company,  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.


                                       10
<PAGE>

         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 391  full-time
employees at December 31, 1998. In order to manage its growth  effectively,  the
Company will need 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;  Limited  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 Systems Incorporated,  ("Pencom").  Accordingly,  the Company
has only a limited independent operating history upon which an evaluation of the
Company  and its  prospects  can be based.  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.

         Variability of Quarterly  Operating  Results.  The Company's  quarterly
revenue,  expenses and operating  results have varied  significantly in the past
and are likely to vary significantly from quarter to quarter in the future. Such
quarterly  fluctuations are 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 which
may effect  operating  results  include  customer  budget  cycles  and  customer
spending priorities such as the Year 2000 compliance 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.  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
depends 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.
                                      11
<PAGE>


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  and  internet  systems.   The
client/server  and  internet  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  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.

         Changes  in Senior  Management.  The  Company  has  recently  announced
several additions and changes in its senior management team. The Company's Chief
Executive  Officer,  Timothy D. Webb, joined the Company during 1998 and John M.
Velasquez,  Vice President of Enterprise Solutions, and Pedro A. Fernandez, Vice
President of Corporate  Strategy and Marketing  came to the Company in the first
quarter of 1999.  With recently  named Vice  President of Software  Research and
Development  Solutions,  Kenneth L.  Drake and the Vice  President  of  Embedded
Systems  Solutions,  Brent R. Terry, the above team comprises the new operations
senior  management.  There can be no assurances  that such changes in the senior
management  of the Company will not adversely  affect the  Company's  results of
operations or financial  condition,  that the new members of the management team
will succeed in their roles in a timely or efficient manner or that they will be
satisfactorily    assimilated,   or   that   new   and   additional   management
responsibilities can be allocated effectively among such executives.  Failure by
the Company to assimilate new  executives,  or the failure of any such executive
to perform  effectively,  could have a material  adverse effect on the Company's
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  Timothy D. Webb,  Keith D.  Thatcher,  Kenneth L. Drake,  Pedro A.
Fernandez,  John M. Velasquez and Brent R. Terry,  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.

                                       12
<PAGE>

         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 and results of operations.

         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.

         Uncertainty  Related  to the Year 2000  Compliance  Issues.  Many older
computer systems and software products currently in use are coded to accept only
two digit  entries in the date code  field.  These date code fields will need to
accept four digit  entries to  distinguish  21st century dates from 20th century
dates.  As a result,  in less than 12 months,  computer  systems and/or software
used by many  companies will need to be upgraded to comply with such "Year 2000"
requirements. Significant uncertainty still exists as to the global implications
of the Year 2000 issue.  The Company  believes that the  purchasing  patterns of
customers  and  potential  customers  may be  affected  by Year 2000 issues in a
variety  of ways.  Many  companies  (including  customers  of the  Company,  and
customers  or potential  customers of the  Company's  customers)  are  expending
significant  resources to correct or patch their  current  hardware and software
systems for Year 2000 compliance.  Such expenditures may result in reduced funds
available for the Company's customers to pursue product development  programs or
IT systems  enhancements  for which the Company's  services  would  otherwise be
utilized. Any of the foregoing,  including costs of defending and resolving Year
2000-related  disputes,   reductions  in  development  programs  or  IT  systems
enhancements  by customers and their  customers or the failure of the Company to
adequately  resolve  internal  Year 2000  compliance  issues  could  result in a
material  adverse  effect  on the  Company's  business,  operating  results  and
financial condition.


                                       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.

         The  Company  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. In 1998,
PSW leased a facility of 10,670 square feet in Mountainview, California adding a
strategic  presence for the Company in the silicon valley. PSW also has space in
Boston, Massachusetts.

         PSW  employees are also located at client sites  throughout  the United
States,  including  Chicago,  Raleigh,  Costa  Mesa,  Menlo Park and  Cupertino.
Additional  office  expansion is anticipated in 1999. 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 1998                      $ 3.13            $ 2.00
Third quarter of 1998                       $ 7.13            $ 1.94
Second quarter of 1998                      $ 9.63            $ 5.56
First quarter of 1998                       $15.00            $ 6.38
Fourth quarter of 1997                      $19.63            $10.31
Third quarter of 1997                       $15.63            $11.38

         As of February 26, 1999,  there were 9,351,301  shares of the Company's
Common Stock  outstanding held by 66 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.  During the year ended December 31, 1998, the Company used $1.8 million
of the  proceeds to acquire  property  and  equipment  and $2.2  million to fund
working  capital  requirements.  The  remaining  $17.0  million is  invested  in
short-term,  interest  bearing  accounts  available  as working  capital for 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

                                       15
<PAGE>

owning  ten  percent  (10%) or more of any  class of  equity  securities  of the
Company or to affiliates of the Company.

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, 1996,  1997 and 1998 and the balance  sheet data as of December 31,
1997 and 1998 are derived  from  financial  statements,  appearing  herein.  The
statements of income data for the years ended December 31, 1994 and 1995 and the
balance  sheet data as of December  31,  1994,  1995 and 1996 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,
                                            -------------------------------------------------------------------
                                              1994          1995           1996         1997           1998
                                            ----------    ---------      ---------    ---------     -----------
                                                          (in thousands, except per share data)
<S>                                           <C>           <C>            <C>           <C>           <C>
Statements of Income (Loss) Data:
Revenue                                       $12,318       $21,147        $31,274       $44,118       $39,101
Operating expenses:
   Technical staff                              7,385        11,193         16,444        22,479        23,440
   Selling and administrative staff             2,320         3,755          5,622         8,405        10,121
   Other expenses                               2,317         3,976          5,684         7,979         8,933
   Special compensation expense(1)                  -             -          2,193           268            75
                                            ----------    ----------     ----------    ----------    ----------
      Total operating expenses                 12,022        18,924         29,943        39,131        42,569
                                            ----------    ----------     ----------    ----------    ----------
Income (loss) from operations                     296         2,223          1,331         4,987        (3,468)
Interest income (expense), net                    (74)          (84)          (170)          431           946
                                            ----------    ----------     ----------    ----------    ----------
Income (loss) before provision
  for income taxes                                222         2,139          1,161         5,418        (2,522)
                                            ----------    ----------     ----------    ----------    ----------

Provision (benefit) for income taxes:
   Nonrecurring charge for termi-
     nation of Subchapter S election                -             -              -         1,200             -
   C Corporation taxes                              -             -              -         1,000         (1,060)
                                            ----------    ----------     ----------    ----------    ----------
Net income (loss)                              $  222       $ 2,139        $ 1,161       $ 3,218        $(1,462)
                                            ==========    ==========     ==========    ==========    ==========

Diluted loss per share                                                                                   $(0.16)
                                                                                                     ==========

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

Shares used in diluted
   earnings (loss) per share
   calculation(3)                               6,635         6,635          6,689         8,517         9,113
                                            ==========    ==========     ==========    ==========    ==========

</TABLE>

                                      16
<PAGE>

Item 6.  Selected Financial Data (continued)
<TABLE>
<CAPTION>
                                                                       December 31,
                                                           1994      1995       1996      1997       1998
                                                           ----      ----       ----      ----       ----
                                                                          (in thousands)
     <S>                                                    <C>       <C>        <C>      <C>        <C>     
      Balance Sheet Data:
      Working capital...................................    $1,933    $2,756     $1,648   $28,074    $27,379
      Total assets......................................     3,538     4,982     11,943    35,420     33,351
      Total stockholders' equity........................     2,675     3,684      3,444    31,859     31,068
----------
</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 Notes 2 and 14 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,  within
the meaning of Section 27A of the  Securities Act of 1933 and Section 21E of the
Securities  Exchange Act of 1934, that involve risks and uncertainties,  such as
statements for the plans,  objectives,  expectations and intentions of PSW. Such
forward  looking  statements are generally  accompanied by words such as "plan,"
"estimate," "expect," "believe," "could," "would," "anticipate," "may," or other
words  that   convey   uncertainty   of  future   events  or   outcomes.   These
forward-looking  statements and other  statements  made elsewhere in this report
are made in reliance on 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 certain factors
that could cause actual future results of the Company to differ  materially from
these statements.

Overview

         PSW  Technologies,  Inc. (the "Company"),  is a software  services firm
that provides high value solutions to information  technology ("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.  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. 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 IT user clients.

         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.  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.


                                       17
<PAGE>

         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.

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
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
were  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  immediately  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 and 1998 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 and $75,000 in 1997 and 1998, respectively.  (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).

















                                       18
<PAGE>

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,
                                                               1996            1997           1998
                                                               ----            ----           ----
<S>                                                             <C>             <C>            <C>
Revenue                                                         100%            100%           100%
Operating Expenses:
     Technical staff                                             53              51             60
     Selling and administrative staff                            18              19             26
     Other expenses                                              18              18             23
     Special compensation expense                                 7               1              -
                                                          ----------      ----------       ---------
Total operating expenses                                         96              89            109
                                                          ----------      ----------       ---------
Income (loss) from operations                                     4              11             (9)
Interest income (expense), net                                   (1)              1              2
Provision (benefit) for income taxes                              1 (a)           4 (a)         (3)
                                                          ----------      ----------       ---------
Net income (loss)                                                2% (a)           8% (a)        (4%)
                                                          ----------      ----------       ---------
</TABLE>

(a) Net income is  presented  on a pro forma  basis as if the  Company  had been
fully subject to federal and state income taxes.

Results of Operations for 1998 Compared with 1997

         Revenue

         Revenue  consists  primarily  of fees for software  services  provided.
Revenue was $39.1 million in 1998,  down 11% from 1997 revenue of $44.1 million,
principally  due to the  decline  in the scope and  number of IT user  projects.
Revenue  attributable  to  software  services  rendered  to IT vendors was $25.8
million  and $27.3  million in 1998 and 1997,  respectively  a decrease of 5% in
1998 compared to 1997. Revenue  attributable to software services rendered to IT
users was $13.3  million  and $16.8  million in 1998 and 1997,  respectively,  a
decrease of 21% in 1998 compared to 1997.

         IBM, including its wholly owned subsidiaries, accounted for 35% and 39%
of revenue in 1998 and 1997, respectively.  The Company may experience a decline
in the level of business from this customer in 1999. No other customer accounted
for more than 10% of revenue in 1998 or 1997.

         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 $23.4 million in 1998, an increase of 4%
over 1997 technical  staff expenses of $22.5 million.  The increase in technical
staff  expenses  was  primarily  due to the  addition  of  personnel  in 1998 in
anticipation of new  engagements.  Technical staff expenses  increased to 60% of
revenue in 1998 from 51% in 1997  primarily as a result of lower  utilization of
technical staff and lower revenues.










                                       19
<PAGE>

         Selling and Administrative Staff

         Selling  and  administrative  staff  expenses  consist  of the  cost of
salaries, payroll taxes, health insurance and workers' compensation for selling,
marketing and administrative personnel, and all commissions and bonuses. Selling
and administrative staff expenses were $10.1 million in 1998, an increase of 20%
from $8.4  million in 1997.  The  increase in selling and  administrative  staff
expenses  was  primarily  due to the  increased  focus  on sales  and  marketing
initiatives  which  resulted  in an increase  to the sales and  marketing  staff
during  1998.  Selling and  administrative  staff  expenses  increased to 26% of
revenue  in 1998 from 19% of  revenue  in 1997.  The  increase  in  selling  and
administrative  staff  expenses as a percentage of revenue is due primarily as a
result of increases in the sales staff and lower revenues.

         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 $8.9 million in 1998, an increase
of 12% over other  expenses of $8.0 million in 1997. The increase is principally
due to higher  occupancy,  travel,  project and bad debt  expenses and severance
costs. Other expenses were 23% of revenue in 1998 compared to 18% in 1997.

         Special Compensation Expense

         Special compensation expense in 1998 and 1997 consisted of amortization
of  stock-based  compensation  originating  in 1996,  which,  in the  aggregate,
totaled  $75,000  and  $268,000  or less than 1% of  revenue  for 1998 and 1997,
respectively. See Notes 9, 12 and 13 of Notes to Financial Statements.

         Income (loss) from Operations

         The Company  recorded a loss from  operations  of $3.5 million in 1998,
down from $5.0 million of income from  operations in 1997.  Loss from operations
was 9% of revenue in 1998,  compared to income from operations of 11% of revenue
in 1997.

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
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.

         IBM, including its wholly owned subsidiaries, accounted for 52% and 39%
of  revenue  in 1997 and 1996,  respectively.  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.

                                       20
<PAGE>

         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.

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
operations as the software  division of Pencom. In 1996, the Company repaid $2.9
million of contributions from Pencom.

         Cash used in operating  activities was $1.7 million in 1998 as compared
to cash  provided by  operations  of $3.1  million and $2.1  million in 1997 and
1996,  respectively.  Total  repayments of borrowings were $5.1 million in 1997.
The Company purchased  approximately $1.8 million, $2.7 million and $1.2 million
of  computer  and office  equipment  in 1998,  1997 and 1996,  respectively.  At
December 31, 1998, the Company did not have any material commitments for capital
expenditures.

         At December 31,  1998,  the Company had cash and cash  equivalents  and
short-term  investments totaling $20.3 million, a decrease from $23.3 million at
December  31,  1997.  During  1998,  the  Company  used $1.8  million to acquire
property and equipment and $1.2 million to fund working capital requirements.

                                       21
<PAGE>

         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 Company did
not draw on the line of credit during 1998.  At December 31, 1998,  there was no
amount outstanding and the available borrowing amount was $7.5 million.

         The Company  anticipates that its existing capital resources  described
above,  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.

Year 2000 Compliance

         Many older computer systems and software products  currently in use are
coded to accept only two digit  entries in the date code field.  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/or software used by
many  companies  will need to be  upgraded  to  comply  with  such  "Year  2000"
requirements.

         All of the services currently offered by the Company are designed to be
Year 2000 compliant.  However,  the Company's  services are often  integrated or
used  in  conjunction  with  third-party  software;  such  software  may  not be
compatible with Company's  services or Year 2000  compliant.  The Company may in
the future be subject to claims based on Year 2000 problems in other's products,
custom scripts created by third parties to interface with the Company's services
or issues arising from the  integration of multiple  products and systems within
an overall  system.  The costs of  defending  and  resolving  Year  2000-related
disputes,  and any  liability  of the  Company  for Year  2000-related  damages,
including  consequential  damages,  could have a material  adverse effect on the
Company's business, operating results and financial condition.

         Over the past three years,  the Company has made Year 2000 compliance a
priority in IT purchasing and  installation  decisions.  The Company's  internal
information  technology  group has  adopted a Year 2000  compliance  program  to
assess and address any Year 2000 issues which remain related to the Company's IT
and non-IT systems.  The program consists of the following  phases:  identifying
Year 2000  application  issues,  updating  applications,  identifying  Year 2000
systems and  operating  systems  issues (such phases are  complete),  collecting
manufacturer's  compliance statements,  verifying solutions to Year 2000 issues,
updating and/or patching  operating  systems,  updating firmware and phasing out
unsupported  hardware  (such phases are in process and scheduled to be completed
in the first  quarter of fiscal  1999).  As of January 1, 1999,  the Company has
spent approximately $25,000 of the currently estimated $30,000 total cost of the
program.  Costs  incurred and expected to be incurred  consist  primarily of the
cost of Company  personnel  involved  in  updating  applications  and  operating
systems  and the  costs of  software  updates  and  patches  (many of which  are
provided  free of charge from the vendors).  Funds for the Year 2000  compliance
program are expected to be provided from available working capital.  The Company
has utilized the Company's internal technical personnel, and intends to continue
to use such  personnel,  to address Year 2000 issues,  rather than contract with
third-party consultants.





                                       22
<PAGE>

         Although the Company has not completed its survey of third parties with
which it has a material  relationship,  the majority of the Company's  customers
are  sophisticated  IT vendors and users who are addressing  their own Year 2000
issues and the Company  relies  primarily  on its own  technical  personnel  and
internal IT systems,  rather than third party  suppliers.  As the Company's Year
2000  compliance  program is on schedule to be completed in the first quarter of
fiscal year 1999, the Company has not formulated a most reasonably  likely worst
case  scenario or  formulated a  contingency  plan should the program fail to be
completed  by such date.  The Company has verified 95% of its third party supply
chain.  Any third party  supplier  that does not respond by the end of the first
quarter of 1999 will be replaced, if necessary.

         Significant  uncertainty still exists as to the global  implications of
the Year 2000  issue.  The  Company  believes  that the  purchasing  patterns of
customers  and  potential  customers  may be  affected  by Year 2000 issues in a
variety  of ways.  Many  companies  (including  customers  of the  Company,  and
customers  or potential  customers of the  Company's  customers)  are  expending
significant  resources to correct or patch their  current  hardware and software
systems for Year 2000 compliance.  Such expenditures may result in reduced funds
available for the Company's customers to pursue product development  programs or
IT systems  enhancements  for which the Company's  services  would  otherwise be
utilized. Any of the foregoing,  including costs of defending and resolving Year
2000-related  disputes,   reductions  in  development  programs  or  IT  systems
enhancements  by customers and their  customers or the failure of the Company to
adequately  resolve  internal  Year 2000  compliance  issues  could  result in a
material  adverse  effect  on the  Company's  business,  operating  results  and
financial condition.

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" and "Additional  Factors that May
Affect Future Results" in Item 1 of this Form 10-K.





















                                       23
<PAGE>

Item 7.A.  Quantitative and Qualitative Disclosures about Market Risks

         The  Company  does  not use  derivative  financial  instruments  in its
non-trading  investment  portfolio.   The  Company  places  its  investments  in
instruments  that  meet high  credit  quality  standards,  as  specified  by the
Company's investment policy.

         The Company is exposed to cash flow and fair value risk from changes in
interest rates, which may affect its financial  position,  results of operations
and  cash  flows.   In  seeking  to  minimize  the  risks  from   interest  rate
fluctuations,  the Company manages exposures  through ongoing  evaluation of its
investment portfolio. The Company does not use financial instruments for trading
or other speculative purposes.

The table below provides information about the Company's non-trading  investment
portfolio.  For investment  securities,  the table presents principal cash flows
and related weighted average fixed interest rates by expected maturity dates.
<TABLE>
<CAPTION>

                                               Investments         Weighted          Fair Value
                                                Maturing            Average              At
          At December 31, 1998                   During            Interest         December 31,
 (in thousands, except interest rates)            1999               Rate               1998
-----------------------------------------     --------------     --------------    ----------------
<S>                                                  <C>                <C>                 <C>
Money market funds                                $   1,571              4.70%          $    1,571
Government issues                                     2,723              4.79%               2,710
Corporate issues                                     13,411              5.42%              13,234
Commercial paper                                      1,635              5.14%               1,621
                                              ==============     ==============    ================
                                                  $  19,340              5.25%          $   19,136
                                              ==============     ==============    ================

</TABLE>





















                                       24
<PAGE>


Item 8.  Financial Statements and Supplementary Data


<TABLE>
<CAPTION>
                                      PSW  TECHNOLOGIES, INC. 

                                   INDEX TO FINANCIAL STATEMENTS



                                                                                                       Page
<S>                                                                                                    <C>
Report of Independent Auditors.......................................................................  F-2
Balance Sheets as of December 31, 1997 and 1998......................................................  F-3
Statements of Income (Loss) for the years ended December 31, 1996, 1997 and 1998.....................  F-4
Statements of Stockholders' Equity for the years ended December 31, 1996, 1997
and  1998 .............................................................................................F-5
Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998........................  F-6
Notes to Financial Statements........................................................................  F-7
</TABLE>
















                                      
<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,  1997  and 1998  and the  related  statements  of  income  (loss),
stockholders'  equity,  and cash flows for each of the three years in the period
ended  December  31,  1998.  These  statements  are  the  responsibility  of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
financial statements based on our audits.

We  conducted  our  audits  in  accordance  with  generally   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 financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material  respects,  the  financial  position of PSW  Technologies,  Inc. at
December 31, 1997 and 1998, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles.


                                                           /s/ Ernst & Young LLP


   Austin, Texas
   January 28, 1999



                                      F-2
<PAGE>
<TABLE>
<CAPTION>
                                                                    PSW Technologies, Inc.
                                                                        Balance Sheets
                                                        (in thousands, except share and per share data)

                                                                                   December 31,
                                                                           1997                       1998
                                                                   ---------------------    -----------------------
<S>                                                                           <C>                     <C>
Assets
Current assets:
   Cash                                                              $            835           $        1,167
   Short-term investments                                                      22,470                   19,136
   Accounts receivable, net of allowance for doubtful
       accounts of $165 and $260 in 1997 and 1998,
       respectively                                                             7,429                    6,171
   Unbilled revenue under customer contracts                                      418                    1,070
   Income tax receivable                                                           46                      896
   Net current deferred income taxes                                                -                      334
   Prepaid expenses and other current assets                                      437                      572
                                                                   ---------------------    -----------------------
Total current assets                                                           31,635                   29,346

Property and equipment, net                                                     3,551                    4,005
Net deferred income taxes                                                         234                        -
                                                                   -----------------------  -----------------------
Total assets                                                         $         35,420           $       33,351
                                                                   =====================    =======================

Liabilities and stockholders' equity 
Current liabilities:
    Accounts payable and accrued expenses                                       2,834                    1,967
    Net current deferred income taxes                                             727                        -
                                                                   ---------------------    -----------------------
Total current liabilities                                                       3,561                    1,967

Net deferred income taxes                                                           -                      316

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, 8,960,935 and 9,293,866 shares issued and                                   
     outstanding at December 31, 1997 and 1998, respectively                                 

                                                                                   90                       93
   Additional paid-in capital                                                  29,484                   29,995
   Deferred compensation                                                         (243)                     (44)
   Accumulated and other comprehensive income                                     (27)                     (69)
   Retained earnings                                                            2,555                    1,093
                                                                   ---------------------    -----------------------
Total stockholders' equity                                                     31,859                   31,068
                                                                   ---------------------    -----------------------
Total liabilities and stockholders' equity                           $         35,420           $       33,351
                                                                   =====================    =======================

                                        See accompanying notes.
</TABLE>

                                      F-3
<PAGE>
<TABLE>
<CAPTION>
                                                                   PSW Technologies, Inc.
                                                                  Statements of Income (Loss)
                                                             (in thousands, except per share data)


                                                                         Year ended December 31,
                                                                 1996             1997                1998
                                                                 ----             ----                ----
                                                                             
                                                                             
<S>                                                            <C>              <C>                <C>
Revenue                                                        $ 31,274         $ 44,118           $  39,101

Operating expenses:
   Technical staff                                               16,444           22,479              23,440
   Selling and administrative staff                               5,622            8,405              10,121
   Other expenses                                                 5,684            7,979               8,933
   Special compensation expense                                   2,193              268                  75
                                                               ---------        ---------          ----------
Total operating expenses                                         29,943           39,131              42,569
                                                               ---------        ---------          ----------

Income (loss) from operations                                     1,331            4,987              (3,468)

Interest income (expense), net                                     (170)             431                 946
                                                               ---------        ---------          ----------
Income (loss) before provision (benefit) for
     income taxes                                                 1,161            5,418             (2,522)
                                                               ---------        ---------          ----------
Provision (benefit) for income taxes:
   Nonrecurring charge for termination
      of Subchapter S election                                        -            1,200                   -
   C Corporation                                                      -            1,000              (1,060)
                                                               ---------        ---------          ----------
Total provision (benefit) for income taxes                            -            2,200             (1,060)
                                                               ---------        ---------          ----------

Net income (loss)                                              $  1,161         $  3,218           $  (1,462)
                                                               =========        =========          ==========

Basic loss per share                                                                               $   (0.16)
                                                                                                   ==========

Diluted loss per share                                                                             $  (0.16)
                                                                                                   ==========

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

   Pro forma net income                                      $     720         $   3,518
                                                             ==========        =========

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

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

   Shares used in basic earnings (loss)
      per share calculation                                      5,538             7,384               9,113
                                                             ==========         =========           =========

   Shares used in diluted earnings (loss)
      per share calculation                                      6,689             8,517               9,113
                                                             ==========         =========           =========


                                        See accompanying note.
</TABLE>

                                      F-4
<PAGE>
<TABLE>
<CAPTION>
                                                                             F-12
                                                                    PSW Technologies, Inc.
                                                              Statements of Stockholders' Equity
                                                                 (in thousands, except shares)
                                                                                                          Retained         Other
                                        Common Stock        Additional                    Earnings      Comprehensive      Total
                                       $.01 Par Value        Paid-in      Deferred      (Accumulated       Income      Stockholders'
                                     -------------------
                                      Shares     Amounts     Capital      Compensation     Deficit)        (Loss)         Equity
                                    --------- ----------   ------------  --------------  --------------  ------------ --------------
<S>                                  <C>          <C>         <C>         <C>              <C>              <C>              <C>
 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
 Comprehensive Income:
    Net income                              -        -             -              -          3,218               -            3,218
    Net unrealized loss on investments      -        -             -              -              -             (27)             (27)

Comprehensive income                        -        -             -              -              -               -            3,191
                                    ---------- ----------   ----------     ----------      ----------     ----------      ----------
 Balance at December 31, 1997       8,960,935       90        29,484           (243)         2,555             (27)          31,859
 Employee stock purchase plan
    issuance of stock                  93,747        2           417              -               -              -              419
 Exercise of stock options and
    warrants                          239,184        1            63              -               -              -               64
 Tax benefit related to stock
    option exercises                        -        -           155              -               -              -              155
 Forfeiture of stock options                -        -          (124)           124               -              -                -
 Amortization of deferred
    compensation                            -        -             -             75               -              -               75
 Comprehensive income:
    Net loss                                -        -             -              -          (1,462)             -           (1,462)
    Net unrealized loss on investments      -        -             -              -               -            (42)             (42)
                                                                                                                          ----------
 Comprehensive income                       -        -             -              -               -              -           (1,504)
                                    ---------- ----------   ----------     ----------     ----------       ----------     ----------
Balance at December 31, 1998        9,293,866  $    93     $  29,995       $    (44)      $   1,093        $   (69)        $ 31,068
                                   ==========  ==========   ==========     ==========     ==========       ==========     ==========

                             See accompanying notes.

</TABLE>

                                       F-5
<PAGE>
<TABLE>
<CAPTION>
                                                                    PSW Technologies, Inc.
                                                                   Statements of Cash Flows
                                                                        (in thousands)

                                                                      1996            1997             1998
                                                                  ------------    ------------     ------------
<S>                                                                    <C>             <C>             <C>
Operating activities
     Net income (loss)                                               $  1,161        $  3,218        $ (1,462)
     Adjustments to reconcile net income (loss) to net cash
         provided by (used in) operating activities:
       Amortization of deferred compensation                            2,193             268              75
       Depreciation and amortization                                      424             825           1,100
       Bad debt expense                                                    75              45             249
       Changes in operating assets and liabilities:
         Accounts receivable                                           (2,344)         (1,367)          1,009
         Due from related party                                          (323)           (258)              -
         Unbilled revenue under customer contracts                       (144)           (174)           (652)
         Prepaid expenses and other current assets                       (864)           (157)           (135)
         Income tax receivable                                              -             (46)           (695)
         Due to related party                                             581               -               -
         Accounts payable and accrued expenses                          1,154             299            (639)
         Deferred revenue                                                 227            (227)              -
         Deferred income taxes                                              -             675            (511)
                                                                  ------------    ------------     ------------
            Net cash provided by (used in) operating activities         2,140           3,101          (1,661)
                                                                  ------------    ------------     ------------


Investing activities
     Purchase of short-term investments                                     -         (22,497)               -
     Proceeds from sale of short-term investments                           -               -            3,292
     Acquisition of property and equipment                              (1,247)        (2,646)          (1,782)
                                                                  ------------    ------------     ------------
            Net cash provided by (used in) investing activities         (1,247)        (25,143)          1,510
                                                                  ------------    ------------     ------------


Financing activities
     Proceeds from (repayments on) line of credit, net                  5,125          (5,125)               -
     Capital distributions, net                                        (2,870)              -                -
     Proceeds from issuance of common stock, net of
        issuance costs                                                      -          26,220              483
     Dividend paid to S corporation stockholders                            -          (1,400)               -
                                                                  ------------    ------------     ------------
            Net cash provided by financing activities                   2,255          19,695              483
                                                                  ------------    ------------     ------------


Net increase (decrease) in cash                                         3,148          (2,347)             332
Cash, beginning of year                                                    34           3,182              835
                                                                  ============    ============     ============
Cash, end of year                                                    $  3,182         $   835         $  1,167
                                                                  ============    ============     ============


Supplemental disclosure of cash flow information
     Interest paid                                                     $  154         $   137           $   20
     Income taxes paid                                                 $    -         $ 1,571           $  148

Supplemental schedule of non-cash activities
     Unrealized loss on investments                                    $    -         $    27           $   42
     Reduction of income taxes payable associated
        with the exercise of stock options                             $    -         $   182           $  155


                                                    See accompanying notes.
</TABLE>

                                      F-6
<PAGE>

                             PSW Technologies, Inc.
                        Notes to the Financial Statements

1.   Nature of Business

PSW  Technologies,  Inc.,  (the  "Company"),  is a software  services  firm that
provides high value  solutions to information  technology  ("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.  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. 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 IT 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.

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  effected on
December 18, 1996 and the 8-for-13 reverse stock split 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.



                                      F-7
<PAGE>

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


2.   Summary of Significant Accounting Policies (continued)

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 and (ii) all commissions and bonuses.

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 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.

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 and $50,000 in 1997 and
1998, respectively. Advertising costs were not material for 1996.




                                      F-8
<PAGE>

2.   Summary of Significant Accounting Policies (continued)

Stock Based Compensation

The Company has adopted the disclosure  provisions 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.

The pro  forma  basic  and  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  Statement  of  Financial
Accounting  Standards  No.  128,  Earnings  Per Share,  and the  Securities  and
Exchange Commission Staff Accounting Bulletin 98.

Reclassifications

Certain  amounts in the prior year  financial  statements  have been restated to
conform with the current year presentation.

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).


                                      F-9
<PAGE>

3.  Stockholders' Equity (continued)

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

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. These 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.

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.  During 1997, the Company  declared and paid a dividend of $1.4
million to the  stockholders  of the Company prior to the  termination  of the S
corporation  status to pay the income taxes for the 1997 taxable earnings of the
Company  allocated  to them.  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.

In May 1998,  the  Company's  Board of  Directors  approved an  amendment to the
Company's 1996 Stock Option/Stock Issuance Plan to increase the number of shares
of Common  Stock  authorized  to be  issued by  1,000,000  shares  resulting  in
2,715,000 shares available for issuance under the plan.

In September 1998, the Company's Board of Directors  authorized the repricing of
options to purchase  737,495 shares of Common Stock effective as of the close of
business on September 29, 1998 to the then fair market value of $1.94 per share.
Under the terms of the repricing,  the repriced options shall become exercisable
in four successive equal annual  installments  from the September  29,1998 grant
date.  The repriced  options have a maximum term of ten years measured from this
date of grant. The Chief Executive Officer did not participate in the repricing.

At December 31, 1998,  the Company has reserved  505,654  shares of Common Stock
for issuance in connection  with warrants  outstanding  and 2,647,000  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>
                                                                    1997                      1998
                                                             --------------------      -------------------
<S>                                                                     <C>                       <C>
Furniture and fixtures                                          $        1,192            $        1,243
Computer equipment                                                       3,480                     3,440
Computer software                                                          603                       860
Leasehold improvements                                                     379                       460
                                                             --------------------      -------------------
                                                                         5,654                     6,003

Less accumulated depreciation and amortization                           2,103                     1,998
                                                             ====================      ===================
                                                                $        3,551            $        4,005
                                                             ====================      ===================
</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 short-term investments at December 31, 1997
and 1998 are as follows (in thousands):
<TABLE>
<CAPTION>
                                     Amortized           Unrealized          Unrealized            Market
        December 31, 1997               Cost               Gains               Losses              Value
                                   ---------------    -----------------    ----------------    ---------------
<S>                                       <C>                   <C>                  <C>              <C>
Money market funds                      $   1,801             $      -             $     -          $   1,801
Government issues                          16,391                   17                  29             16,379
Corporate issues                            4,305                   20                  35              4,290
                                   ===============    =================    ================    ===============
                                        $  22,497             $     37             $    64          $  22,470
                                   ===============    =================    ================    ===============
</TABLE>
<TABLE>
<CAPTION>
                                     Amortized           Unrealized          Unrealized            Market
        December 31, 1998               Cost               Gains               Losses              Value
                                   ---------------    -----------------    ----------------    ---------------
<S>                                        <C>                    <C>                  <C>             <C>
Money market funds                      $   1,571             $      -             $     -          $   1,571
Government issues                           2,714                    -                   4              2,710
Corporate issues                           13,294                    4                  64             13,234
Commercial paper                            1,626                    -                   5              1,621
                                   ===============    =================    ================    ===============
                                        $  19,205              $     4             $    73          $  19,136
                                   ===============    =================    ================    ===============
</TABLE>
Gross gains and gross losses on the sale of investments  were not significant in
1997 and 1998.  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>   
                                                                       1997                   1998
                                                               ------------------     ------------------
<S>                                                                      <C>                     <C>
Trade payables                                                    $          532         $          460
Accrued vacation                                                             442                    320
Accrued bonuses                                                              455                    141
Payroll and other taxes payable                                              437                    124
Other accounts payable and accrued expenses                                  968                    922
                                                               ==================     ==================
                                                                  $        2,834         $        1,967
                                                               ==================     ==================
</TABLE>



                                      F-11
<PAGE>

7.   Note Payable to Bank

The  Company  has a  revolving  line of credit with a bank which was amended and
extended  until May 1, 1999 and  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 Company did not draw on the line of credit
during 1998. The line of credit contained certain restrictive  convenants which,
among other things,  required the Company to maintain a minimum net worth and to
meet  certain  financial  ratios.  At  December  31,  1998,  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%.

8.   Significant Customers

One  customer  and  two  of  its   wholly-owned   subsidiaries   accounted   for
approximately 52%, 39% and 35% of total revenue for the years ended December 31,
1996, 1997 and 1998, respectively. This customer accounted for approximately 18%
of accounts  receivable  at December 31, 1998.  Another  customer  accounted for
approximately  14% of total  revenue for the year ended  December 31,  1996.  No
other customer accounted for more than 10% of revenue in 1996, 1997 or 1998.

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 2,715,000  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, 1997 and 1998 amounting to approximately $1,538,000, $268,000 and $75,000,
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 - $2.65         $3.00 - $9.00            $10.25 - $15                 Total
                                     --------------------   ---------------------   ---------------------   ------------------------
                                                Weighted                 Weighted                Weighted                Weighted
                                       Number   Average      Number      Average       Number    Average      Number     Average
                                    of shares   Exercise    of shares    Exercise    of shares   Exercise    of shares   Excercise
                                                 Price                   Price                    Price                   Price
                                     ---------  ---------   ---------   ---------    ---------  ---------    ---------  ------------
<S>                                  <C>         <C>        <C>            <C>       <C>          <C>       <C>             <C>
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
Cancelled 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
Granted during the year (a) .......   780,745       1.96      983,082        4.77       12,800      11.15     1,776,627        3.59
Exercised during the year .........  (229,452)      0.11       (7,732)       4.98            -          -      (237,184)       0.27
Cancelled during the year (a) .....   (72,896)      1.50     (963,760)       6.40     (163,665)     12.31    (1,200,321)       6.90
                                     ----------  ---------   ---------   ----------  ----------  ----------  ----------   ----------
Balance at December 31, 1998 ......   984,969    $  1.63      729,347     $  3.98       24,936    $ 11.76     1,739,252     $  2.73
                                     ==========  ==========  ==========  ==========  ==========  ==========  ==========   ==========

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
                                     ==========  ==========  ==========  ==========  ==========  ==========  ==========   ==========

Exercisable at December 31, 1998 ..   203,536    $  0.46      149,093     $  4.55       17,994    $ 11.75       370,623     $  2.65
                                     ==========  ==========  ==========  ==========  ==========  ==========  ==========   ==========

Weighted average fair value of
    options granted during 1998 ..               $  1.96                  $  4.77                 $ 11.15                   $  3.59 
                                                 ==========              ==========              ==========               ==========
Weighted average remaining
    contractual life in years, at
    December 31, 1998 ............                  8.84                     9.09                    9.03                      8.95
                                                 ==========              ==========              ==========               ==========

(a) Amount includes 737,495 shares pertaining to options repriced in September 1998.
</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. The Company sold 53,732 and 93,747 shares of Common
Stock to employees through the Purchase Plan in 1997 and 1998, respectively.

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 and $52,000
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 and 1998,  respectively,
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 and 1998 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.
The  Company  contributed  approximately  $132,000  to  the  Plan  in  1998.  No
contributions  were made to the Plan in 1996 or 1997 by the Software Division or
PSW.


                                      F-14
<PAGE>

9.   Employee Benefit Plans  (continued)

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           
                                     -------------------------------------        1997              1998
                                        Vested at          Non-vested at         Option            Option
Assumption                             Grant Date           Grant Date           Grants            Grants
----------------                     ----------------     ----------------    --------------    -------------
<S>                                           <C>                  <C>               <C>              <C>
Risk-free interest rate                        5.93%                6.23%             6.34%            6.00%
Dividend yield                                    0%                   0%                0%               0%
Volatility factor of the expected
  market price of the Company's
  common stock                                 0.374                0.374             0.521            0.771
Average life                                 3 years              6 years           6 years          6 years
</TABLE>

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,  1997 and 1998, pro forma net income (loss) under
SFAS 123 amounted to  approximately  $658,000,  $2.7 million and ($4.7) million,
respectively and pro forma basic earnings (loss) per share and pro forma diluted
earnings  (loss) per share under SFAS 123  amounted to  approximately  $.012 and
$0.09  in  1996,  $0.36  and  $0.32 in 1997 and  ($0.52)  and  ($0.52)  in 1998,
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,
                                                                  1996                1997               1998
                                                                  ----                ----               ----
<S>                                                                <C>                 <C>                <C>
Services performed by related party:
   Recruiting services                                          $   316            $    60             $    -
   Contracted technical services                                      -                  9                 62
   Legal and accounting                                              21                 28                  -
Allocated expenses:
   Rent                                                             448                 37                  -
   Corporate and officers' salaries                                 125                  -                  -
                                                        ----------------    ---------------    ---------------
      Total expenses included in other expenses                     910                134                 62
   Interest                                                         104                  -                  -
                                                        ----------------    ---------------    ---------------
Total related party expenses                                   $  1,014           $    134            $    62
                                                        ================    ===============    ===============
</TABLE>

                                      F-15
<PAGE>

10.   Related Party Transactions (continued)

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.

11.   Commitments

The Company  leases its office  space  through  noncancellable  operating  lease
arrangements. 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>
  1999                                                   $ 1,959
  2000                                                     1,840
  2001                                                     1,790
  2002                                                     1,824
  2003                                                     1,626
  Thereafter                                                   -
                                                     ================
  Total                                                  $9,039
                                                     ================
</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 subleased  these  premises.  However,  the Company entered into an agreement
with Pencom to guarantee  Pencom's  sublease  income.  Future  minimum  sublease
rental income that the Company has guaranteed is as follows:
<TABLE>
<CAPTION>

Years ending December 31 (in thousands):
<S>                                                                <C>
  1999                                                   $          380
  2000                                                              285
                                                         ----------------
   Total                                                   $        665
                                                         ================
</TABLE>

Rent expense,  including rent allocated by Pencom,  for the years ended December
31, 1996, 1997 and 1998 was approximately  $601,000,  $1,258,000 and $1,566,000,
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  were 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.

                                      F-16
<PAGE>

12.   Income Taxes (continued)

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  provision  for  income  taxes  for the year  ended
December 31, 1996,  of $441,000 is 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. The tax benefit for income taxes of $1,060,000  attributable to December
31, 1998, is computed  using an effective tax rate of 42% which differs from the
federal statutory rate of 34% as a result of state taxes and tax-exempt income.

Significant  components  of the  provision  (benefit)  for  income  taxes are as
follows:
<TABLE>
<CAPTION>
                                                  1997              1998
                                             --------------    -------------
<S>                                                 <C>               <C> 
Current:
   Federal                                        $  1,526        $   (505)
   State                                               180             (44)
                                             --------------    -------------
      Total current                                  1,706            (549)
Deferred:
   Federal                                             442            (470)
   State                                                52             (41)
                                             --------------    -------------
      Total deferred                                   494            (511)
                                             ==============    =============
                                                  $  2,200        $ (1,060)
                                             ==============    =============
</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         Historical
                                                  1996             1997              1997            1998
                                              -------------    -------------     -------------    ------------
<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%              3.8%          (3.4%)
Permanent differences, primarily
   tax-exempt income                                     -            (3.0%)            (0.7%)         (4.8%)
Nonrecurring charge due to
   Subchapter S termination                              -                -             22.1%              -
S Corporation income not subject to
   tax                                                   -                -             (20.7%)            -
Other                                                    -                -              2.1%            0.2%
                                              =============    =============     =============    ============
Effective tax rate                                   38.0%            35.0%             40.6%         (42.0%)
                                              =============    =============     =============    ============

</TABLE>



                                      F-17
<PAGE>

12.   Income Taxes (continued)

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               1998
                                                  ------------     ---------------
<S>                                                    <C>                <C>
Deferred tax assets:
   Allowances and reserves                         $    183           $    122
   Accrued expenses                                     246                278
   Stock option compensation expense                    575                286
                                                  ------------     ---------------
Total deferred tax assets                             1,004                686
Deferred tax liabilities:
   Fixed assets                                         (84)              (263)
   Cash to accrual adjustment                        (1,151)                 -
   Prepaid expenses and other                          (262)              (405)
                                                  ------------     ---------------
Total deferred tax liabilities                       (1,497)              (668)
                                                  ------------     ===============
Net deferred tax liabilities                        $  (493)          $     18
                                                  ============     ===============

</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.

13.   Special Compensation Expense

As  described  in Notes 9 and 10,  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 and
$75,000  was  recognized  for the  years  ended  December  31,  1997  and  1998,
respectively.  These transactions reduced income from operations, net income and
diluted  earnings per share for the years ended December 31, 1996, 1997 and 1998
as follows (in thousands, except per share data):

<TABLE>
<CAPTION>

                                                    1996(a)              1997(a)                1998
                                                ----------------     ----------------    -------------------
<S>                                                  <C>                   <C>                   <C>
Operating income                                    $   2,193            $    268              $    75
Net income                                              1,360                 169                   43
Diluted earnings per share                               0.19                0.02                 0.01
</TABLE>

(a)  Net income and  earnings  per share  amounts are  presented  on a pro forma
     basis as if the Company had been subject to federal and state income taxes.
     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 the  provisions  of SFAS  128 and SAB 98  resulted  in an
     increase  to pro  forma  diluted  earnings  per  share for 1996 of $.01 per
     share.

Deferred  compensation as of December 31, 1998 of approximately  $44,000 will be
amortized over the remaining vesting periods in 1999 and 2000.



                                      F-18
<PAGE>

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>
                                                         1996(a)             1997(a)               1998
                                                    ----------------    ----------------    -----------------
<S>                                                         <C>                 <C>                 <C>
Numerator:
  Net income (loss)                                        $    720           $   3,518            $  (1,462)
                                                    ================    ================    =================

Denominator:
  Shares used in basic earnings (loss)
    per share calculation                                     5,538               7,384                9,113

  Effect of dilutive securities:
    Employee stock options                                      646                 627                    -
    Warrants                                                    505                 506                    -
                                                    ----------------    ----------------    -----------------
  Shares used in diluted earnings (loss)
    per share calculation                                     6,689               8,517                9,113
                                                    ================    ================    =================

Basic earnings (loss) per share                           $    0.13           $    0.48            $   (0.16)
                                                    ================    ================    =================

Diluted earnings (loss) per share                         $    0.11           $    0.41            $   (0.16)
                                                    ================    ================    =================
</TABLE>



(a)  Net income and  earnings  per share  amounts are  presented  on a pro forma
     basis as if the Company had been subject to federal and state income taxes.
     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 the provisions of SFAS 128 and SAB 98 resulted
     in an increase to pro forma diluted earnings per share for 1996 of $.01 per
     share.

Options to purchase 1.74 million  shares of Common Stock at an average  exercise
price of $2.73 per share were  outstanding  at December 31,  1998,  but were not
included in the computation of diluted net loss per share as its effect would be
anti-dilutive.




                                      F-19
<PAGE>

15.   Comprehensive Income

As of January 1, 1998, the Company adopted SFAS No. 130, Reporting Comprehensive
Income.  SFAS No. 130  establishes  new rules for the  reporting  and display of
comprehensive income and its components; however, the adoption of this Statement
had no impact on the Company's net income or stockholders'  equity. SFAS No. 130
requires  unrealized  gains  or  losses  on  the  Company's   available-for-sale
securities,  which prior to adoption were reported  separately in  shareholders'
equity,  to be  included in other  comprehensive  income.  Prior year  financial
statements  have been  reclassified  to conform to the  requirements of SFAS No.
130.

The components of  comprehensive  income for the years ended 1996, 1997 and 1998
are as follows:
<TABLE>
<CAPTION>
                                                       1996(a)              1997(a)                1998
                                                   ---------------      ---------------      ---------------
<S>                                                          <C>                <C>                 <C>
Net income (loss)                                           $ 720              $ 3,518            $ (1,462)

Unrealized gain (loss) on short-term
 investments                                                    -                  (41)                (74)
Income tax (expense) benefit related to items
  of other comprehensive income                                 -                   14                  32

                                                   ---------------      ---------------       ---------------
 
Comprehensive income (loss)                                 $ 720              $ 3,491            $ (1,504)
                                                   ===============      ===============       ===============
</TABLE>
(a)  Net income and  comprehensive  income  amounts are presented on a
     pro forma basis as if the Company had been subject to federal and
     state income taxes.

The components of accumulated  other  comprehensive  income at December 31, 1997
and 1998 are as follows:

<TABLE>
<CAPTION>
                                                                              1997                 1998
                                                                        ---------------      ---------------
<S>                                                                               <C>                  <C>
Unrealized loss on short-term investments                                      $  (27)             $   (69)
                                                                        ===============      ===============
</TABLE>

16.       Litigation

The Company is involved in legal  proceedings,  claims and litigation arising in
the ordinary  course of business.  In the opinion of management,  the outcome of
such current  legal  proceedings,  claims and  litigation  could have a material
effect on quarterly or annual operating results or cash flows when resolved in a
future period.  However,  in the opinion of  management,  these matters will not
materially affect the Company's financial position.



                                      F-20
<PAGE>

17.       Quarterly Information (Unaudited)

Summarized quarterly financial information for 1996, 1997 and 1998 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 (a)                            $   .06          $    .06            $      -         $    (.02)
  Shares used in diluted earnings
    per share calculation  (a)                 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 (a)                           $    .09         $     .10          $      .11         $     .11
  Shares used in diluted earnings
    per share calculation  (a)                 6,740             7,290               9,973            10,063

1998
  Total revenues                           $   9,758         $   9,867          $    9,255         $  10,221
  Operating loss                                (564)             (433)             (2,415)              (56)
  Net income (loss)                             (212)             (210)             (1,130)               90
  Diluted earnings (loss)
    per share                              $   (0.02)        $   (0.02)         $    (0.12)        $    0.01
  Shares used in diluted earnings
    (loss) per share calculation               8,990             9,057               9,146            10,053

</TABLE>

(a)      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 the  provisions  of SFAS 128 and SAB 98
         resulted  in an increase to pro forma  diluted  earnings  per share for
         1996 of $.01 per share.


                                      F-21
<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.

3.  Exhibits
<TABLE>
<CAPTION>
    
Number   Description  
<S>      <C>
  **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  1996 Stock Option/Stock  Issuance Plan.  
**10.17  Employee Stock Purchase Plan.  
**10.18  PSW Profit Sharing Plan. 
**10.19  Description of Executive Bonus Plan. 
**10.20  Stock Purchase Agreement dated as of January 1, 1997 between Michael J. Maples and the Registrant.  
**10.21  Stock  Subscription  dated  October 1, 1996 between  Pencom Systems  Incorporated and the Registrant.  
**10.22  Asset Contribution  Agreement dated October 1, 1996 between Pencom Systems  Incorporated  and the  Registrant.

</TABLE>


                                     
<PAGE>
<TABLE>
<CAPTION>
<S>     <C>    
**10.23  Assignment and Assumption  Agreement  dated October 1, 1996 between the Registrant and Pencom  Systems  Incorporated.  
**10.24  Warrant dated October 1, 1996 issued by the Registrant to Pencom Systems  Incorporated.  
**10.25  Warrant dated  October 1, 1996  issued by the  Registrant  to Stephen  Markman.  
**10.26  Warrant  dated  October 1, 1996 issued by the  Registrant  to Thomas  Pallister.
**10.27  Warrant dated October 1, 1996 issued by the  Registrant to Joy Venegas.
(1)10.28 Mountainview Lease Agreement dated May 11, 1998 between the Registrant and South  Bay/Copley Joint Venture  
(1)10.29 1996 Stock  Option/Stock  Issuance Plan Amendment 
(2)10.30 Employment  Agreement dated August 28, 1998 between the Registrant  and  Timothy D. Webb.  
   10.31 Employment Agreement dated January 18, 1999 between the Registrant and Pedro A. Fernandez.
   10.32 Employment Agreement dated January 25, 1999 between the Registrant and John M. Velasquez.
   23.1  Consent  of Ernst & Young  L.L.P.  
   27.1  Financial  Data Schedule  

--------- 

**   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. 
(1)  Incorporated  herein by reference to the exhibits to the Company's Report on Form 10-Q for the three-month period
     ended June 30, 1998.  
(2)  Incorporated  herein by reference to the exhibits to the Company's Report on Form 10-Q for the three-month period 
     ended September 30, 1998. 

   Reports on Form 8-K:  
   During the quarter ended December 31, 1998, no current reports on Form 8-K were filed.
</TABLE>

<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.
<TABLE>
<CAPTION>
<S>                                 <C>
                                     PSW TECHNOLOGIES, INC.

March 31, 1999                            By: /s/ Timothy D. Webb____________________
Date                                      Timothy D. Webb, President, Chief Executive Officer 
                                          and Director (Principal Executive Officer)


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

March 31, 1999                       By: /s/ Keith D. Thatcher__________________
Date                                     Keith D. Thatcher, Chief Financial Officer     
                                         (Principal Financial Officer)

March 31, 1999                       By: /s/ Kasaundra L. Smith_________________
Date                                     Kasaundra L. Smith, Financial Reporting Manager 
                                         (Principal Accounting Officer)

March 31, 1999                       By: /s/ Wade E. Saadi______________________
Date                                     Wade E. Saadi, Chairman of the Board of Directors

March 31, 1999                       By: /s/ Edward C. Ateyeh, Jr.______________
Date                                     Edward C. Ateyeh, Jr., Director

March 31, 1999                       By: /s/ W. Frank King______________________
Date                                     Dr. W. Frank King, Director

March 31, 1999                       By: /s/ Thomas A. Herring__________________
Date                                     Thomas A. Herring, Director


March 31, 1999                       By: /s/ Kevin B. Kurtzman__________________
Date                                     Kevin B. Kurtzman, Director

March 31, 1999                       By: /s/ Michael J. Maples__________________
Date                                     Michael J. Maples, Director

March 31, 1999                       By: /s/ Jonathan D. Wallace________________
Date                                     Jonathan D. Wallace, Esq., Director

</TABLE>