<PAGE>


                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q



(Mark One)

[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

                     For the quarterly period ended September 30, 2001

                                       or

[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934

                          COMMISSION FILE NUMBER 29947

                      INTEGRATED INFORMATION SYSTEMS, INC.
             (Exact name of registrant as specified in its charter)

         DELAWARE                                             86-0624332
  (State of Incorporation)                               (IRS Employer I.D. No.)

                            1480 SOUTH HOHOKAM DRIVE
                              TEMPE, ARIZONA 85281
                    (Address of principal executive offices)

                                 (480) 317-8000
                         (Registrant's telephone number)

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 the number of shares outstanding of each of the issuer's classes of
common stock, not including shares held in treasury:

As of November 8, 2001, there were 16,057,750 shares of common stock, $0.001 par
value, outstanding.


<PAGE>


               INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>

                                                                                          PAGE
<S>                                                                                       <C>
PART I        FINANCIAL INFORMATION  .....................................................    3

      ITEM 1    FINANCIAL STATEMENTS  ....................................................    3

                Condensed Consolidated Balance Sheets as of September 30, 2001 and
                December 31, 2000 ........................................................    3
`
                Condensed Consolidated Statements of Operations for Three and Nine
                Months Ended September 30, 2001 and 2000 .................................    4

                Condensed Consolidated Statements of Cash Flows for Nine
                Months Ended September 30, 2001 and 2000 .................................    5

                Notes to Condensed Consolidated Financial Statements  ....................    6

      ITEM 2    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
                CONDITION AND RESULTS OF OPERATIONS ......................................    7

      ITEM 3    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
                MARKET RISK ..............................................................   11

PART II      OTHER INFORMATION ...........................................................   19

      ITEM 1    LEGAL PROCEEDINGS ........................................................   19

      ITEM 2   CHANGES IN SECURITIES AND USE OF PROCEEDS .................................   19

      ITEM 6   EXHIBITS AND REPORTS ON FORM 8-K  .........................................   20

SIGNATURES ...............................................................................   20

SIGNATURE PAGE ...........................................................................   20

</TABLE>


<PAGE>


PART I.          FINANCIAL INFORMATION

ITEM 1.          FINANCIAL STATEMENTS


               INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY

                      CONDENSED CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>

                                                                                 SEPTEMBER 30,     DECEMBER 31,
                                                                                     2001              2000
                                                                                     ----              ----
                                                                                  (UNAUDITED)
<S>                                                                               <C>                <C>
ASSETS
Current assets:
   Cash and cash equivalents                                                        $13,851          $46,541
   Restricted cash                                                                    2,117               --
   Accounts receivable, net of allowance of $6,822 and $6,794, respectively           3,806            6,572
   Income tax receivable                                                                 --              111
   Unbilled revenues on contracts                                                       323              472
   Prepaid expenses and other current assets                                            668            3,109
                                                                                        ---            -----

           Total current assets                                                      20,765           56,805
Property and equipment, net                                                          12,264           23,647
Goodwill                                                                                981               --
Other assets                                                                          1,441              872
                                                                                      -----              ---

                                                                                   $ 35,451          $81,324
                                                                                   ========          =======

LIABILITIES, CONVERTIBLE PREFERRED
STOCK AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable and accrued expenses                                            $ 5,956           $6,494
   Current installments of capital lease obligations                                  3,793            4,322
   Deferred revenues on contracts                                                       260              449
                                                                                    -------           ------
           Total current liabilities                                                 10,009           11,265
Capital lease obligations, less current installments                                  1,305            3,909
                                                                                    -------           ------

           Total liabilities                                                         11,314           15,174
Series A Convertible Preferred Stock, $.001 par value;
   5,000,000 shares authorized; zero shares issued
   and outstanding at September 30, 2001 and December 31, 2000                           --               --
Series B Convertible Preferred Stock, $.001 par value;
   5,000,000 shares authorized; zero shares issued
   and outstanding at September 30, 2001 and December 31, 2000                           --               --
Series C Convertible Preferred Stock, $.001 par value
   5,000,000 shares authorized; zero shares issued
   and outstanding at September 30, 2001 and December 31, 2000                           --               --
Stockholders' equity:
   Common stock, $.001 par value, authorized 100,000,000
     shares, issued and outstanding 16,106,050 and
     20,683,922 shares at September 30, 2001
     and December 31, 2000, respectively                                                 16               21
   Additional paid-in capital                                                        93,773           93,613
   Accumulated deficit                                                              (64,384)         (27,441)
   Accumulated other comprehensive loss:
         Foreign currency translation                                                   (58)             (43)
                                                                                    -------           ------

                                                                                     29,347           66,150
   Treasury stock, at cost, 4,851,800 shares at September 30, 2001                   (5,210)              --
                                                                                    -------           ------

           Total stockholders' equity                                                24,137           66,150
                                                                                    -------           ------

                                                                                   $ 35,451          $81,324
                                                                                   ========          =======
</TABLE>


See accompanying notes to condensed consolidated financial statements.



                                       3

<PAGE>


               INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY

                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)

<TABLE>
<CAPTION>

                                                        THREE MONTHS ENDED         NINE MONTHS ENDED
                                                           SEPTEMBER 30,              SEPTEMBER 30,
                                                         2001        2000           2001        2000
                                                         ----        ----           ----        ----
<S>                                                     <C>        <C>             <C>         <C>
 Revenues .........................................     $6,172     $17,336        $25,264     $43,171
 Cost of revenues .................................      5,814      10,362         23,774      24,659
 Other charges. ...................................         47          --         11,353          --
                                                         -----      ------         ------      ------
           Gross profit (loss). ...................        311       6,974         (9,863)     18,512
 Operating expenses:
   Selling and marketing. .........................      1,408       1,828          4,343       6,783
   General and administrative .....................      7,881       9,571         23,538      22,615
                                                         -----      ------         ------      ------
           Total operating expenses ...............      9,289      11,399         27,881      29,398
                                                         -----      ------         ------      ------

 Loss from operations .............................     (8,978)     (4,425)       (37,744)    (10,886)
 Interest income, net .............................        207         738            801       1,715
                                                         -----      ------         ------      ------

 Loss before income taxes .........................     (8,771)     (3,687)       (36,943)     (9,171)
 Provision for income taxes .......................         --          --             --          --
                                                         -----      ------         ------      ------

       Net loss ...................................   $ (8,771)   $ (3,687)     $ (36,943)   $ (9,171)
                                                      ========    ========      =========    ========

 Loss per share:
    Basic and diluted .............................     $(0.52)     $(0.18)        $(1.96)     $(0.49)
                                                        ======      ======         ======      ======

 Weighted average number of common shares
   outstanding ....................................     16,888      20,474         18,824      18,881
                                                        ======      ======         ======      ======
</TABLE>

See accompanying notes to condensed consolidated financial statements.

                                       4

<PAGE>


               INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY

                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>

                                                                                    NINE MONTHS ENDED
                                                                                       SEPTEMBER 30
                                                                                    2001          2000
                                                                                    ----          ----
                                                                                        (UNAUDITED)
<S>                                                                                 <C>           <C>

   Cash flows from operating activities:
     Net loss ..................................................................  $ (36,943)   $ (9,171)
     Adjustments to reconcile net loss to net cash
        used in operating activities:
        Depreciation and amortization ..........................................      6,399       4,549
        Other charges ..........................................................     11,353          --
        Net change in allowance for doubtful accounts ..........................         28       3,220
        Increase (decrease) in cash resulting from changes in:
          Accounts receivable ..................................................      2,903     (12,926)
          Income tax receivable ................................................        111         539
          Unbilled revenues on contracts  ......................................        353        (112)
          Prepaid expenses and other current assets ............................        197        (841)
          Other assets  ........................................................       (420)     (3,700)
          Accounts payable and accrued expenses ................................       (635)      2,820
          Deferred revenues on contracts  ......................................       (247)        (92)
                                                                                       -----        ----

             Net cash used in operating activities  ............................    (16,901)    (15,714)
                                                                                    --------    --------

   Cash flows from investing activities:
     Capital expenditures ......................................................     (2,870)    (15,328)
     Acquisitions ..............................................................     (2,442)         --
                                                                                    --------    -------

             Net cash used in investing activities  ............................     (5,312)    (15,328)

   Cash flows from financing activities:
     Restricted cash  ..........................................................     (2,117)         --
     Net repayments on lines of credit  ........................................         --      (1,015)
     Long-term debt repayments  ................................................         --        (885)
     Repayment of capital lease obligations ....................................     (3,290)     (1,940)
     Proceeds of initial public offering, net of expenses ......................         --      67,516
     Issuance of Series C Convertible Preferred Stock, net of expenses .........         --      19,411
     Issuance of common stock and exercise of stock options ....................        160         409
     Repurchase of common stock ................................................     (5,215)         --
                                                                                    --------    -------

             Net cash provided by (used in) financing activities  ..............    (10,462)     83,496
                                                                                    --------    -------

   Effect of exchange rate on cash  ............................................        (15)        (30)
                                                                                    --------    -------

   Increase (decrease) in cash and cash equivalents ............................    (32,690)     52,424
   Cash and cash equivalents, at beginning of period  ..........................     46,541         863
                                                                                    --------    -------

     Cash and cash equivalents, at end of period  ..............................   $ 13,851     $53,287
                                                                                   ========     =======

   Acquisition of property and equipment and assumption of
      capital lease obligations ................................................       $150      $9,748
                                                                                       ----      ------

</TABLE>


See accompanying notes to condensed consolidated financial statements.



                                       5

<PAGE>


               INTEGRATED INFORMATION SYSTEMS, INC. AND SUBSIDIARY
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been
prepared by Integrated Information Systems, Inc. (the "Company") pursuant to the
rules and regulations of the Securities and Exchange Commission regarding
interim financial reporting. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements and should be read in conjunction with the
consolidated financial statements and notes thereto included in the Company's
Annual Report on Form 10-K for the year ended December 31, 2000. The
accompanying condensed consolidated financial statements reflect all adjustments
(consisting solely of normal, recurring adjustments), which are, in the opinion
of management, necessary for a fair presentation of results for the interim
periods presented. The results of operations for the three-, six-, and
nine-month periods ended September 30, 2001 are not necessarily indicative of
the results to be expected for any future period or the full fiscal year.

2. Use of Estimates

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

3. Revenue Recognition

The Company recognizes revenue when each of the following four criteria are met:
    . Persuasive evidence of an arrangement exists;
    . Delivery has occurred or services have been rendered;
    . The seller's price to the buyer is fixed or determinable; and
    . Collectibility is reasonably assured.

Revenues for time-and-material contracts are recognized as the services are
rendered. Revenues pursuant to fixed fee contracts are recognized as services
are rendered on the percentage-of-completion method of accounting (based on the
ratio of labor hours incurred to total estimated labor hours). Revenues from
maintenance or post-contract support agreements are recognized as earned over
the terms of the agreements. Revenues from recurring services such as
application management and hosting operations are recognized as services are
provided each month. Revenues for services rendered are not recognized until
collectibility is reasonably assured.

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. Unbilled revenues on contracts are comprised of earnings on
certain contracts in excess of contractual billings on such contracts. Billings
in excess of earnings are classified as deferred revenues on contracts.

4. Restricted Cash

In March and May 2001, the Company deposited $1,806,000 into a construction
escrow account. The funds in this account are being used to fund the build-out
of tenant improvements at the Company's new 71,000 square foot facility in
Tempe, Arizona. Through September 30, 2001, $689,000 of the restricted cash was
used toward these tenant improvements.

In June 2001, the Company deposited $1,000,000 into a restricted certificate of
deposit account. The funds in this account serve as collateral against various
letters of credit totaling $1,000,000.

5. Repurchase of Common Stock

During the nine months ended September 30, 2001, the Company repurchased
4,851,800 shares of its Common Stock at a cost of approximately $5.2 million.
These shares are reflected as treasury stock in the accompanying financial
statements.

6. Other Charges

During the second quarter of 2001, the Company recorded an impairment charge of
approximately $11.3 million related to certain underutilized data center
facility computer equipment and leasehold improvements of $9.1 million, and
related inventoried software licenses of $2.2 million. During the second quarter
of 2001, management determined that the future revenues to be generated from the
Company's application outsourcing services would not be sufficient to recover
the cost of the assets utilized in such operations,



                                       6

<PAGE>


and, accordingly, performed an analysis for impairment under the guidance of
FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of.

Based on this analysis, management determined that the fair market values of the
computer equipment and leasehold improvements related to the data center were
less than the net book value of these assets and, therefore, recorded an asset
impairment charge of $9.1 million to reduce the book value of the assets to
their estimated fair market value, which was determined to be zero.
Additionally, management determined during the second quarter of 2001 that the
software licenses to be utilized to serve certain application outsourcing
services customers also had a fair value less than their book value and,
therefore, recorded a charge of $2.2 million to write the licenses down to their
estimated fair value, which was determined to be zero.

These assets and software licenses are utilized solely for the purpose of
generating application outsourcing revenues; therefore, the charges have been
recorded as costs of revenues.

7. Acquisitions

On August 29, 2001, we completed a series of transactions with K2 Digital, Inc.,
a publicly held digital services firm based in New York City. In that
transaction, we hired approximately 24 management and consulting employees of
K2, acquired certain related fixed assets, and assumed certain of the leased
office space of K2 in New York City. The total purchase price consisted of cash
payments of $561,000 for certain K2 assets, $156,000 for the assumption of
liabilities, and $282,000 for the payment of payroll and certain operating
expenses for K2 prior to the acquisition date. In the preliminary purchase price
allocation, $480,000 was recorded as goodwill.

On September 28, 2001, we completed a similar series of transactions with STEP
Technology, Inc., a Portland, Oregon-based information technology consulting
firm. In that transaction, we hired approximately 54 management and consulting
personnel of STEP, acquired certain related assets, and assumed a portion of
STEP's office space in Portland. The total purchase price consisted of cash
payments of $1,126,000 for certain STEP assets and $513,000 for the payment of
payroll and certain operating expenses for STEP. In the preliminary purchase
price allocation, $385,000 was recorded as goodwill. In addition to the cash
consideration, under the purchase agreement, if in 2002, 2003, and 2004 annual
earnings from STEP operations are positive, STEP is entitled to three percent of
the revenues generated by customers acquired or employees hired in this
transaction.

The following summary, prepared on a proforma basis, presents the results of
operations as if the acquisition of K2 and STEP had been completed as of
January 1, 2000 (unaudited).

                                       Nine months ended       Nine months ended
                                      September 30, 2001      September 30, 2000
                                      ------------------      ------------------

        Revenues                        $  34,053                  $  56,335
        Loss from operations              (43,515)                   (14,190)
        Net loss                          (42,641)                   (10,702)

The proforma results are not necessarily indicative of what actually would have
occurred if the transactions had been completed as of January 1, 2000. In
addition, they are not intended to be a projection of future results and do
not reflect any synergies that might be achieved from combined operations.

8. Net Loss Per Share

The following table sets forth the computation of shares used in computing basic
and diluted net loss per share (in thousands, except per share amounts):


<TABLE>
<CAPTION>

                                                       THREE MONTHS ENDED                NINE MONTHS ENDED
                                                          SEPTEMBER 30,                     SEPTEMBER 30,
                                                       2001           2000              2001             2000
                                                       ----           ----              ----             ----
                                                           (UNAUDITED)                       (UNAUDITED)
<S>                                                  <C>            <C>                <C>             <C>
  Net loss  ......................................  $  (8,771)     $ (3,687)         $ (36,943)       $ (9,171)
                                                    ==========     =========         ==========       =========

  Weighted average outstanding common shares  ....     16,888        20,474             18,824          18,881
  Effect of dilutive securities:
       Stock options and warrants ................        132         1,461                162           1,713
       Antidilutive effect of securities  ........       (132)       (1,461)              (162)         (1,713)
                                                       -------       -------            -------         -------

  Weighted average common equivalent shares
    outstanding ..................................     16,888        20,474             18,824          18,881
                                                       ======        ======            ========         =======

   Loss per share:
       Basic and diluted  ........................     $(0.52)       $(0.18)           $ (1.96)         $(0.49)
                                                       =======       =======           ========         =======
</TABLE>


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

OVERVIEW

Since our inception in 1989, Integrated Information Systems has been a leader in
applying emerging technologies by building and operating integrated information
systems for clients. IIS offers cost-conscious, productive, profit-minded
solutions across the entire service continuum with single provider
accountability.


                                       7

<PAGE>


We derive our revenues primarily from the delivery of professional services. We
offer our services to clients under time and materials contracts or under fixed
fee contracts. For time and material projects, we recognize revenues based on
the number of hours worked by consultants at a rate per hour agreed upon with
our clients. We recognize revenues from fixed-price contracts on a
percentage-of-completion method based on project hours worked. The percentage of
our revenues from fixed fee contracts was approximately 11% in the first nine
months of 2001 and 5% in 2000. We provide our application outsourcing services
at a minimum monthly fee and charge extra fees for services that exceed
agreed-upon parameters. Revenues from these services are recognized as services
are provided. Revenues for services rendered are not recognized until
collectibility is reasonably assured.

Our cost of revenues consists primarily of employee compensation and benefits
and depreciation of hosting facility property and equipment. Sales and marketing
expenses consist primarily of compensation and benefits, and the costs of
marketing programs. General and administrative expenses consist primarily of
compensation and benefits for our executive management and our finance,
administration, information technology, and human resources personnel. General
and administrative expenses also include research and development expense,
depreciation, bad debt expense and operating expenses such as rent, insurance,
telephones, office supplies, travel, outside professional services, training,
and facilities costs.

We have historically derived and believe that we will continue to derive a
significant portion of our revenues from a limited number of clients who may
change from year to year. Any cancellation, deferral, or significant reduction
in work performed for our principal clients could harm our business and cause
our operating results to fluctuate significantly from period to period. As a
result of our investments in infrastructure and increase in operating expenses
in 1999 and 2000, we incurred a net loss in 2000 and during the first nine
months of 2001. Our quarterly revenue, cost of revenues, and operating results
have varied in the past due to fluctuations in the utilization of project
personnel and are likely to vary significantly in the future. Therefore, we
believe that period-to-period comparisons of our operating results may not
necessarily be meaningful and should not be relied upon as indications of future
performance.

On August 29, 2001, we completed a series of transactions with K2 Digital, Inc.,
a publicly held digital services firm based in New York City. In that
transaction, we hired approximately 24 management and consulting employees of
K2, acquired certain related fixed assets, and assumed certain of the leased
office space of K2 in New York City. The transactions were paid for with cash
and the assumption of certain operating expenses of K2 (See Note 7).

On September 28, 2001, we completed a similar series of transactions with STEP
Technology, Inc., a Portland, Oregon-based information technology consulting
firm. In that transaction, we hired approximately 54 management and consulting
personnel of STEP, acquired certain related assets, and assumed a portion of
STEP's office space in Portland. The transaction was paid for with cash and the
assumption of certain operating expenses of STEP (See Note 7).

In connection with the K2 and STEP transactions, the company incurred $116,000
in acquisition costs which were recorded in goodwill as a component of the
purchase price.

In a subsequent event, on October 31, 2001, we completed another series of
transactions with INTEFLUX, Inc., a Phoenix, Arizona-based information
technology consultancy with international operations in London, England. In that
transaction, we hired approximately 19 management and consulting personnel of
INTEFLUX, acquired certain related assets, and assumed the leased office space
of INTEFLUX in Phoenix and in London. The transaction was paid for with a
combination of cash and restricted shares of our common stock, as well as the
assumption of certain operating expenses of INTEFLUX.

RESULTS OF OPERATIONS

REVENUES. Revenues decreased 64% to $6.2 million for the three months ended
September 30, 2001, compared to $17.3 million in the same period of 2000. For
the first nine months of 2001, revenues decreased 41% to $25.3 million compared
to $43.2 million in the same period of 2000. Revenues from our largest customer
decreased to $1.2 million and $5.9 million for the three- and nine-month periods
ended September 30, 2001, compared to $3.8 million and $8.9 million for the same
periods of 2000. Declines in billed hours and new engagements resulted in
decreases of approximately $6.9 million and $12.0 million in revenues for the
three- and nine-month periods ended September 30, 2001, compared to the same
periods in 2000. Declines in average hourly bill rates resulted in decreases of
approximately $4.3 million and $5.9 in revenues for the three- and nine-month
periods ended September 30, 2001, compared to the same periods of 2000. We
believe that these declines in revenue reflect general weakening in our industry
sector, which we expect to continue into 2002. During the first nine months of
2001, we did not record $2.1 million of revenue in connection with services
provided to customers where collection was not deemed probable.

COST OF REVENUES. Cost of revenues decreased 43% to $5.9 million for the three
months ended September 30, 2001, compared to $10.4 million for the same period
of 2000. For the first nine months of 2001, cost of revenues increased 42% to
$35.1 million compared to $24.7 million for the same period of 2000. As a
percentage of revenue, cost of revenues were 95% and 139% in the three months
and nine months ended September 30, 2001, compared to 60% and 57% for the same
periods in 2000. These increases were due primarily to decreases in revenues and
a non-cash charge of approximately $11.3 million recorded in



                                       8

<PAGE>


the three-month period ended June 30, 2001. Approximately $9.1 million of this
impairment charge was related to underutilized data center facility computer
equipment and leasehold improvements, and approximately $2.2 million of this
impairment charge was related to inventoried software licenses.

For additional information, see Note 6 of our Financial Statements found in this
Quarterly Report on Form 10-Q.

SELLING AND MARKETING EXPENSES. Selling and marketing expenses decreased 23% to
$1.4 million for the three months ended September 30, 2001, compared to $1.8
million for the same period of 2000. For the first nine months of 2001, selling
and marketing expenses decreased 36% to $4.3 million, compared to $6.8 million
for the same period of 2000. The decreases are due primarily to reductions of
dedicated sales and marketing personnel and decreases in spending for
advertising and promotion for the first nine months of 2001, compared to the
same period of 2000. As a percentage of revenues, selling and marketing expenses
increased to 23% and 17% for the three- and nine-month periods ended September
30, 2001, from 11% and 16% for the same periods of 2000, primarily as a result
of the decrease in revenues.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased 18% to $7.9 million for the three months ended September 30, 2001,
compared to $9.6 million for the same period of 2000. During the first nine
months of 2001, general and administrative expenses increased 4% to $23.5
million, compared to $22.6 million for the same period of 2000. The decrease for
the three-month period ended September 30, 2001, was primarily attributable to
reductions in general and administrative personnel offset by facility rent
expense and legal claim accruals. The increase for the nine-month period ended
September 30, 2001, was attributable to approximately $1.4 million additional
facility rent expense due to regional office expansion that occurred in the
second quarter of 2000, approximately $900,000 of additional depreciation
expense, and approximately $1.2 million to additional compensation and benefits
paid to administrative personnel. These increases were offset by a reduction of
approximately $600,000 of bad debt expense. The balance of the increase was
related to increases in other expenses such as telecommunications costs,
professional services, legal accruals and office administration. As a percentage
of revenues, general and administrative expenses increased to 128% and 93% for
the three- and nine-month periods ended September 30, 2001, from 55% and 52% for
the same periods of 2000, due primarily to decreases in revenues in 2001.

INTEREST INCOME, NET. Interest income, net of interest expenses, decreased to
$207,000 for the three months ended September 30, 2001, compared to $738,000 for
the same period of 2000. During the first nine months of 2001, interest income,
net of interest expenses, decreased to $801,000, compared to $1.7 million for
the same period of 2000. The decreases are due primarily to the use of invested
proceeds from both our preferred stock financing in January 2000 and our initial
public offering in March and April 2000 during the first nine months of 2001.

LIQUIDITY AND CAPITAL RESOURCES

Since inception, we have funded our operations and investments in property and
equipment through cash generated from operations, capital lease financing
arrangements, bank borrowings, and equity financings. In January 2000, we raised
$20.2 million, before expenses of $800,000, through a private placement of
Series C preferred stock to institutional and other accredited investors. In
March and April 2000, we raised an additional $67.5 million (net of underwriting
discounts and other offering expenses) through our initial public offering of
4,945,000 shares of our common stock.

At September 30, 2001, we had approximately $13.9 million in cash and cash
equivalents and $10.8 million in working capital, as compared to $53.3 million
and $58.5 million at September 30, 2000, and $46.5 million and $45.5 million at
December 31, 2000.

For the nine months ended September 30, 2001 and 2000, net cash used in
operating activities was $16.9 million and $15.7 million, respectively. Cash
used in operating activities in each of these periods was the result of net
losses, adjusted for non-cash items primarily related to depreciation,
amortization and asset impairment, and fluctuations in accounts receivable,
prepaid expenses and other current assets, and accounts payable and accrued
expenses.

For the nine months ended September 30, 2001 and 2000, net cash used in
investing activities was $5.3 million and $15.3 million, respectively. Cash used
in investing activities in each period consisted primarily of purchases of
computer equipment, furniture and leasehold improvements, and, in the quarter
ending September 30, 2001, for our acquisitions of assets of other companies.
During 2000 we invested approximately $7 million, net of leased furniture and
equipment, in our application outsourcing services data center (See Note 6). We
anticipate additional capital expenditures of approximately $500,000 in the
fourth quarter of 2001 related to tenant improvements and acquisitions.

For the nine months ended September 30, 2001, net cash used in financing
activities was $10.5 million, compared to net cash provided by financing
activities of $83.5 million for the nine months ended September 30, 2000. During
the first nine months of



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2001, we repurchased 4,851,800 shares of our common stock for approximately $5.2
million. Our net repayments of capital lease obligations totaled approximately
$3.3 million for the same period. We also allocated $2.8 million to restricted
cash and used $689,000 during the first nine months of 2001. Cash provided by
financing activities in 2000 related to the sale of our preferred stock in a
private placement and our common stock in our initial public offering, partially
offset by debt repayment.

Non-cash investing and financing activities for the nine-month periods ended
September 30, 2001 and 2000 consisted of new capital lease obligations for
property and equipment of approximately $150,000 and $9.7 million, respectively.

As of September 30, 2001, we had a master lease agreement to finance up to $3.0
million of computer equipment with Imperial Bank. The master lease agreement has
an implied interest rate of approximately 10.5%. As of September 30, 2001,
approximately $1.4 million was outstanding under this master lease agreement.
The master lease agreement expires on various dates through June 2002. In June
2001, the Company deposited $1,000,000 into a restricted certificate of deposit
account. The funds in this account serve as collateral against various letters
of credit totaling $1,000,000.

We believe that current cash balances will be sufficient to meet our working
capital and capital expenditure requirements for the remainder of 2001. We
anticipate that we will need additional financing to fund our cash requirements
beyond 2001. In this regard, we expect to continue to invest in our business in
an effort to grow revenues, including through acquisitions. Additional needed
financing may not be available on terms favorable to us, if at all. If we are
unable to raise additional capital and significantly reduce operating losses,
our business activities may be significantly curtailed.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2001, the FASB issued Statement No. 141, Business Combinations, and
Statement No. 142, Goodwill and Other Intangible Assets. Statement 141 requires
that the purchase method of accounting be used for all business combinations
initiated after June 30, 2001 as well as all purchase method business
combinations completed after June 30, 2001. Statement 141 also specifies
criteria intangible assets acquired in a purchase method business combination
must meet to be recognized and reported apart from goodwill, noting that any
purchase price allocable to an assembled workforce may not be accounted for
separately. Statement 142 will require that goodwill and intangible assets with
indefinite useful lives no longer be amortized, but instead tested for
impairment at least annually in accordance with the provisions of Statement 142.
Statement 142 will also require that intangible assets with definite useful
lives be amortized over their respective estimated useful lives to their
estimated residual values, and reviewed for impairment in accordance with SFAS
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of.

The Company is required to adopt the provisions of Statement 141 as of July 1,
2001, and Statement 142 effective January 1, 2002. Furthermore, any goodwill and
any intangible asset determined to have an indefinite useful life that are
acquired in a purchase business combination completed after June 30, 2001 will
not be amortized, but will continue to be evaluated for impairment in accordance
with the appropriate pre-Statement 142 accounting literature. In preliminary
purchase price allocations, the Company has recorded $981,000 of goodwill
acquired in business combinations completed during the third quarter of 2001.

Statement 141 will require upon adoption of Statement 142, that the Company
evaluate its existing intangible assets and goodwill acquired in a prior
purchase business combination, and to make any necessary reclassifications in
order to conform with the new criteria in Statement 141 for recognition apart
from goodwill. Upon adoption of Statement 142, the Company will be required to
reassess the useful lives and residual values of all intangible assets acquired
in purchase business combinations, and make any necessary amortization period
adjustments by the end of the first interim period after adoption. In addition,
to the extent an intangible asset is identified as having an indefinite useful
life, the Company will be required to test the intangible asset for impairment
in accordance with the provisions of Statement 142 within the first interim
period. Any impairment loss will be measured as of the date of adoption and
recognized as the cumulative effect of a change in accounting principle in the
first interim period.

In connection with the transitional goodwill impairment evaluation, Statement
142 will require the Company to perform an assessment of whether there is an
indication that goodwill is impaired as of the date of adoption. To accomplish
this the Company must identify its reporting units and determine the carrying
value of each reporting unit by assigning the assets and liabilities, including
the existing goodwill and intangible assets, to those reporting units as of the
date of adoption. The Company will then have up to six months from the date of
adoption to determine the fair value of each reporting unit and compare it to
the reporting unit's carrying amount. To the extent a reporting unit's carrying
amount exceeds its fair value, an indication exists that the reporting unit's
goodwill may be impaired and the Company must perform the second step of the
transitional impairment test. In the second step, the Company must compare the
implied fair value of the reporting unit's goodwill, determined by allocating



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<PAGE>

the reporting unit's fair value to all of it assets (recognized and
unrecognized) and liabilities in a manner similar to a purchase price allocation
in accordance with Statement 141, to its carrying amount, both of which would be
measured as of the date of adoption. This second step is required to be
completed as soon as possible, but no later than the end of the year of
adoption. Any transitional impairment loss will be recognized as the cumulative
effect of a change in accounting principle in the Company's statement of
operations.

Finally, any unamortized negative goodwill existing at the date Statement
142 is adopted must be written off as the cumulative effect of a change in
accounting principle.

As of July 1, 2001, the date of adoption of Statement 141, the Company had
no unamortized goodwill and no unamortized identifiable intangible assets
subject to the transition provisions of Statement 141. The Company has recorded
no amortization expense related to goodwill for the year ended December 31, 2000
and the six months ended June 30, 2001. As of September 30, 2001, the Company
has preliminarily recorded $981,000 of goodwill acquired in business
combinations completed during the third quarter of 2001. The adoption of
Statement 142 on January 1, 2002, is not expected to have a material effect on
our consolidated financial statements.

In August 2001, the FASB issued Statement No. 143, Accounting for Asset
Retirement Obligations (Statement No. 143), which addresses financial accounting
and reporting for obligations associated with the retirement of tangible
long-lived assets and for the associated asset retirement costs. Statement No.
143 requires an enterprise to record the fair value of an asset retirement
obligation as a liability in the period in which it incurs a legal obligation
associated with the retirement of tangible long-lived assets that result from
the acquisition, construction, development and/or normal use of the assets. The
enterprise also is to record a corresponding increase to the carrying amount of
the related long-lived and to depreciate that cost over the life of the asset.
The liability is changed at the end of each period to reflect the passage of
time (i.e., accretion expense) and changes in the estimated future cash flows
underlying the initial fair value measurement. Because of the extensive use of
estimates, most enterprises will record a gain or loss when they settle the
obligation. The Company is required to adopt Statement No. 143 for fiscal years
beginning after June 15, 2002. The adoption is not expected to have a material
effect on our consolidated financial statements.

On October 3, 2001, the FASB issued Statement No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets ("Statement 144"), which addresses
financial accounting and reporting for the impairment or disposal of long-lived
assets. While Statement 144 supersedes FASB Statement No. 121, Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,
it retains many of the fundamental provisions of that Statement. Statement 144
also supersedes the accounting and reporting provisions of APB Opinion No. 30,
Reporting the Results of Operations--Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions, for the disposal of a segment of a business. Statement
144 will be effective for the year ending December 31, 2002. It is not expected
to have a material impact on our consolidated financial statements.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

To date, we have not utilized derivative financial instruments or
derivative commodity instruments. We do not expect to employ these or other
strategies to hedge market risk in 2001. We invest our cash in money market
funds, which are subject to minimal credit and market risk. We believe that the
market risks associated with these financial instruments are immaterial.

All of our revenues are realized currently in U.S. dollars and are from
customers primarily in the United States. Therefore, we do not believe that we
currently have any significant direct foreign currency exchange rate risk.

FACTORS THAT MAY AFFECT FUTURE RESULTS AND OUR STOCK PRICE

This Quarterly Report on Form 10-Q includes forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Act of 1934. Forward-looking statements give our current
expectations or forecasts of future events. Words such as "expects," "may,"
"anticipates," "intends," "would," "will," "plans," "believes," "estimates,"
"should," and similar expressions identify forward-looking statements.
Forward-looking statements in this Form 10-Q include express or implied
statements concerning our future revenues, expenditures, capital or other
funding requirements, the adequacy of our current cash and working capital
balances to fund our present and planned operations and financing needs,
expansion of and demand for our service offerings, and the growth of our
business and operations, as well as future economic and other conditions both
generally and in our specific geographic and product and services markets. These
statements are based on estimates, projections, beliefs, and assumptions, and
are not guarantees of future performance. From time to time, we also may provide
oral or written forward-looking statements in other materials we release to the
public.

     We caution that the following important factors, among others, in the
future could cause our actual results to differ materially from those expressed
in forward-looking statements made by or on behalf of us in filings with the
Securities and Exchange Commission, press releases, communications with
investors, and oral statements. Any of these factors, among others, could also
negatively impact our operating results and financial condition and cause the
trading price of our common stock to decline or fluctuate significantly. We
undertake no obligation to publicly update any forward-looking statements,
whether as a result of new information, future events or otherwise. You are
advised, however, to consult any further disclosures we make in our reports
filed with the Securities and Exchange Commission and in future public
statements and press releases.

WE HAVE EXPERIENCED OPERATING LOSSES AND MAY INCUR OPERATING LOSSES IN FUTURE
PERIODS, WHICH COULD CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE.

     We had a net loss of approximately $25.4 million for the year ended
December 31, 2000, and a net loss of approximately $36.9 million for the nine
months ended September 30, 2001. We will continue to incur losses in 2001. If we
do not achieve revenue growth or reduce expenses we could experience greater
operating losses, including for periods after 2001. These losses or any
fluctuation in our operating results could cause us to limit our business
activities and cause the market value of our common stock to decline further.

WE MAY NEED ADDITIONAL CAPITAL WHICH, IF NOT AVAILABLE TO US, MAY ALTER OUR
BUSINESS PLAN OR LIMIT OUR ABILITY TO ACHIEVE GROWTH IN REVENUES AND WHICH, IF
AVAILABLE AND RAISED, WOULD DILUTE YOUR OWNERSHIP INTEREST IN US.



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We incurred negative cash flows from operations in 2000 and continue to do so in
2001. Although we believe that we have sufficient cash to sustain negative cash
flows from operations for the balance of the year, thereafter we will need to
raise additional funds through public or private equity or debt financings in
order to:

        .    Support capital expenditures;

        .    Take advantage of acquisition or expansion opportunities;

        .    Develop new services;

        .    Address working capital needs; or

        .    Address unanticipated contingencies

Our inability to obtain financing on terms acceptable, or at all, may limit our
business activities and our ability to increase revenues or to achieve
profitability. Our stock price, like the stock price of many competitors in our
industry, has been depressed in recent periods, which could limit our ability to
obtain any needed financing on acceptable terms, or at all. In addition, if we
are able to raise additional capital through the sale of equity securities, your
investment in us would be diluted, which could cause our stock price to further
decline. Any debt financing could entail restrictive covenants, which could
limit our business activities and flexibility.

IF WE DO NOT CONTINUE TO MEET THE NASDAQ NATIONAL MARKET'S LISTING REQUIREMENTS,
WE MAY BE DELISTED FROM NASDAQ, REDUCING THE LIQUIDITY AND VALUE OF OUR COMMON
STOCK.

Companies listed on Nasdaq are required to meet specific criteria for continued
listing on Nasdaq. Included in this criteria are:

        .    $10.0 million in stockholders' equity (until November 1, 2002, this
             requirement is satisfied by maintaining net assets of at least $4.0
             million);

        .    750,000 shares in the public float (i.e., not owned by insiders);

        .    $5.0 million market value of public float;

        .    $1.00 minimum bid price;

        .    400 shareholders;

        .    2 market makers; and

        .    Compliance with certain corporate governance criteria.

At various times since January 2001, our common stock has traded for less than
$1.00 per share on the Nasdaq National Market. If a security listed on Nasdaq
trades for less than $1.00 for thirty consecutive days, Nasdaq begins a process
pursuant to which the issuer's securities may be delisted from the Nasdaq.
Similarly, if the market value of the public float or our common stock
diminishes to less than $5.0 million for thirty consecutive days, Nasdaq begins
a process pursuant to which the issuer's securities may be delisted from Nasdaq.
As of November 9, 2001, the aggregate market value of our public float was
approximately $3.6 million and our common stock had traded for less than $1.00
per share for more than thirty consecutive days. In response to the
extraordinary market conditions following the tragedy of September 11th, Nasdaq
has implemented an across-the-board moratorium on the minimum bid and public
float requirements for continued listing on Nasdaq until January 2, 2002. Once
the moratorium is lifted, we may be unable to meet the Nasdaq listing
requirements and our common stock may be delisted. Any such delisting would
adversely affect the liquidity and further depress the price of our common
stock.

WE RELY ON A SMALL NUMBER OF CLIENTS FOR MOST OF OUR REVENUES AND OUR REVENUES
WILL DECLINE SIGNIFICANTLY IF WE CANNOT RETAIN OR REPLACE, OR IF WE EXPERIENCE
COLLECTION PROBLEMS FROM, THESE CLIENTS.

We derive, and expect to continue to derive, a significant portion of our
revenues from a limited number of clients. Our two largest clients accounted for
37% and 30% of our revenues during the first nine months of 2001 and in fiscal
2000, respectively.

Virtually all of our client contracts may be canceled by the client following
limited notice and without economic penalty; however, the client is responsible
for fees earned through the date of contract termination unless a valid offset
exists. The revenues derived from specific clients are likely to vary from
period to period, and a major client in one year may not use our services in a
subsequent year. The loss of a large client or project in any period could
result in a decline in our revenues and profitability from period to period, and
cause significant and sudden declines or fluctuations in the market value of our
common stock. In addition, because a large portion of our receivables relate to
a limited number of clients and large projects, write-offs



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<PAGE>


attributable to one or a few of these clients or projects could exceed our
allowance for doubtful accounts and significantly harm our operating results.

SOME OF OUR CLIENTS ARE EMERGING COMPANIES THAT HAVE LITTLE OR NO OPERATING
HISTORY AND MAY LACK THE RESOURCES TO PAY OUR FEES, WHICH COULD CAUSE US TO
INCUR LOSSES ON THESE ACCOUNTS.

We provide services to many small emerging companies that have limited operating
histories and resources to pay our fees. Occasionally, we provide services to
select start-up companies in exchange for equity in those clients. These
companies often have little or no earnings or cash flow and their business is
generally at greater risk of failing than more established, traditional
businesses. As a result, these clients may be unable to pay for our services in
a timely manner, or at all. This would reduce our cash flow, making it difficult
to carry on our business without additional funds, and could lead to the
inefficient allocation of our professional and other resources. In addition, if
the equities we receive from these companies decline in value, we may be
required to reduce the value of these equity investments. We have not accepted
any equity from our customers for services rendered during the first nine months
of 2001.

In the first nine months of 2001 and in fiscal 2000, we recorded bad debt
expense of $880,000 and $11.8 million, respectively. Of the $11.8 million in bad
debt expense incurred in 2000, approximately $7.4 million was attributable to
development stage and dot-com clients that have not been able to pay as a result
of the slow-down in funding for start up ventures in 2000. The remaining $4.4
million in bad debt expense was attributable to disputes with clients. We are
currently in arbitration with these clients to resolve these disputes. Certain
of these clients have asserted counter-claims against us.

THE MARKET FOR OUR SERVICES MAY NOT GROW AND THIS COULD HURT OUR ABILITY TO
BECOME PROFITABLE.

In anticipation of a continued increase in demand for consulting and application
outsourcing services, we made substantial infrastructure investments to support
the anticipated demand for our services. While the IT services market in which
we compete steadily grew in 2000, this growth was lower than anticipated and
further slowed in 2001. If demand for our services does not grow, or if we do
not capture sufficient market share for these services, we may not be able to
achieve profitability.

THE VALUATION MODEL FOR COMPANIES SUCH AS OURS HAS CHANGED AND OUR INABILITY TO
ACHIEVE PROFITABILITY WOULD MATERIALLY ADVERSELY AFFECT OUR STOCK PRICE.

When our stock became publicly traded in 2000, companies in our sector were
valued generally upon revenue growth, with little regard for profitability. Over
the past few periods, companies in our sector have been increasingly measured
based on cash flows and profits. In addition, our revenues and those in our
industry have generally declined over these periods. If we are unable to achieve
profitability and positive cash flow, our stock price will continue to suffer
and could further decline, and the liquidity for our stock could deteriorate
further as well.

DIFFICULTIES IN INTEGRATING OUR RECENT ACQUISITIONS INTO OUR CONTINUING
OPERATIONS COULD ADVERSELY AFFECT OUR PROFITABILITY, CAUSING OUR STOCK PRICE TO
FLUCTUATE OR DECLINE.

Due to our recent transactions, we must integrate the operations of K2 Digital,
STEP Technology, INTEFLUX, and any future acquired operations into our service
offerings. In integrating our operations, several factors may impair our ability
to realize the benefits of these transactions. Among these factors are our
ability to:

        .    Retain and continue to serve the clients of acquired companies;

        .    To coordinate and integrate the capabilities of new professional
             staff with the services offered by us;

        .    Retain the consulting staff and executives of acquired companies;

        .    To generate sufficient revenues to offset the costs and expenses of
             recent and future transactions; and

        .    Minimize unexpected costs, expenses, and liabilities resulting from
             these acquisitions.

If we are unable to successfully manage these factors, our recent acquisitions
could further depress our financial results and the price of our common stock.

OUR RESULTS OF OPERATIONS MAY VARY FROM QUARTER TO QUARTER IN FUTURE PERIODS
AND, AS A RESULT, WE MAY NOT MEET THE EXPECTATIONS OF OUR INVESTORS AND
ANALYSTS, WHICH COULD



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CAUSE OUR STOCK PRICE TO FLUCTUATE OR DECLINE.

Our revenues and results of operations have fluctuated significantly in the past
and could fluctuate significantly in the future. We incurred net losses of $25.4
million and $36.9 million for fiscal 2000 and the first nine months of 2001,
respectively. In 2000, our quarterly net losses ranged from $2.3 million in the
first quarter to $16.3 in the fourth quarter. You should not rely on period-to-
period comparisons of operations as an indication of future performance.

Our results may fluctuate due to the factors described in this Form 10-Q, as
well as:

        .    The loss of or failure to replace any significant clients;

        .    Variation in demand for our services;

        .    Higher than expected bad debt write-offs;

        .    Changes in the mix of services that we offer; and

        .    Increases in our operating expenses.

A substantial portion of our operating expense is related to personnel costs and
overhead, which cannot be adjusted quickly and is therefore relatively fixed in
the short term. Our operating expenses are based, in significant part, on our
expectations of future revenues. If actual revenues are below our expectations,
we may not achieve our anticipated operating results. Moreover, it is possible
that in some future periods our results of operations may be below the
expectations of analysts and investors. In this event, the market price of our
common stock is likely to decline.

IF WE FAIL TO KEEP PACE WITH THE RAPID TECHNOLOGICAL CHANGES THAT CHARACTERIZE
OUR INDUSTRY, OUR COMPETITIVENESS WOULD SUFFER, CAUSING US TO LOSE PROJECTS OR
CLIENTS AND CONSEQUENTLY REDUCING OUR REVENUES AND THE PRICE OF OUR COMMON
STOCK.

Our market and the enabling technologies used by our clients are characterized
by rapid, frequent, and significant technological changes. If we fail to respond
in a timely or cost-effective way to these technological developments, we may
not be able to meet the demands of our clients, which would affect our ability
to generate revenues and achieve profitability. We have derived, and expect to
continue to derive, a large portion of our revenues from creating solutions that
are based upon today's leading and developing technologies and which are capable
of adapting to future technologies. Our historical results of operations may not
reflect our new service offerings and may not give you an accurate indication of
our ability to adapt to these future technologies.

OUR FAILURE TO MEET CLIENT EXPECTATIONS OR DELIVER ERROR-FREE SERVICES COULD
DAMAGE OUR REPUTATION AND HARM OUR ABILITY TO COMPETE FOR NEW BUSINESS OR RETAIN
OUR EXISTING CLIENTS, WHICH MAY LIMIT OUR ABILITY TO GENERATE REVENUES AND
ACHIEVE OR MAINTAIN PROFITABILITY.

Many of our engagements involve the delivery of information technology services
that are critical to our clients' businesses. Any defects or errors in these
services or failure to meet clients' specifications or expectations could result
in:

        .    Delayed or lost revenues due to adverse client reaction;

        .    Requirements to provide additional services to a client at no or a
             limited charge;

        .    Refunds of fees for failure to meet obligations;

        .    Negative publicity about us and our services; and

        .    Claims for substantial damages against us.

In addition, we sometimes implement critical functions for high profile clients
or for projects that have high visibility and widespread usage in the
marketplace. If these functions experience difficulties, whether or not as a
result of errors in our services, our name could be associated with these
difficulties and our reputation could be damaged, which would harm our business.

WE MAY LOSE MONEY ON FIXED-PRICE CONTRACTS BECAUSE WE MAY FAIL TO ACCURATELY
ESTIMATE AT THE BEGINNING OF PROJECTS THE TIME AND RESOURCES REQUIRED TO FULFILL
OUR OBLIGATIONS UNDER OUR CONTRACTS; THE ADDITIONAL EXPENDITURES THAT WE MUST
MAKE TO FULFILL THESE CONTRACT OBLIGATIONS MAY CAUSE OUR PROFITABILITY TO
DECLINE OR PREVENT US FROM ACHIEVING PROFITABILITY AND COULD REDUCE THE PRICE OF
OUR COMMON STOCK.



                                       14

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Although we provide consulting services primarily on a time and materials
compensation basis, approximately 5% of our consulting revenue was derived from
fixed-price, fixed-time engagements in 2000, and approximately 11% of revenues
were derived from fixed-price, fixed-time engagements for the nine months ended
September 30, 2001. The percentage of our revenues derived from fixed-price,
fixed time engagements may increase in the future, as influenced by changes in
demand and market conditions. While we believe we have the ability to estimate
the expected cost to be incurred under any given contract, our failure to
accurately estimate the resources required for a fixed-price, fixed-time
engagement or our failure to complete our contractual obligations in a manner
consistent with our projections or contractual commitments could harm our
overall profitability and our business. From time to time, we have been required
to commit unanticipated additional resources to complete some fixed-price,
fixed-time engagements, resulting in losses on these engagements. We believe
that we may experience similar situations in the future. In addition, we may
negotiate a fixed price for some projects before the design specifications are
finalized, resulting in a fixed price that is too low and causing a decline in
our operating results.

OUR LACK OF LONG-TERM CONTRACTS WITH CLIENTS AND OUR CLIENTS' ABILITY TO
TERMINATE CONTRACTS WITH LITTLE OR NO NOTICE REDUCES THE PREDICTABILITY OF OUR
REVENUES AND INCREASES THE POTENTIAL VOLATILITY OF OUR STOCK PRICE.

Our clients generally retain us on an engagement-by-engagement basis, rather
than under long-term contracts. In addition, our current clients can generally
reduce the scope of or cancel their use of our services without penalty and with
little or no notice. As a result, our revenues are difficult to predict. Because
we incur costs based on our expectations of future revenues, our failure to
predict our revenues accurately may cause our expenses to exceed our revenues,
which could cause us to incur increased operating losses. Although we try to
design and build complete integrated information systems for our clients, we are
sometimes retained to design and build discrete segments of the overall system
on an engagement-by-engagement basis. Since the projects of our large clients
can involve multiple engagements or stages, there is a risk that a client may
choose not to retain us for additional stages of a project or that the client
will cancel or delay additional planned projects. These cancellations or delays
could result from factors related or unrelated to our work product or the
progress of the project, including changing client objectives or strategies, as
well as general business or financial considerations of the client. If a client
defers, modifies, or cancels an engagement or chooses not to retain us for
additional phases of a project, we may not be able to rapidly re-deploy our
employees to other engagements and may suffer underutilization of employees and
the resulting harm to our operating results. Our operating expenses are
relatively fixed and cannot be reduced on short notice to compensate for
unanticipated variations in the number or size of engagements in progress.

Since the second half of 2000, many companies have experienced financial
difficulties or uncertainty and have begun to cancel or delay spending on
business and IT consulting initiatives. After the terrorist attacks of September
11, 2001, many companies have experienced further financial difficulties or
uncertainty and have cancelled or delayed additional spending on business and IT
consulting initiatives. The financial difficulties of many dot-com companies may
also reduce the urgency of larger companies' IT initiatives. If current or
potential clients continue to cancel or delay their IT initiatives, our business
and results of operations could be materially adversely affected.

WE MAY NOT BE SUCCESSFUL IN RETAINING OUR CURRENT TECHNOLOGY ALLIANCES OR
ENTERING INTO NEW ALLIANCES, WHICH COULD HAMPER OUR ABILITY TO MARKET OR DELIVER
SOLUTIONS NEEDED OR DESIRED BY OUR CLIENTS AND LIMIT OUR ABILITY TO INCREASE OR
SUSTAIN OUR REVENUES AND ACHIEVE OR MAINTAIN PROFITABILITY.

We rely on vendor alliances for client referral and marketing opportunities,
access to advanced technology and training, and for other important benefits.
These relationships are non-exclusive, and the vendors are free to enter into
similar or more favorable relationships with our competitors. Whether written or
oral, many of the agreements underlying our relationships are general in nature,
do not legally bind the parties to transact business with each other or to
provide specific client referrals, cross-marketing opportunities, or other
intended benefits to each other, have indefinite terms, and may be ended at the
will of either party. We may not be able to maintain our existing strategic
relationships and may fail to enter into new relationships. If we are unable to
maintain these relationships, the benefits that we derive from these
relationships, including the receipt of important sales leads, cross-marketing
opportunities, access to emerging technology training and certifications, and
other benefits, may be lost. Consequently, we may not be able to offer desired
solutions to clients, which would result in a loss of revenues and our inability
to effectively compete for clients seeking emerging or leading technologies
offered by these vendors.

IF WE ARE UNABLE TO SUCCESSFULLY OPERATE OUR REGIONAL OFFICES, WE MAY INCUR
INCREASED OPERATING EXPENSES WITHOUT CORRESPONDING INCREASED REVENUES, WHICH MAY
LIMIT OUR ABILITY TO ACHIEVE OR MAINTAIN PROFITABILITY AND CAUSE THE PRICE OF
OUR COMMON STOCK TO DECLINE.



                                       15

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A key component of our business strategy is to increase revenues delivered from
our offices in Atlanta, Boston, Denver, Irvine, Jacksonville, Las Vegas, Los
Angeles, New York and Portland (Oregon), as well as our solutions development
center in India. We may not be able to operate our regional offices profitably
or successfully expand these offices. If we do not implement this strategy
successfully, we may incur increased operating expenses without increased
revenues, which would harm our operating results and our stock price.

IF OUR EFFORTS TO DEVELOP BRAND AWARENESS ARE NOT SUCCESSFUL, WE MAY NOT BE ABLE
TO INCREASE OUR REVENUES SUFFICIENTLY TO OFFSET THE MARKETING COSTS THAT WE WILL
INCUR IN THESE EFFORTS.

Because the information technology professional service industry recently
experienced a decline in demand, an element of our business strategy is to
develop and maintain widespread awareness of our brand name in our target
markets. If our marketing efforts are not successful, we may not experience
increases in revenues.

BECAUSE WE OPERATE IN A HIGHLY COMPETITIVE AND RAPIDLY CHANGING INDUSTRY,
COMPETITORS COULD CAUSE US TO LOSE BUSINESS OPPORTUNITIES OR PROFESSIONAL
PERSONNEL AND LIMIT OUR ABILITY TO INCREASE OR SUSTAIN REVENUE LEVELS.

The business areas in which we compete are intensely competitive and subject to
rapid change. Consequently, we expect competition to continue and to intensify.
Competitors could hire professionals or win new client engagements that we are
competing for. If this occurs, our ability to generate increased revenues may be
limited and we may not achieve profitability. Our competitors fall into several
categories and include a range of entities providing a mix of general
management, information technology consulting services, and Internet services.
Many of our competitors have longer operating histories, larger client bases,
and greater brand or name recognition, as well as greater financial, technical,
marketing, and public relations resources. Our competitors may be able to
respond more quickly to technological developments and changes in clients'
needs. Further, as a result of the low barriers to entry, we may face additional
competition from new entrants into our markets. We do not own any technologies
that preclude or inhibit competitors from entering the general business areas in
which we compete. Existing or future competitors may independently develop and
patent or copyright technologies that are superior or substantially similar to
our technologies, which may place us at a competitive disadvantage.

WE MAY NOT BE ABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS AND, AS A RESULT,
WE COULD LOSE COMPETITIVE ADVANTAGES, WHICH DIFFERENTIATE OUR SOLUTIONS AND OUR
ABILITY TO ATTRACT AND RETAIN CLIENTS.

Our success is dependent, in part, upon our intellectual property rights. We
rely upon a combination of trade secret, confidentiality and nondisclosure
agreements, and other contractual arrangements, as well as copyright and
trademark laws, to protect our proprietary rights. We have no patents or pending
patent applications. We enter into confidentiality agreements with our
employees, we generally require that our consultants and clients enter into
these agreements, and we attempt to limit access to and distribution of our
proprietary information. Nevertheless, we may be unable to deter
misappropriation of our proprietary information or to detect unauthorized use
and take appropriate steps to enforce our intellectual property rights or
proprietary information.

We attempt to retain significant ownership or rights to use our internally
developed software applications, which we can market and adapt through further
customization for other client projects. Under some of our client contracts, all
of our project developments are the property of the client, and we have no or
limited rights to reuse or provide these developments in other client projects.
To the extent that we are unable to negotiate contracts that permit us to reuse
code and methodologies, or to the extent that we have conflicts with our clients
regarding our ability to do so, we may be unable to provide services to some of
our clients within price and timeframes acceptable to these clients.

Although we believe that our services, trade or service names, and products do
not infringe upon the intellectual property rights of others, claims could be
asserted against us in the future. If asserted, we may be unable to successfully
defend these claims, which could cause us to cease providing some services or
products and limit any competitive advantage we derive from our trademarks or
names.

If any of these events occur, our ability to differentiate ourselves and compete
effectively could be limited and we may lose revenue opportunities.

WE OCCASIONALLY AGREE NOT TO PERFORM SERVICES FOR OUR CLIENTS' COMPETITORS,
WHICH



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MAY LIMIT OUR ABILITY TO GENERATE FUTURE REVENUES AND INHIBIT OUR BUSINESS
STRATEGY.

In order to secure particularly large engagements or engagements with
industry-leading clients, we have agreed on limited occasions not to perform
services, or not to utilize some of our intellectual property rights developed
for clients, for competitors of those clients for limited periods of time
ranging from one to three years. In our agreement with American Express, our
largest client, we have agreed not to perform services for competitors of
American Express for one year after each project completion date and not to
assign consultants who have worked on American Express projects to other
clients' competitive projects for nine months after completing work for American
Express. These non-compete provisions reduce the number of our prospective
clients and our potential sources of revenue. These agreements also may limit
our ability to execute a part of our business strategy of leveraging our
business expertise in discreet industry segments by attracting multiple clients
competing in those industries. In addition, these agreements increase the
significance of our client selection process because some of our clients compete
in markets where only a limited number of companies gain meaningful market
share. If we agree not to perform services or to utilize intellectual property
rights for a particular client's competitors or competitive projects, we are
unlikely to receive significant future revenues in that particular market.

OUR LONG SALES CYCLES MAKE OUR REVENUES DIFFICULT TO PREDICT, WHICH COULD CAUSE
OUR REVENUES OR PROFITABILITY TO BE BELOW ANALYST OR INVESTOR EXPECTATIONS,
CAUSING OUR STOCK PRICE TO FLUCTUATE AND DECLINE SIGNIFICANTLY.

The timing of our revenues is difficult to predict because of the length and
variance of the time required to complete a sale. Our sales cycle typically
ranges in length from three months to nine months and is sometimes longer. Prior
to retaining us for a project, our clients often undertake an extensive review
of their systems, needs and budgets, and may require approval at various levels
within their organization. The length or unpredictability of our sales cycle
could cause our revenues or profitability to be below the expectations of
analysts or investors and our stock price to fluctuate significantly.

IF WE ARE UNABLE TO SUCCESSFULLY POSITION AND SELL OUR APPLICATION OUTSOURCING
SERVICES, OUR PROFITABILITY AND THE PRICE OF OUR COMMON STOCK MAY DECLINE.

Our ability to increase revenues and profitability depends in part on the
adoption and acceptance of third-party application hosting services by our
clients. We have expended significant resources and expect to continue to invest
to increase our data center capacity to accommodate our hosting services. To
date, these services have not been profitable and we have not been able to
attract and retain a significant number of clients. If we do not achieve
profitability from these services, our operating results and stock price will
continue to be negatively affected. In June 2001, we recorded a non-cash charge
of $11.3 million relating to certain under-utilized data center assets.

THE LOSS OF MR. JAMES G. GARVEY, JR., OUR FOUNDER, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, MAY HARM OUR ABILITY TO OBTAIN AND RETAIN CLIENT ENGAGEMENTS, MAINTAIN
A COHESIVE CULTURE, OR COMPETE EFFECTIVELY.

Our success will depend in large part upon the continued services of James G.
Garvey, Jr., our President, Chief Executive Officer, and founder. We have an
employment contract with Mr. Garvey. Mr. Garvey is precluded under his agreement
from competing against us for one year should he leave us. The loss of services
of Mr. Garvey could harm us and cause a loss of investor confidence in our
business, which could cause the trading price of our stock to decline. In
addition, if Mr. Garvey resigns to join a competitor or to form a competing
company, the loss of Mr. Garvey and any resulting loss of existing or potential
clients to any competitor could harm our business. If we lose Mr. Garvey, we may
be unable to prevent the unauthorized disclosure or use by other companies of
our technical knowledge, practices, or procedures. In addition, due to the
substantial number of shares of our common stock owned by Mr. Garvey, the loss
of Mr. Garvey's services could cause investor or analyst concern that Mr. Garvey
may sell a large portion of his shares, which could cause a rapid and
substantial decline in the trading price of our common stock.

IF WE ARE UNABLE TO ATTRACT AND RETAIN PROFESSIONAL STAFF, WE WILL BE UNABLE TO
PROVIDE OUR SERVICES EFFECTIVELY AND CONSEQUENTLY MAY BE UNABLE TO INCREASE OR
MAINTAIN CURRENT REVENUE LEVELS OR ACHIEVE OR MAINTAIN PROFITABILITY, WHICH
WOULD CAUSE THE PRICE OF OUR COMMON STOCK TO DECLINE.

We derive substantially all of our revenue from the billings of our professional
services personnel on projects. If we fail to attract and retain professionals,
we may not be able to successfully compete for new projects, timely finish
existing projects, or generally carry out our business plan. The continuing
evolution of new technology requires integrated solutions implemented by
professionals qualified in leading and emerging technologies. There is
competition for professionals with the skills required to



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provide these solutions. We may lose prospective qualified employees to clients
or competitors. We may not attract a sufficient number of highly skilled
professionals, or retain, train, and motivate the professionals that we do
attract. Failure to do so could impair our ability to adequately manage and
complete our existing projects or obtain new projects. In addition, declines in
the trading price of our common stock could materially and adversely affect
employee morale and retention and other aspects of our business.

THE VOLUME OF TRADING OF OUR COMMON STOCK COULD FLUCTUATE SIGNIFICANTLY,
ADVERSELY AFFECTING OUR STOCK PRICE.

The stock prices of many technology companies, such as ours, have declined
significantly in recent periods. If investor interest in these stocks continues
to decline generally or does not increase, the price of our common stock could
continue to decline suddenly and significantly.

THE SALE OF A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK IN THE PUBLIC
MARKET COULD ADVERSELY AFFECT THEIR MARKET PRICE, NEGATIVELY IMPACTING YOUR
INVESTMENT.

There are a substantial number of shares currently available for sale in the
public market. The sales of a substantial number of shares of our common stock
in the public market could depress the market price of our common stock and
could impair our ability to raise capital through the sale of additional equity
securities.

THE HOLDINGS OF MR. GARVEY MAY LIMIT YOUR ABILITY TO INFLUENCE THE OUTCOME OF
DIRECTOR ELECTIONS AND OTHER MATTERS SUBJECT TO A STOCKHOLDER VOTE, INCLUDING A
SALE OF OUR COMPANY ON TERMS THAT MAY BE ATTRACTIVE TO YOU.

James G. Garvey, Jr., a director, executive officer, and our founder, currently
owns approximately 66% of our outstanding common stock. Mr. Garvey's stock
ownership and management positions enable him to exert considerable influence
over us, including in the election of directors and the approval of other
actions submitted to our stockholders. In addition, without the consent of Mr.
Garvey, we may be prevented from entering into transactions that could be viewed
as beneficial to other stockholders, including a sale of Integrated Information
Systems. This could prevent you from selling your stock to a potential acquirer
at prices that exceed the market price of our stock, or could cause the market
price of our common stock to decline.

OUR CHARTER DOCUMENTS COULD MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE
US, WHICH COULD LIMIT YOUR ABILITY TO SELL YOUR STOCK TO AN ACQUIRER AT A
PREMIUM PRICE OR COULD CAUSE OUR STOCK PRICE TO DECLINE.

Our certificate of incorporation and by-laws may make it difficult for a third
party to acquire control of us, even if a change in control would be beneficial
to stockholders. Our certificate of incorporation authorizes our board of
directors to issue up to 5,000,000 shares of "blank check" preferred stock.
Without stockholder approval, the board of directors has the authority to attach
special rights, including voting and dividend rights, to this preferred stock.
With these rights, preferred stockholders could make it more difficult for a
third party to acquire our company.

Our by-laws do not permit any person other than at least three members of our
board of directors, our President, the Chairman of the Board, or holders of at
least a majority of our stock to call special meetings of the stockholders. In
addition, a stockholder's proposal for an annual meeting must be received within
a specified period in order to be placed on the agenda. Because stockholders
have limited power to call meetings and are subject to timing requirements in
submitting stockholder proposals for consideration at meetings, any third-party
takeover or other matter that stockholders wish to vote on that is not supported
by the board of directors could be subject to significant delays and
difficulties.

If a third party finds it more difficult to acquire us because of these
provisions, you may not be able to sell your stock at a premium price that may
have been offered by the acquirer, and the trading price of our stock may be
lower than it otherwise would be if these provisions were not in effect.

OUR CURRENT STOCK REPURCHASE PLAN MAY ADVERSELY AFFECT THE TRADING VOLUME AND
LIQUIDITY OF OUR COMMON STOCK AND COULD CAUSE OUR STOCK PRICE TO DECLINE.

In May 2001, our board authorized a stock repurchase plan, which authorized us
to purchase up to $5 million of our common stock on the open market in
compliance with applicable SEC regulations. In August 2001, our board authorized
the repurchase of additional shares of IIS common stock from time to time
provided that these purchases would, in no event, leave the company with less
than 5 million shares of common stock in the public float. If we continue to
repurchase our common stock under this plan, the number of shares of our common
stock outstanding will decrease. This decrease could reduce the trading volume



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of our common stock, which may adversely impact the liquidity and value of our
common stock. As of November 9, 2001, we have repurchased 4,920,000 shares of
our common stock at a cost of approximately $5.3 million.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Beginning on or about July 10, 2001, a number of purported class action lawsuits
have been filed in the United States District Court for the Southern District of
New York against the Company, certain of its current and former officers and
directors, and the members of the underwriting syndicate involved in the
Company's initial public offering. The complaints have since been consolidated
into a single action. The lawsuits are essentially identical, and purport to
bring suit on behalf of those who purchased the Company's publicly traded
securities between March 17, 2000 and June 27, 2001. Plaintiffs allege that
defendants made false and misleading statements, purport to assert claims for
violations of the federal securities laws, and seek unspecified compensatory
damages and other relief. Similar complaints have been filed against over 180
other issuers that have had initial public offerings since 1998, and all such
actions have now been included in a single coordinated proceeding. The Company
believes the claims are without merit and intends to defend the actions
vigorously.

In the last year, the Company has initiated a number of legal proceedings
against former customers to collect unpaid professional services fees and
related expenses. The Company currently has six such collection matters pending
which, in the aggregate, seek payment of approximately $5.3 million in unpaid
professional services fees and related expenses. The largest of these matters is
an arbitration proceeding against CommercialWare, Inc. in which the Company is
seeking approximately $3.4 million in unpaid fees. In several of these
collection matters, the former customers have asserted counterclaims for
unspecified damages and other relief. The Company believes that these
counterclaims are without merit and intends to defend them vigorously.

Additionally, the company is, from time to time, party to various legal
proceedings arising in the ordinary course of business. The company evaluates
such claims on a case-by-case basis, and its policy is to vigorously contest any
such claims which it believes are without merit.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

On March 16, 2000, the Securities and Exchange Commission declared effective our
Registration Statement on Form S-1 (File No. 333-94861) for our initial public
offering. On March 22, 2000, IIS closed its offering for 4,600,000 shares of
Common Stock at a public offering price of $15.00 per share. On April 19, 2000,
IIS closed an offering of an additional 690,000 shares at the same public
offering price pursuant to exercise of the underwriters' over-allotment option,
345,000 of which shares were sold by IIS, and 345,000 were sold by James G.
Garvey, Jr., the founder, Chairman, CEO, and President of IIS.

Through September 30, 2001, approximately $60.0 million of IIS' proceeds from
the offering have been applied to working capital, to capital improvements to
our facilities, and to repurchase shares of our common stock. The remaining net
proceeds are being maintained in a portfolio of money market funds and
investment grade securities.



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ITEM 6.         EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

3.1    Amended and Restated Certificate of Incorporation (incorporated by
       reference to Exhibit 3.3 of the Company's Quarterly Report on Form 10-Q
       (File No. 333-94861) for the period ending June 30, 2000).

3.2    Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 of
       the Company's Annual Report on Form 10-K (File No. 333-94861) for the
       period ending December 31, 2000).

10.30  Lease Agreement between the Company and Regency Tower LLC dated February
       22, 2001.

10.31  Assignment and Assumption of Lease between the Company, The CIT
       Group/Equipment Financing, Inc., and Birtcher Arizona, LLC Manager for
       AmberJack, Ltd. dated July 10, 2001.

10.32  Assignment and Assumption of Lease between the Company, The CIT
       Group/Equipment Financing, Inc., and Birtcher Arizona, LLC Manager for
       AmberJack, Ltd. dated July 10, 2001.

10.33  Assignment and Assumption of Lease and License Agreement between the
       Company and K2 Digital, Inc. dated August 1, 2001.

10.34  Lease Agreement between the Company and Resilient Floor Covering Pension
       Fund Dated September 28, 2001.

10.35  David A. Wirthlin's Separation Agreement.

(b) Reports on Form 8-K

     The Company filed a Current Report on Form 8-K on July 18, 2001, relating
     to a class action lawsuit filed against the Company and certain of its
     current and former directors.

     The Company also filed a Current Report on Form 8-K on October 4, 2001,
     relating to the acquisition of specified STEP Technology, Inc. assets and
     the hiring of the executive management and key professional staff of STEP.
     __________________

    SIGNATURES

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

                                            INTEGRATED INFORMATION SYSTEMS, INC.
                                            Registrant

                                            /s/ James G. Garvey, Jr.
                                            ------------------------
                                            James G. Garvey, Jr.,
                                            Chief Executive Officer

Date: November 14, 2001




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