UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

FORM 20-F/AAmendment No.1



|                                                                    | o | REGISTRATION
            STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE
    ACT OF 1934
|------------------------------------------------------------------- | - | --------------------------------------------------------------------------------------------------------------
|                                                                    |   |                                                                                                               
|OR                                                                 
|                                                                    |   |                                                                                                               
|                                                                    |   |                                                                                                               
|                                                                    | x | ANNUAL REPORT PURSUANT
    TO SECTION 13 OF 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934                      
|                                                                    |   |                                                                                                               
|For the fiscal year
    ended December 31, 2006                    
|                                                                    |   |                                                                                                               
|OR                                                                 
|                                                                    |   |                                                                                                               
|                                                                    | o | TRANSITION REPORT
            PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
    1934      
|                                                                    |   |                                                                                                               
|For the transition
    period from __________ to __________        
|                                                                    |   |                                                                                                               
|                                                                    | o | SHELL COMPANY REPORT
            PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
    1934   
|                                                                    |   |                                                                                                               
|Date of event requiring
    this shell company report _____________

Commission
File No. 1-8201

ALADDIN KNOWLEDGE SYSTEMS LTD.(Exact name of Registrant as specified in its charter
and translation of Registrants name into English)

_______________________

Israel (Jurisdiction of incorporation or organization)35 Efal Street, Kiryat Arye, Petach Tikva 49511, Israel (Address of principal executive offices)

_______________________Securities registered or to be registered pursuant to Section 12(b) of the Act:Ordinary Shares, nominal value 0.01 New Israeli Shekel per share(Class of Securities)

Nasdaq Global Market(Name of Exchange)

Securities registered or to be registered pursuant to Section 12(g) of the Act: None(Title of Class)

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:None(Title of Class)

Indicate the number of outstanding
  shares of each of the issuers classes of capital or common stock as ofDecember 31, 2006:14,683,488 Ordinary Shares

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act.

o  Yesx  No

---



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.

x  Yeso  No

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

o  Yesx  No

Indicate by check mark whether the
  registrant is a large accelerated filer, an accelerated filer, or a non-accelerated
  filer. See definition of accelerated filer and large accelerated filer in
Rule 12b-2 of the Exchange Act.

o  Large
  Accelerated Filerx  Accelerated
  Filero  Non-Accelerated
  Filer

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

Item 17o  Item 18x

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o  Yes7Nox

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EXPLANATORY NOTE

This Amendment No.1 on Form 20-F/A
  speaks as of the filing date of the Annual Report on Form 20-F of Aladdin Knowledge
  Systems, Ltd. (the Company) (the Form 20-F) for the fiscal year end December
31, 2006, filed on July 2, 2007 with the Securities and Exchange Commission (SEC). This Amendment No.1 is being filed to include the Report of Independent Auditors of Blick Rothenberg for the period ended December 31, 2006 (the
Report), which was mistakenly omitted from the Form 20-F, and to update the exhibit list to include the consent of this firm of Independent Auditors to the incorporation by reference of their Report in the the Companys
Registration Statements on Form S-8.

This Amendment No.1 is also being
filed to correct errors in Notes 2 and 7 to the Consolidated Financial Statements.

Item 18: FINANCIAL STATEMENTS

See our consolidated financial statements,
following the signature page below.

Item 19: EXHIBITS

The exhibits filed with or incorporated into this annual report are listed on the index of exhibits below.

|1.1  |   | Articles of Association, as amended, dated February 6, 2005(1)                                      
|---- | - | ----------------------------------------------------------------------------------------------------
|     |   |                                                                                                     
|     |   |                                                                                                     
|1.3  |   | Memorandum of Association of the registrant.(2)(3)                                                  
|     |   |                                                                                                     
|4.1  |   | Form of Indemnification Agreement between the registrant and each of the members of its board of    
|     |   | directors and its officers.(4)                                                                      
|     |   |                                                                                                     
|4.2  |   | Convertible Loan Agreement dated as of April 29, 2004, by and between C-Signature Ltd. and the      
|     |   | registrant. (4)(5)                                                                                  
|     |   |                                                                                                     
|8    |   | List of subsidiaries.*                                                                              
|     |   |                                                                                                     
|11   | . | Code of Ethics(4)                                                                                   
|     |   |                                                                                                     
|12.1 |   | Certification by Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|12.2 |   | Certification by Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|13.1 |   | Certification by Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|13.2 |   | Certification by Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|15.1 |   | Consent letter from Kost, Forer,
    Gabbay & Kasierer.**                                           
|    
|15.2 |   | Consent letter from Blick Rothenberg.**                                                             

*Previously filed as an
  exhibit to the Companys Form 20-F for the year ended December 31, 2006.

** Filed herewith.

|(1) | Incorporated by reference from our Registration Statement on Form F-3, File No. 333-121361, as amended, filed with the Commission on March 8, 2005.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) | Incorporated by reference from our Registration Statement on Form F-1 File No. 33-67980, as amended, filed with the Commission on August 26, 1993. 
|   
|(3) | English translation or summary from Hebrew original.                                                                                               
|   
|(4) | Incorporated by reference from our 2003 Annual Report on Form 20-F filed with the Commission on June 30, 2004.                                     
|   
|(5) | Portions of this exhibit have been omitted pursuant to a request for confidential treatment.                                                       
|   



---



SIGNATURES

Pursuant
  to the requirements of Section 12 of the Securities Exchange Act of 1934, the
  registrant certifies that it meets all the requirements for filing on Form
  20-F and has duly caused and  authorized the undersigned to signthis
amendment to such annual report on its behalf in the City of Petach Tikva, State
of Israel, on this 16th day of October 2007.



ALADDIN
      KNOWLEDGE SYSTEMS LTD.By:
      /s/
      Jacob (Yanki) MargalitJacob (Yanki)
      MargalitChief
      Executive Officer andChairman of
      the Board


---



EXHIBITS INDEX

The exhibits filed with or incorporated into this annual report are listed on the index of exhibits below.

|1.1  |   | Articles of Association, as amended, dated February 6, 2005(1)                                      
|---- | - | ----------------------------------------------------------------------------------------------------
|     |   |                                                                                                     
|1.3  |   | Memorandum of Association of the registrant.(2)(3)                                                  
|     |   |                                                                                                     
|4.1  |   | Form of Indemnification Agreement between the registrant and each of the members of its board of    
|     |   | directors and its officers.(4)                                                                      
|     |   |                                                                                                     
|4.2  |   | Convertible Loan Agreement dated as of April 29, 2004, by and between C-Signature Ltd. and the      
|     |   | registrant.(4)(5)                                                                                   
|     |   |                                                                                                     
|8    |   | List of subsidiaries.*                                                                              
|     |   |                                                                                                     
|11   | . | Code of Ethics(4)                                                                                   
|     |   |                                                                                                     
|12.1 |   | Certification by Chief Executive Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|12.2 |   | Certification by Chief Financial Officer pursuant to section 302 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|13.1 |   | Certification by Chief Executive Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|13.3 |   | Certification by Chief Financial Officer pursuant to section 906 of the Sarbanes-Oxley Act of 2002.*
|     |   |                                                                                                     
|15.1 |   | Consent letter from Kost, Forer,
    Gabbay & Kasierer.**                                           
|     |   |                                                                                                     
|15.2 |   | Consent letter from Blick Rothenberg.**                                                             

*Previously filed as an
exhibit to the Companys Form 20-F for the year ended December 31, 2006.

** Filed
        herewith.

|(1) | Incorporated by reference from our Registration Statement on Form F-3, File No. 333-121361, as amended, filed with the Commission on March 8, 2005.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) | Incorporated by reference from our Registration Statement on Form F-1 File No. 33-67980, as amended, filed with the Commission on August 26, 1993. 
|   
|(3) | English translation or summary from Hebrew original.                                                                                               
|   
|(4) | Incorporated by reference from our 2003 Annual Report on Form 20-F filed with the Commission on June 30, 2004.                                     
|   
|(5) | Portions of this exhibit have been omitted pursuant to a request for confidential treatment.                                                       
|   

---



ALADDIN KNOWLEDGE SYSTEMS LTD. AND ITS
SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006

IN U.S. DOLLARS

INDEX

|                                                                    |  |       
|------------------------------------------------------------------- |  | ------
|                                                                    |  | Page  
|                                                                    |  |       
|                                                                    |  |       
|Report of Independent Registered Public Accounting Firm             |  | 2     
|                                                                    |  |       
|Consolidated Balance Sheets                                         |  | 3 - 4 
|                                                                    |  |       
|Consolidated Statements of Income                                   |  | 5     
|                                                                    |  |       
|Statements of Changes in Shareholders Equity                       |  | 6     
|                                                                    |  |       
|Consolidated Statements of Cash Flows                               |  | 7 - 8 
|                                                                    |  |       
|Notes to Consolidated Financial Statements                          |  | 9 - 43
|                                                                   
|Report of Independent Registered
            Public Accounting Firm |  | 44    

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

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(ERNST & YOUNG LOGO)

REPORT OF
INDEPENDENT PUBLIC ACCOUNTING FIRM

To the Board of
Directors and Shareholders of

ALADDIN
KNOWLEDGE SYSTEMS LTD.

We
have audited the accompanying consolidated balance sheets of Aladdin Knowledge
Systems Ltd. (the Company) and its subsidiaries as of December 31, 2005 and
2006, and the related consolidated statements of income, changes in
shareholders equity and cash flows for each of the three years in the period
ended December 31, 2006. These financial statements are the responsibility
of the Companys management. Our responsibility is to express an opinion on
these financial statements, based on our audits. We did not audit the financial
statements of Aladdin Western Europe Ltd., a wholly-owned U.K. subsidiary,
which statements reflect total assets constituting 2% in 2005 and 2006, and
total revenues constituting 16% in 2004, 13% in 2005 and 7% in 2006 of the
related consolidated totals. Those statements were audited by other auditors
whose report has been furnished to us, and our opinion, insofar as it relates
to the data included for Aladdin Western Europe Ltd., is based solely on the
report of the other auditors.

We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. We were not engaged to
perform an audit of the Companys internal control over financial reporting.
Our audits include consideration of internal control over financial reporting
as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the
effectiveness of the Companys internal control over financial reporting.
Accordingly, we express no such opinion. An audit also includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits and the report of
other auditors provide a reasonable basis for our opinion.

In
our opinion, based on our audits and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of the Company and its
subsidiaries as of December 31, 2005 and 2006, and the consolidated results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2006, in conformity with U.S. generally accepted accounting
principles.

As
discussed in Note 2 to the consolidated financial statements, in 2006, the
Company adopted Statement Financial Accounting Standards No. 123(revised 2004),
Share Based Payment.

|                 |                                 
|---------------- | --------------------------------
|Tel-Aviv, Israel | KOST FORER GABBAY & KASIERER    
|July 2, 2007     | A Member of Ernst & Young Global

- 2 -

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|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|CONSOLIDATED BALANCE SHEETS                               
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                               |  |              |         |      |   |         | 
|---------------------------------------------------------------------------------------------- |  | ------------ | ------- | ---- | - | ------- | 
|                                                                                               |  | December 31, |        
|                                                                                               |  |              |        
|                                                                                               |  | 2005         |         | 2006 |  
|                                                                                               |  |              |         |      |  
|ASSETS                                                                                         |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|CURRENT
  ASSETS:                                                                              |  |              |         |      |   |         | 
|Cash and cash equivalents                                                                      |  | $            | 28,426  |      | $ | 39,734  | 
|Marketable securities (Note 3)                                                                 |  |              | 48,815  |      |   | 51,147  | 
|Trade receivables (net of allowance for
  doubtful accounts - $ 377 in 2005 and $ 274 in 2006) |  |              | 13,957  |      |   | 16,427  | 
|Other accounts receivable and prepaid
  expenses (Note 4)                                      |  |              | 3,517   |      |   | 4,253   | 
|Deferred income taxes (Note 12)                                                                |  |              | 1,159   |      |   | 1,526   | 
|Inventories (Note 5)                                                                           |  |              | 6,998   |      |   | 7,299   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  current assets                                                                         |  |              | 102,872 |      |   | 120,386 | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|LONG-TERM
  INVESTMENTS:                                                                       |  |              |         |      |   |         | 
|Prepaid expenses                                                                               |  |              | 174     |      |   | 202     | 
|Investment in other companies (Note 6)                                                         |  |              | 6,399   |      |   | 5,763   | 
|Severance pay fund                                                                             |  |              | 2,455   |      |   | 2,673   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  long-term investments                                                                  |  |              | 9,028   |      |   | 8,638   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|PROPERTY AND
  EQUIPMENT, NET (Note 7)                                                         |  |              | 3,081   |      |   | 5,695   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|OTHER ASSETS                                                                                   |  |              |         |      |   |         | 
|Intangible assets, net (Note 8)                                                                |  |              | 1,995   |      |   | 4,045   | 
|Goodwill (Note 9)                                                                              |  |              | 7,685   |      |   | 7,685   | 
|Deferred income taxes (note 12)                                                                |  |              | 1,217   |      |   | 1,595   | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  other assets                                                                           |  |              | 10,897  |      |   | 13,325  | 
|                                                                                               |  |              |         |      |   |         | 
|                                                                                               |  |              |         |      |   |         | 
|Total
  assets                                                                                 |  | $            | 125,878 |      | $ | 148,044 | 
|                                                                                               |  |              |         |      |   |         | 

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

- 3 -

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|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|CONSOLIDATED BALANCE SHEETS                               
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | ---- | - | ------- | -
|                                                                                                                                                                                                                                |  | December 31, |        
|                                                                                                                                                                                                                                |  |              |        
|                                                                                                                                                                                                                                |  | 2005         |         | 2006 |  
|                                                                                                                                                                                                                                |  |              |         |      |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                                                                            |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|CURRENT
  LIABILITIES:                                                                                                                                                                                                          |  |              |         |      |   |         |  
|Trade payables                                                                                                                                                                                                                  |  | $            | 4,454   |      | $ | 5,794   |  
|Deferred revenues                                                                                                                                                                                                               |  |              | 5,645   |      |   | 6,173   |  
|Accrued expenses and other accounts payable
  (Note 10)                                                                                                                                                                         |  |              | 7,799   |      |   | 8,618   |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|Total
  current liabilities                                                                                                                                                                                                     |  |              | 17,898  |      |   | 20,585  |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|ACCRUED
  SEVERANCE PAY                                                                                                                                                                                                         |  |              | 3,243   |      |   | 3,441   |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|OTHER LONG TERM LIABILITIES (Note 10)                                                                                                                                                                                           |  |              |        |      |   | 1,369   |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|COMMITMENTS
  AND CONTINGENT LIABILITIES (Note 11)                                                                                                                                                                              |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|SHAREHOLDERS
  EQUITY (Note 13):                                                                                                                                                                                               |  |              |         |      |   |         |  
|Share capital: Ordinary shares of NIS 0.01
  par value - Authorized: 20,000,000 shares at December 31, 2005 and 2006;
  Issued and Outstanding: 14,485,063 and 14,683,488 shares at December 31, 2005
  and 2006, respectively. |  |              | 44      |      |   | 44      |  
|Additional paid-in capital                                                                                                                                                                                                      |  |              | 78,954  |      |   | 82,439  |  
|Deferred stock based compensation                                                                                                                                                                                               |  |              | (15     | )    |   |        |  
|Accumulated other comprehensive loss                                                                                                                                                                                            |  |              | (3,559  | )    |   | (3,178  | )
|Retained earnings                                                                                                                                                                                                               |  |              | 29,313  |      |   | 43,344  |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|Total
  shareholders equity                                                                                                                                                                                                    |  |              | 104,737 |      |   | 122,649 |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  
|Total
  liabilities and shareholders equity                                                                                                                                                                                    |  | $            | 125,878 |      | $ | 148,044 |  
|                                                                                                                                                                                                                                |  |              |         |      |   |         |  

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

- 4 -

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|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|CONSOLIDATED STATEMENTS OF INCOME                         
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                               |  |                         |            |      |   |            |  |   |            | 
|------------------------------------------------------------------------------ |  | ----------------------- | ---------- | ---- | - | ---------- |  | - | ---------- | 
|                                                                               |  | Year ended December 31, |           
|                                                                               |  |                         |           
|                                                                               |  | 2004                    |            | 2005 |   | 2006       | 
|                                                                               |  |                         |            |      |   |            | 
|Revenues (Note 14):                                                            |  |                         |            |      |   |            |  |   |            | 
|Software security                                                              |  | $                       | 50,650     |      | $ | 56,578     |  | $ | 60,556     | 
|Enterprise security                                                            |  |                         | 18,471     |      |   | 25,195     |  |   | 28,482     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Total revenues                                                                 |  |                         | 69,121     |      |   | 81,773     |  |   | 89,038     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Cost of revenues:                                                              |  |                         |            |      |   |            |  |   |            | 
|Software security                                                              |  |                         | 9,541      |      |   | 9,870      |  |   | 9,292      | 
|Enterprise security                                                            |  |                         | 4,240      |      |   | 7,101      |  |   | 10,721     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Total cost of
  revenues                                                       |  |                         | 13,781     |      |   | 16,971     |  |   | 20,013     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Gross profit                                                                   |  |                         | 55,340     |      |   | 64,802     |  |   | 69,025     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Operating expenses:                                                            |  |                         |            |      |   |            |  |   |            | 
|Research and development                                                       |  |                         | 12,028     |      |   | 12,131     |  |   | 14,336     | 
|Selling and marketing                                                          |  |                         | 24,677     |      |   | 26,952     |  |   | 28,703     | 
|General and administrative                                                     |  |                         | 8,805      |      |   | 11,169     |  |   | 12,780     | 
|Settlement charge (Note 11b)                                                   |  |                         |           |      |   | 2,000      |  |   |           | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Total operating
  expenses                                                     |  |                         | 45,510     |      |   | 52,252     |  |   | 55,819     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Operating income                                                               |  |                         | 9,830      |      |   | 12,550     |  |   | 13,206     | 
|Financial income, net (Note 15a)                                               |  |                         | 53         |      |   | 1,038      |  |   | 3,240      | 
|Other income (expenses), net                                                   |  |                         | (138       | )    |   | 14         |  |   | 284        | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Income before taxes on income                                                  |  |                         | 9,745      |      |   | 13,602     |  |   | 16,730     | 
|Taxes on income (Note 12)                                                      |  |                         | 957        |      |   | 1,246      |  |   | 2,699      | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Net income                                                                     |  | $                       | 8,788      |      | $ | 12,356     |  | $ | 14,031     | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Earnings per share (Note 15b):                                                 |  |                         |            |      |   |            |  |   |            | 
|Basic                                                                          |  | $                       | 0.74       |      | $ | 0.89       |  | $ | 0.96       | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Diluted                                                                        |  | $                       | 0.68       |      | $ | 0.85       |  | $ | 0.93       | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Weighted average number of shares used in
  computation of earnings per share: |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Basic                                                                          |  |                         | 11,939,905 |      |   | 13,899,319 |  |   | 14,596,119 | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 
|Diluted                                                                        |  |                         | 12,999,600 |      |   | 14,580,328 |  |   | 15,077,579 | 
|                                                                               |  |                         |            |      |   |            |  |   |            | 

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

- 5 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD. 
  AND ITS SUBSIDIARIES    
|STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY             
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|------------------------------------------------------------------------------------------------------------ |  | --------------- | ------ | ------------------------------ | - | ----------------- | - | ------------------------------------- | ---- | --------------------------------------------------- | - | ------------------- | - | ------------------------------ | --------- | ------------------------------ | - | ------ | - | - | ------ | - | - | ------- | -
|                                                                                                             |  | Share
  capital |        | Additional
  paid-in
  capital |   | Treasury
  shares |   | Deferred
  Stock-based
  compensation |      | Accumulated
  other
  comprehensive
  Income (loss) |   | Retained
  earnings |   | Total
  comprehensive
  income |           | Total
  shareholders
  equity |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |  
|Balance as of
  January 1, 2004                                                                              |  | $               | 37     |                                | $ | 36,147            |   | $                                     | (377 | )                                                   | $ |                    |   | $                              | (3,092    | )                              | $ | 8,241  |   |   |        |   | $ | 40,956  |  
|Exercise of stock
  options                                                                                  |  |                 | 2      |                                |   | 3,335             |   |                                       | 377  |                                                     |   |                    |   |                                |          |                                |   | (72    | ) |   |        |   |   | 3,642   |  
|Deferred
  stock-based compensation                                                                          |  |                 |       |                                |   | 214               |   |                                       |     |                                                     |   | (214                | ) |                                |          |                                |   |       |   |   |        |   |   |        |  
|Amortization of
  deferred stock compensation                                                                |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   | 148                 |   |                                |          |                                |   |       |   |   |        |   |   | 148     |  
|Comprehensive
  income:                                                                                      |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other
  comprehensive loss:                                                                                  |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized gain
  on available-for-sale marketable securities, net of taxes                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 223       |                                |   |       |   | $ | 223    |   |   | 223     |  
|Foreign currency
  translation adjustments                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 85        |                                |   |       |   |   | 85     |   |   | 85      |  
|Unrealized losses
  from hedging transactions                                                                |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (405      | )                              |   |       |   |   | (405   | ) |   | (405    | )
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other
  comprehensive loss                                                                             |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   | (97    | ) |   |        |  
|Net income                                                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   | 8,788  |   |   | 8,788  |   |   | 8,788   |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total
  comprehensive income                                                                                 |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 8,691  |   |   |         |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of
  December 31, 2004                                                                            |  |                 | 39     |                                |   | 39,696            |   |                                       |     |                                                     |   | (66                 | ) |                                | (3,189    | )                              |   | 16,957 |   |   |        |   |   | 53,437  |  
|Issuance of Ordinary
  shares, net                                                                           |  |                 | 5      |                                |   | 38,773            |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |        |   |   | 38,778  |  
|Exercise of stock
  options                                                                                  |  |                 | **)   |                                |   | 485               |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |        |   |   | 485     |  
|Amortization of
  deferred stock-based compensation                                                          |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   | 51                  |   |                                |          |                                |   |       |   |   |        |   |   | 51      |  
|Comprehensive
  income:                                                                                      |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other
  comprehensive loss:                                                                                  |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized loss
  on available-for-sale marketable securities, net of taxes                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (302      | )                              |   |       |   |   | (302   | ) |   | (302    | )
|Foreign currency
  translation adjustments                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (492      | )                              |   |       |   |   | (492   | ) |   | (492    | )
|Unrealized gain
  from hedging transactions                                                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 424       |                                |   |       |   |   | 424    |   |   | 424     |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other
  comprehensive loss                                                                             |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   | (370   | ) |   |        |  
|Net income                                                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   | 12,356 |   |   | 12,356 |   |   | 12,356  |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total
  comprehensive income                                                                                 |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 11,986 |   |   |         |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of
  December 31, 2005                                                                            |  |                 | 44     |                                |   | 78,954            |   |                                       |     |                                                     |   | (15                 | ) |                                | (3,559    | )                              |   | 29,313 |   |   |       |   |   | 104,737 |  
|Reclassification of deferred compensation
  to additional paid-in capital due to implementation of SFAS 123R |  |                 |       |                                |   | (15               | ) |                                       |     |                                                     |   | 15                  |   |                                |          |                                |   |       |   |   |       |   |   |         |  
|Stock-based
  compensation expenses                                                                          |  |                 |       |                                |   | 2,268             |   |                                       |     |                                                     |   |                     |   |                                |          |                                |   |       |   |   |       |   |   | 2,268   |  
|Exercise of stock
  options                                                                                  |  |                 | ** )  |                                |   | 835               |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |       |   |   | 835     |  
|Deferred tax due
  to issuance expenses from previous years                                                  |  |                 |       |                                |   | 397               |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   |       |   |   | 397     |  
|Comprehensive
  income:                                                                                      |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Other
  comprehensive gain:                                                                                  |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Unrealized loss
  on available-for-sale marketable securities, net of taxes                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (56       | )                              |   |       |   |   | (56    | ) |   | (56     | )
|Foreign currency
  translation adjustments                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | 441       |                                |   |       |   |   | 441    |   |   | 441     |  
|Unrealized loss
  from hedging transactions                                                                  |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                | (4        | )                              |   |       |   |   | (4     | ) |   | (4      | )
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total other comprehensive
  income                                                                           |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   |       |   |   | 381    |   |   |         |  
|Net income                                                                                                   |  |                 |       |                                |   |                  |   |                                       |     |                                                     |   |                    |   |                                |          |                                |   | 14,031 |   |   | 14,031 |   |   | 14,031  |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Total
  comprehensive income                                                                                 |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   | $ | 14,412 |   |   |         |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  
|Balance as of
  December 31, 2006                                                                            |  | $               | 44     |                                | $ | 82,439            |   | $                                     |     |                                                     | $ |                    |   | $                              | *) (3,178 | )                              | $ | 43,344 |   |   |        |   | $ | 122,649 |  
|                                                                                                             |  |                 |        |                                |   |                   |   |                                       |      |                                                     |   |                     |   |                                |           |                                |   |        |   |   |        |   |   |         |  

|   |                     
|-- | --------------------
|*) | Composed as follows:

|     |                                                                                            |      |                    |        |   |   |        |  
|---- | ------------------------------------------------------------------------------------------ | ---- | ------------------ | ------ | - | - | ------ | -
|     |                                                                                            |      | As of December 31, |       
|2005 |                                                                                            | 2006
|     |                                                                                            |      |                    |        |   |   |        |  
|     | Accumulated unrealized
  gains from available-for-sale marketable securities, net of taxes |      | $                  | 114    |   | $ | 58     |  
|     | Accumulated unrealized
  gains from hedging transactions                                   |      |                    | 19     |   |   | 15     |  
|     | Accumulated foreign
  currency translation adjustments                                     |      |                    | (3,692 | ) |   | (3,251 | )
|     |                                                                                            |      |                    |       
|     | Accumulated other comprehensive
  loss                                                     |      | $                  | (3,559 | ) | $ | (3,178 | )
|     |                                                                                            |      |                    |        |   |   |        |  

|    |                                      
|--- | -------------------------------------
|**) | Represents
  an amount lower than $1.

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

- 6 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.
  AND ITS SUBSIDIARIES     
|CONSOLIDATED STATEMENTS OF CASH FLOWS                     
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|-------------------------------------------------------------------------------------------- |  | ----------------------- | ------- | ---- | - | ------- | - | - | ------ | -
|                                                                                             |  | Year ended December 31, |        
|                                                                                             |  |                         |        
|                                                                                             |  | 2004                    |         | 2005 |   | 2006    |  
|                                                                                             |  |                         |         |      |   |         |  
|Cash flows from operating activities:                                                        |  |                         |         |      |   |         |   |   |        |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Net income                                                                                   |  | $                       | 8,788   |      | $ | 12,356  |   | $ | 14,031 |  
|Adjustments required to reconcile net
  income to net cash provided by operating activities: |  |                         |         |      |   |         |   |   |        |  
|Depreciation and amortization                                                                |  |                         | 2,072   |      |   | 1,967   |   |   | 2,416  |  
|Gain from sale of property and equipment                                                     |  |                         | (7      | )    |   | (22     | ) |   | (60    | )
|Accrued interest on available-for-sale
  marketable debt securities                          |  |                         |        |      |   | (262    | ) |   | (240   | )
|Gain from sale of marketable securities                                                      |  |                         |        |      |   |        |   |   | (183   | )
|Other- than- temporary decline in fair
  value for available-for-sale marketable securities  |  |                         |        |      |   | 117     |   |   |       |  
|Increase (decrease) in accrued severance
  pay, net                                          |  |                         | (74     | )    |   | 16      |   |   | (20    | )
|Stock-based compensation expenses                                                            |  |                         | 148     |      |   | 51      |   |   | 2,268  |  
|Deferred income taxes, net                                                                   |  |                         |        |      |   | (803    | ) |   | (354   | )
|Increase in trade receivables                                                                |  |                         | (2,515  | )    |   | (1,619  | ) |   | (2,224 | )
|Decrease (increase) in inventories                                                           |  |                         | 198     |      |   | (1,277  | ) |   | (97    | )
|Increase in other accounts receivable and
  prepaid expenses                                 |  |                         | (1,315  | )    |   | (189    | ) |   | (700   | )
|Increase in trade payables                                                                   |  |                         | 1,160   |      |   | 936     |   |   | 1,321  |  
|Increase in deferred revenues                                                                |  |                         | 1,378   |      |   | 852     |   |   | 528    |  
|Increase in other
  long term liabilities                                                    |  |                         |        |      |   |        |   |   | 1,369  |  
|Increase (decrease) in accrued expenses and
  other accounts payable                         |  |                         | (997    | )    |   | 2,502   |   |   | 840    |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Net cash provided by operating activities                                                    |  |                         | 8,836   |      |   | 14,625  |   |   | 18,895 |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Cash flows from investing activities:                                                        |  |                         |         |      |   |         |   |   |        |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Investment in available-for-sale marketable
  securities                                     |  |                         | (7,000  | )    |   | (40,465 | ) |   | (6,500 | )
|Investment in other assets                                                                   |  |                         |        |      |   |        |   |   | (2,508 | )
|Purchase of property and equipment                                                           |  |                         | (1,237  | )    |   | (2,303  | ) |   | (4,576 | )
|Proceeds from sale of property and
  equipment                                               |  |                         | 15      |      |   | 34      |   |   | 95     |  
|Proceeds from sales of available-for-sale
  marketable securities                            |  |                         |        |      |   |        |   |   | 4,371  |  
|Purchase of intangible assets                                                                |  |                         | (1,220  | )    |   |        |   |   |       |  
|Investment in other companies                                                                |  |                         | (2,376  | )    |   | (850    | ) |   | (1,100 | )
|Proceeds from return on investment of other
  companies                                      |  |                         |        |      |   | 910     |   |   | 1,736  |  
|Payment for the purchase of Aladdin
  Knowledge Espanã, S.L.,(1)                             |  |                         | (1,791  | )    |   |        |   |   |       |  
|                                                                                             |  |                         |         |      |   |         |   |   |        |  
|Net cash used in investing activities                                                        |  |                         | (13,609 | )    |   | (42,674 | ) |   | (8,482 | )
|                                                                                             |  |                         |         |      |   |         |   |   |        |  

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

- 7 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD. 
  AND ITS SUBSIDIARIES    
|CONSOLIDATED STATEMENTS OF CASH FLOWS                     
|                                                          
|U.S. dollars in thousands, except share and per share data

|                                                               |  |                         |        |      |   |        |   |   |        | 
|-------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | 
|                                                               |  | Year ended December 31, |       
|                                                               |  |                         |       
|                                                               |  | 2004                    |        | 2005 |   | 2006   |  
|                                                               |  |                         |        |      |   |        |  
|Cash flows
  from financing activities:                        |  |                         |        |      |   |        |   |   |        | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Proceeds from issuance of shares, net                          |  | $                       |       |      | $ | 38,778 |   | $ |       | 
|Proceeds from exercise of options                              |  |                         | 3,642  |      |   | 485    |   |   | 835    | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Net cash
  provided by financing activities                    |  |                         | 3,642  |      |   | 39,263 |   |   | 835    | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Effect of
  exchange rate changes on cash and cash equivalents |  |                         | 157    |      |   | (101   | ) |   | 60     | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Increase
  (decrease) in cash and cash equivalents             |  |                         | (974   | )    |   | 11,113 |   |   | 11,308 | 
|Cash and
  cash equivalents at the beginning of the year       |  |                         | 18,287 |      |   | 17,313 |   |   | 28,426 | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Cash and
  cash equivalents at the end of the year             |  | $                       | 17,313 |      | $ | 28,426 |   | $ | 39,734 | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Supplemental
  disclosure:                                     |  |                         |        |      |   |        |   |   |        | 
|                                                              
|Cash paid during the year for:                                 |  |                         |        |      |   |        |   |   |        | 
|Income taxes                                                   |  | $                       | 698    |      | $ | 1,058  |   | $ | 2,009  | 
|                                                               |  |                         |        |      |   |        |   |   |        | 
|Non-cash
  activities:                                         |  |                         |        |      |   |        |   |   |        | 
|                                                              
|Investment in intangible assets                                |  | $                       | 260    |      | $ |       |   | $ |       | 
|                                                               |  |                         |        |      |   |        |   |   |        | 

|    |                                                                                     |  |   |       | 
|--- | ----------------------------------------------------------------------------------- |  | - | ----- | 
|(1) | Payment for purchase of Aladdin Knowledge
  Espanã, S.L., (see Note 1b):            |  |   |       | 
|    |                                                                                     |  |   |       | 
|    | Fair value of assets acquired
  and liabilities assumed at the date of acquisition: |  |   |       | 
|    |                                                                                     |  |   |       | 
|    | Working capital net (excluding cash and
  cash equivalents in the amount of $ 188)  |  | $ | 223   | 
|    | Property and equipment                                                              |  |   | 13    | 
|    | Customer list                                                                       |  |   | 1,151 | 
|    | Goodwill                                                                            |  |   | 404   | 
|    |                                                                                     |  |   |       | 
|    |                                                                                     |  | $ | 1,791 | 
|    |                                                                                     |  |   |       | 

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

- 8 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |        
|-------- | -------
|NOTE 1:- | GENERAL

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a. | Aladdin
  Knowledge Systems Ltd. and its wholly-owned subsidiaries (collectively, the
  Company or Aladdin) is a global provider of security solutions that
  reduce software theft, authenticate network users and protect against
  unwanted Internet and e-mail content, including spam and viruses. The
  Ordinary shares of the Company are quoted on The Nasdaq National Market
  (Nasdaq) under the symbol ALDN. Since July 28, 2004, the shares are also
  quoted on the Tel Aviv Stock Exchange. The Companys security products are
  organized into two segments: Software Digital Rights Management, or DRM, and
  enterprise security.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The
  Companys software DRM products allow software publishers to manage licensing
  and distribution of their software while limiting revenue loss from software
  theft and piracy. The HASP products include: HASP HL and HASP NET,
  hardware-based software security systems and HASP SL, a software marketing,
  licensing and distribution platform.                                                                                                                                                                                                                                                                                             
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | Within the enterprise security segment, Aladdin develops and markets
  its patented USB-based eToken hardware and software solution for strong
  authentication and digital identity management using a portable device, and
  the eSafe line of integrated content security solutions that protects PCs and
  networks against viruses, worms, spam, spyware, and non-productive and malicious
  Internet-borne content.                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The Company
  is dependent upon sole source suppliers for certain key components used in
  its products. Although there are limited number of manufacturers of these
  particular components, the Companys management believes that other suppliers
  could provide similar components at comparable terms. A change in suppliers,
  however, could cause a delay in manufacturing and a possible loss of sales,
  which could adversely affect the operating results of the Company and its
  financial position.                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | b. | Acquisition
  of Aladdin Knowledge Systems España, S.L.:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | On July 16,
  2004, the Company entered into a Share Purchase Agreement with the
  shareholders of its former distributor, Aladdin Knowledge Systems España, S.L
  (Aladdin España), in order to enhance the service provided to
  Spanish-speaking countries. Pursuant to the agreement, the Company acquired
  100% of Aladdin Españas shares, and thereafter it became a wholly-owned
  subsidiary of the Company.                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | The total
  consideration for the purchase of the shares was $ 1,979 (including
  approximately $ 136 acquisition costs).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    | Aladdin
  España is engaged in the marketing, distributing, selling, licensing and
  support of certain proprietary software products of the Company in Spain. The
  acquisition has been accounted for using the purchase method of accounting
  and, accordingly, the purchase price has been allocated to the assets
  acquired and the liabilities assumed based on the estimated fair value at the
  date of acquisition. Regarding the allocation of the goodwill, see also Note
  9.                                                                                                                                                              

- 9 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                 |                                                                                                                                                
|-------- | --------------- | -----------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 1:- | GENERAL (Cont.)
|         |                 |                                                                                                                                                
|         |                 | Based upon a
  valuation of tangible and intangible assets acquired, the Company has
  allocated the total cost of the acquisition, as follows:

|                            |  |                  |       | 
|--------------------------- |  | ---------------- | ----- | 
|                            |  | July 16, 
  2004 |      
|                            |  |                  |      
|                            |  |                  |       | 
|Current
  assets            |  | $                | 802   | 
|Property and
  equipment    |  |                  | 13    | 
|Intangible
  assets:        |  |                  |       | 
|Customer list               |  |                  | 1,151 | 
|Goodwill                    |  |                  | 404   | 
|                            |  |                  |       | 
|                            |  |                  |       | 
|Total assets
  acquired     |  |                  | 2,370 | 
|                            |  |                  |       | 
|                            |  |                  |       | 
|Liabilities
  assumed:      |  |                  |       | 
|Current liabilities         |  |                  | 391   | 
|                            |  |                  |       | 
|                            |  |                  |       | 
|Total
  liabilities assumed |  |                  | 391   | 
|                            |  |                  |       | 
|                            |  |                  |       | 
|Net assets
  acquired       |  | $                | 1,979 | 
|                            |  |                  |       | 

- 10 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Basis of presentation:                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | The
  consolidated financial statements have been prepared according to United
  States Generally Accepted Accounting Principles (U.S. GAAP).                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | 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 amounts reported in the financial statements and accompanying
  notes. Actual results could differ from these estimates.
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Financial statements in United States dollars:                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | 1.                                                                                                                                                                                                                                                                                                       | The majority
  of the revenues of the Company and certain of its subsidiaries is generated
  in United States dollars (dollar). In addition, a substantial portion of
  the Companys and certain of its subsidiaries costs is incurred in dollars.
  The Companys management believes that the dollar is the primary currency of
  the economic environment in which the Company and certain of its subsidiaries
  operate. Thus, the functional and reporting currency of the Company and
  certain of its subsidiaries is the dollar. Accordingly, monetary accounts
  maintained in currencies other than the dollar are remeasured into U.S.
  dollars in accordance with Statement of Financial Accounting Standard Board
  No. 52 Foreign Currency Translation.
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                          | All
  transactions gains and losses of the remeasured monetary balance sheet items
  are reflected in the statement of operations as financial income or expenses,
  as appropriate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | 2.                                                                                                                                                                                                                                                                                                       | The
  financial statements of a foreign Subsidiary, whose functional currency is
  not the U.S. dollar, have been translated into U.S. dollars. All balance
  sheet accounts have been translated using the exchange rates in effect at the
  balance sheet date. Statement of operations amounts have been translated
  using the average exchange rate for the year. The resulting aggregate
  translation adjustments are reported as a component of accumulated other
  comprehensive loss in shareholders equity.                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Principles of consolidation:                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | The
  consolidated financial statements include the accounts of the Company and its
  wholly-owned subsidiaries. Intercompany transactions and balances, including
  profits from intercompany sales not yet realized outside the Group, have been
  eliminated upon consolidation.                     
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Cash and cash equivalents:                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Cash and
  cash equivalents include short-term, highly liquid investments that are
  readily convertible to cash with maturities of three months or less at the
  date acquired.                                                                                                                        

- 11 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Marketable securities:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Management
  determines the appropriate classification of its investments in marketable
  debt securities at the time of purchase and re-evaluates such designations as
  of each balance sheet date. During 2006, 2005 and 2004, all marketable
  securities covered by Statement of Financial Accounting Standard No. 115
  Accounting for Certain Investments in Debt and Equity Securities were
  designated as available-for-sale.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Accordingly,
  these securities are stated at fair value, with unrealized gains and losses
  reported in accumulated other comprehensive loss, a separate component of
  shareholders equity, net of taxes. Realized gains and losses on sales of
  investments, and impairment of investments, as determined on a specific
  identification basis, are included in the consolidated statement of
  operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | FASB Staff
  Position (FSP) No. 115-1, The Meaning of Other-Than-Temporary Impairment
  and Its Application to Certain Investment (FSP 115-1) provides guidance
  for determining when an investment is considered impaired, whether impairment
  is other-than temporary, and measurement of an impairment loss. An investment
  is considered impaired if the fair value of the investment is less than its
  cost. If, after consideration of all available evidence to evaluate the
  realizable value of its investment, impairment is determined to be other
  than- temporary, then an impairment loss should be recognized equal to the
  difference between the investments cost and its fair value. FSP 115-1
  nullifies certain provisions of Emerging Issues Task Force (EITF) Issue No.
  03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to
  Certain Investments (EITF 03-1) while retaining the disclosure
  requirements of EITF 03-1 which the Company adopted in 2003.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | Investment in other
  companies:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The investment in companies, in which the
  Company holds 20% or more (which are not subsidiaries), is accounted using
  the equity method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The investment in companies, in which the
  Company holds less than 20%, is stated at cost, since the Company does not
  have the ability to exercise significant influence over operating and financial
  policies of the investees.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The
  Companys Investment in IDesia Ltd. (IDesia) in which the Company holds
  27.4% is accounted for under the cost method after the Company considers the
  guidance provided within EITF 02-14 Whether an Investor Should Apply the
  Equity Method of Accounting to Company Investments Other than Common Stock.
  The Company determined that since its investment in IDesias Preferred Shares
  is not in-substance common stock, the equity method should not be applied
  (see Note 6b).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         | The
  Companys investment in Athena Smartcard Solution Ltd. (Athena) in which
  the Company holds 23.5% was accounted for under the equity method. Since the
  investment was made at the end of the year (November 29, 2006) and due to
  immaterial results in Athenas activity, the Companys implementation of the
  equity method to such investment as of December 31, 2006 was immaterial (see
  Note 6c).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

- 12 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | The
  Companys investment in the other companies is reviewed for impairment
  whenever events or changes in circumstances indicate that the carrying amount
  of an investment may not be recoverable, in accordance with Accounting
  Principle Board Opinion No. 18, The Equity Method of Accounting for
  Investments in Common Stock (APB No. 18) and EITF 03-1, The
  meaning of other-than-temporary impairment and its application to certain investments. (EITF
  03-1)
  As of December 31, 2006, based on managements most recent analysis, no
  impairment losses have been identified.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Inventories:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Inventories
  are stated at the lower of cost or market value. Inventory provisions are
  provided to cover risks arising from slow-moving items, technological
  obsolescence, excess inventories and for market prices lower than cost.                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Cost is
  determined for all types of inventory using the moving average cost method.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Property and equipment:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Property and
  equipment are stated at cost, net of accumulated depreciation. Depreciation
  is calculated by the straight-line method over the estimated useful lives of
  the assets, at the following annual rates:                                                                                                                                                                                                                                                                                                                                                                                      

|                                     |  |                                                                 
|------------------------------------ |  | ----------------------------------------------------------------
|                                     |  | %                                                               
|                                     |  |                                                                 
|                                     |  |                                                                 
|Computers
  and peripheral equipment |  | 33                                                              
|Office
  furniture and equipment     |  | 7 - 10 (mainly 7%)                                              
|Motor
  vehicles                     |  | 15                                                              
|Leasehold
  improvements             |  | Over the shorter of the term of the
  lease or useful life lease

| |                                                                                                                                                                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Intangible assets:                                                                                                                                                                                                                                                                                                                                             
| |                                                                                                                                                                                                                                                                                                                                                                
| | Intangible
  assets acquired are amortized over their useful lives using a method of
  amortization that reflects the pattern in which the economic benefits of the
  intangible assets are consumed or otherwise used up, in accordance with
  Statement of Financial Accounting Standards No. 142 Goodwill and Other
  Intangible Assets, (SFAS No. 142).
| |                                                                                                                                                                                                                                                                                                                                                                
| | Indefinite-lived
  intangible assets are not amortized, but rather are subject to an annual
  impairment test.                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                
| | Other
  intangible assets are amortized using the straight-line method over the
  following estimated useful life:                                                                                                                                                                                                                                             

|                     |  |      
|-------------------- |  | -----
|                     |  | Years
|                     |  |      
|                     |  |      
|Current
  technology |  | 5    
|Customer
  list      |  | 7    
|Domain name          |  | 3    
|Patent               |  | 13.5 

- 13 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Goodwill:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Goodwill is
  measured as the excess of the cost of an acquired company over the sum of the
  amounts assigned to tangible and identifiable intangible assets acquired less
  liabilities assumed. Goodwill is not amortized, but rather reviewed for
  impairment at least annually in accordance with the provisions of SFAS No.
  142. The goodwill impairment test under SFAS No. 142 involves a two-step
  approach. Under the first step, the Company determines the fair value of each
  reporting unit to which goodwill has been assigned. The reporting units of
  the Company for purposes of the impairment test are the Companys two
  operating segments, the software security DRM, and enterprise security, as
  these are the components of the business for which discrete financial information
  is available and segment management regularly reviews the operating results
  of those components. The Company then compares the fair value of each
  reporting unit to its carrying value, including goodwill. The Company
  estimates the fair value of each reporting unit by estimating the present
  value of the reporting units future cash flows. If the fair value exceeds
  the carrying value, no impairment loss is recognized. If the carrying value
  exceeds the fair value, the goodwill of the reporting unit is considered
  potentially impaired and the second step is completed in order to measure the
  impairment loss. Under the second step goodwill is reduced to its implied
  fair value through an adjustment to the goodwill balance, resulting in an
  impairment charge. The Company performs the annual impairment tests during
  the fourth fiscal quarter. During 2004, 2005 and 2006, no impairment losses
  were identified.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Impairment of long-lived assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | The
  long-lived assets of the Company and its subsidiaries and certain
  identifiable intangible assets are reviewed for impairment in accordance with
  Statement of Financial Accounting Standard No. 144 Accounting for the
  Impairment or Disposal of Long-Lived Assets(SFAS No. 144), whenever events
  or changes in circumstances indicate that the carrying amount of an asset may
  not be recoverable. Recoverability of assets to be held and used is measured
  by a comparison of the carrying amount of an asset to the future undiscounted
  cash flows expected to be generated by the assets. If such assets are
  considered to be impaired, the impairment to be recognized is measured by the
  amount by which the carrying amount of the assets exceeds the fair value of
  the assets. During 2004, 2005 and 2006, no impairment losses were identified.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | Income taxes:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         | The Company
  and its subsidiaries account for income taxes in accordance with Statement of
  Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS
  No. 109). This Statement prescribes the use of the liability method whereby
  deferred tax assets and liability account balances are determined based on
  the differences between financial reporting and tax bases of assets and
  liabilities and are measured using the enacted tax rates and laws that will
  be in effect when the differences are expected to reverse. The Company and
  its subsidiaries provide a valuation allowance, if necessary, to reduce
  deferred tax assets to the amounts that are more likely-than-not to be
  realized.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

- 14 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Research and development costs:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Research and
  development costs are charged to the statement of operations as incurred.
  Statement of Financial Accounting Standard No. 86, Accounting for the Costs
  of Computer Software to be Sold, Leased or Otherwise Marketed (SFAS No.
  86), requires capitalization of certain software development costs,
  subsequent to the establishment of technological feasibility.                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Based on the
  Companys product development process, technological feasibility is
  established upon completion of a working model. Costs incurred by the Company
  between completion of the working models and the point at which the products
  are ready for general release have been insignificant. Therefore, all
  research and development costs have been expensed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Revenue recognition:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  derives revenues from sales of its hardware products (HASP HL, HASP NET) and
  from licensing the right to use its software products (eSafe, eToken and HASP
  SL) which include maintenance and support.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The hardware
  based products contain an insignificant embedded software element which is
  incidental to the product as a whole since the embedded software is not
  marketed or sold separately and is used solely in connection with the
  operation of the hardware products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The eToken
  is a hardware and software based product which contains a software content
  which is more than incidental to the product as a whole since the Companys
  marketing efforts focus on the software solution, the PCS services are
  provided on the software component and most of the R&D expenses related
  to the product are in relation to the software component. Accordingly, the
  Company accounts for its eToken sales in accordance with SOP 97-2.                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  generates revenues from sale of its products directly to end-users and
  indirectly, mostly through value-added resellers, original equipment
  manufacturers and independent distributors (all of whom are considered
  end-users). Other than pricing terms which may differ due to the different
  volume of purchases between resellers, manufacturers and distributors and
  end-users, there are no material differences in the terms and arrangements
  involving direct and indirect customers. All of the Companys products sold
  through agreements with value-added resellers, original equipment
  manufacturers and independent distributors are non-exchangeable, non
  refundable, non-returnable and without any rights of price protection or
  stock rotation. Accordingly, the Company considers them all as end-users.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  accounts for its software sales in accordance with Statement of Position No.
  97-2, Software Revenue Recognition, as amended (SOP No. 97-2) and for its
  hardware products in accordance with Staff Accounting Bulletin No. 104
  Revenue Recognition (SAB 104) when persuasive evidence of an arrangement
  exists, delivery has occurred, the vendors fee is fixed or determinable, no
  further obligation exists and collectibility is probable.                                                                                                                                                                                                                                                                                                                                                                             

- 15 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Persuasive evidence of an arrangement exists.
  The Company determines that persuasive evidence of an arrangement exists with
  respect to a customer when it has a written contract, which is signed by both
  the Company and the customer or a purchase order from the customer
  (documentation is dependent on the business practice for each type of
  customer).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Delivery has occurred. The Companys
  hardware and software products may be physically delivered to the customer,
  or with regard to software products, the products may be electronically
  delivered to the customer. The Company determines that delivery of hardware
  products has occurred when the title and risk of loss have been transferred
  to the customer. In connection with delivery of software products, the
  Company determines that delivery has occurred upon shipment of the software
  or, when the software is made available to the customer through electronic
  delivery, when the customer has been provided with access codes that allow
  the customer to take immediate possession of the software.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | The fee is fixed or determinable. Generally,
  payments that are due within six months are deemed to be fixed or determinable
  based on the Companys successful collection history on such arrangements
  without giving concessions. Arrangements with payment terms extending beyond
  these customary payment terms are considered not to be fixed or determinable,
  and revenue from such arrangements is recognized as payments become due from
  the customer, provided that all other revenue recognition criteria have been
  met.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | Collectibility is probable. The Company
  determines whether collectibility is probable on a case-by case basis. When
  assessing probability of collection, the Company considers the customers
  financial condition, the number of years in business with the customer and
  the history of collection. If the Company determines if the outset of the
  arrangement that collectibility is not probable based upon its review
  process, revenue is recognized as payments are received.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         | With regard
  to software arrangements involving multiple elements such as software product
  and maintenance and support, the Company has adopted Statement of Position
  No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition with
  Respect to Certain Transactions (SOP No. 98-9). According to SOP No. 98-9,
  revenues should be allocated to the different elements in the arrangement
  under the residual method when Vendor Specific Objective Evidence (VSOE)
  of fair value exists for all undelivered elements and no VSOE exists for the
  delivered elements. Under the residual method, at the outset of the
  arrangement with the customer, the Company defers revenue for the fair value
  of its undelivered elements (maintenance and support) and recognizes revenue
  for the remainder of the arrangement fee attributable to the elements
  initially delivered in the arrangement (software product) when the basic
  criteria in SOP No. 97-2 have been met. Any discount in the arrangement is
  allocated to the delivered element. Maintenance and support revenue is
  deferred and recognized on a straight-line basis over the term of the
  maintenance and support agreement. The VSOE of fair value of the undelivered
  elements (maintenance and support) is determined based on the price charged
  for the undelivered element when sold separately or for new arrangements based upon the price that management will determine to charge.

- 16 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Time-based
  licenses including maintenance and on-going support are recognized over the
  term of the agreement. VSOE of fair value does not exist for the related
  support arrangement as maintenance is not priced or offered separately for
  such arrangements. In these cases, the Company recognizes the license and
  maintenance revenue ratably over the period of each arrangement.                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | In certain
  cases where a multiple elements arrangement exist, the fair value of each
  undelivered element is determined based on VSOE for that element and revenue is allocated
  to each undelivered element based upon its fair value. The revenue associated with each
  element is recognized using the respective methodology discussed above. The
  Company uses the residual method in accordance with SOP 97-2.                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Deferred
  revenues include unearned amounts received from maintenance and support
  contracts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Severance pay:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | The
  Companys liability for its Israeli employees severance pay is calculated
  pursuant to Israels Severance Pay Law, based on the most recent salary of
  the Israeli employees, multiplied by the number of years of employment as of
  balance sheet date. Employees are entitled to one months salary for each
  year of employment, or a portion thereof. The Companys liability for all of
  its employees in Israel is fully provided by monthly deposits with severance
  pay funds, insurance policies and by an accrual. The value of those policies
  is recorded as an asset in the Companys balance sheet.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | The
  deposited funds include profits accumulated up to the balance sheet date. The
  deposited funds may be withdrawn, only upon fulfillment of the obligation
  pursuant to Israels Severance Pay Law or labor agreements. The value of the
  deposited funds is based on the cash surrendered value of these policies, and
  includes immaterial profits.                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Severance
  pay expenses net of fund's profit for the years ended December 31, 2004, 2005
  and 2006 amounted to $ 1,057, $ 1,336 and $ 1,206, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Advertising expenses:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Advertising
  expenses are charged to the statement of operations, as incurred. Advertising
  expenses for the years ended December 31, 2004, 2005 and 2006 were $ 3,488,
  $ 4,504 and $ 4,208 respectively.                                                                                                                                                                                                                                                                                                                                                                                                                  
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Concentrations of credit risks:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         | Financial
  instruments that potentially subject the Company to concentrations of credit
  risk consist principally of cash and cash equivalents, marketable securities
  and trade receivables.                                                                                                                                                                                                                                                                                                                                                                                                                               

- 17 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The majority
  of the Companys cash and cash equivalents are invested in U.S. dollar
  deposits with major banks in Israel, the United States, Japan, Germany, the
  Netherlands, United Kingdom, Spain and France. Management believes that the
  financial institutions that hold the Companys investments are financially
  sound and accordingly, minimal credit risk exists with respect to these
  investments. Such cash and cash equivalents in the United States may be in
  excess of insured limits and are not insured in other jurisdictions.                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The
  Companys marketable securities include investments in U.S. Government
  Auction rate, Bonds And Equity securities. Management believes that minimal
  credit risk exists with respect to these marketable securities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The trade
  receivables of the Company and its subsidiaries are derived from sales to
  customers located primarily in the United States, Europe, Japan and Israel.
  The Company performs ongoing credit evaluations of its customers and, to date
  has not experienced any material losses. An allowance for doubtful accounts
  is determined with respect to those amounts that the Company has determined
  to be doubtful of collection, on a specific account basis.                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The doubtful
  accounts expenses for the years ended December 31, 2004, 2005 and 2006 were
  $ 194, $ 114 and $ 208, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Basic and diluted earnings per share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Basic
  earnings per share are computed based on the weighted average number of Ordinary
  shares outstanding during each year. Diluted earnings per share are computed
  based on the weighted average number of Ordinary shares outstanding during
  each year, plus dilutive potential Ordinary shares considered outstanding
  during the year, in accordance with Statement of Financial Accounting
  Standards No. 128, Earnings per Share (SFAS No. 128).                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | The total
  weighted average number of outstanding options excluded from the calculations
  of diluted earnings per share was 0, 90,925 and 182,670 for the years ended
  December 31, 2004, 2005 and 2006, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | Accounting for stock-based compensation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         | On January
  1, 2006, the Company adopted Statement of Financial Accounting Standards No.
  123 (revised 2004), Share-Based Payment (SFAS 123(R)) which requires the
  measurement and recognition of compensation expense based on estimated fair
  values for all share-based payment awards made to employees and directors.
  SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting
  for Stock Issued to Employees (APB 25), under which the Company previously
  accounted for its share based awards granted to employees and directors, for
  periods beginning in fiscal 2006. In March 2005, the Securities and Exchange
  Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to
  SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption
  of SFAS 123(R).

- 18 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | SFAS 123(R)
  requires companies to estimate the fair value of equity-based payment awards
  on the date of grant using an option-pricing model. The value of the portion
  of the award that is ultimately expected to vest is recognized as an expense
  over the requisite service periods in the Companys consolidated income
  statement. Prior to the adoption of SFAS 123(R), the Company accounted for
  equity-based awards to employees and directors using the intrinsic value
  method in accordance with APB 25 as allowed under Statement of Financial
  Accounting Standards No. 123, Accounting for Stock-Based Compensation
  (SFAS 123).                                                                                                                                           
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  adopted SFAS 123(R) using the modified prospective transition method, which
  requires the application of the accounting standard starting from January 1,
  2006, the first day of the Companys fiscal year 2006. Under that transition
  method, compensation cost recognized in 2006, includes: (a) compensation cost
  for all share-based payments granted prior to, but not yet vested as of
  January 1, 2006, based on the grant date fair value estimated in accordance
  with the original provisions of Statement 123, and (b) compensation cost for
  all share-based payments granted starting from January 1, 2006, based on the
  grant-date fair value estimated in accordance with the provisions of
  Statement 123(R). Results for prior periods have not been restated.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The Company
  recognizes compensation expenses for the value of its awards, which have
  graded vesting, based on the accelerated attribution method over the vesting
  period, net of estimated forfeitures. Estimated forfeitures are based on
  actual historical pre-vesting forfeitures.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | As a result
  of adopting SFAS 123(R) on January 1, 2006, the Companys income before income
  taxes for 2006, is $ 2,253 lower than if it had continued to account for
  stock-based compensation under APB 25. Net income and net income after tax
  for year ended December 31, 2006, was $ 2,253 lower, than if the Company had
  continued to account for stock-based compensation under APB No. 25. Basic and
  diluted net earnings per share for 2006, are $ 0.15 per share lower, than if
  the Company had continued to account for share-based compensation under APB
  25.                                                                                                                                                                                                                    
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | Prior to
  January 1, 2006, the Company applied the intrinsic value method of accounting
  for stock options as prescribed by APB 25, whereby compensation expense is
  equal to the excess, if any, of the quoted market price of the stock over the
  exercise price at the grant date of the award.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|         | The
  Pro-forma table below illustrates the effect of the Companys stock based
  compensation expense on net income and basic and diluted earnings per share
  for 2005 and 2004, had the Company applied the fair value recognition
  provisions of SFAS 123, as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

- 19 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                            
|-------- | -------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)    
|         |                                            
|         | Pro forma
  information under SFAS No. 123:

|                                                         |  |                           |       |      |   |        | 
|-------------------------------------------------------- |  | ------------------------- | ----- | ---- | - | ------ | 
|                                                         |  | Year ended
  December 31, |      
|                                                         |  |                           |      
|                                                         |  | 2004                      |       | 2005 |  
|                                                         |  |                           |       |      |  
|                                                         |  |                           |       |      |   |        | 
|Net income - as reported                                 |  | $                         | 8,788 |      | $ | 12,356 | 
|Add: stock-based employee
  compensation intrinsic value |  |                           | 148   |      |   | 51     | 
|Deduct: stock-based employee
  compensation - fair value |  |                           | 1,059 |      |   | 1,659  | 
|                                                         |  |                           |       |      |   |        | 
|                                                         |  |                           |       |      |   |        | 
|Pro forma net income:                                    |  | $                         | 7,877 |      | $ | 10,748 | 
|                                                         |  |                           |       |      |   |        | 
|                                                         |  |                           |       |      |   |        | 
|Net earnings per share:                                  |  |                           |       |      |   |        | 
|                                                         |  |                           |       |      |   |        | 
|Basic net earnings per
  Ordinary share, as reported     |  | $                         | 0.74  |      | $ | 0.89   | 
|                                                         |  |                           |       |      |   |        | 
|                                                         |  |                           |       |      |   |        | 
|Diluted net earnings per
  Ordinary share, as reported   |  | $                         | 0.68  |      | $ | 0.85   | 
|                                                         |  |                           |       |      |   |        | 
|                                                         |  |                           |       |      |   |        | 
|Basic pro forma net earnings
  per Ordinary share        |  | $                         | 0.66  |      | $ | 0.77   | 
|                                                         |  |                           |       |      |   |        | 
|                                                         |  |                           |       |      |   |        | 
|Diluted pro forma net
  earnings per Ordinary share      |  | $                         | 0.61  |      | $ | 0.74   | 
|                                                         |  |                           |       |      |   |        | 

| |                                                                                                                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The fair
  value for options granted in 2004, 2005 is amortized over their vesting
  period and estimated at the date of grant using the Black-Scholes-Merton
  options pricing model with the following weighted average assumptions:

|                               |  |                         |           |      |  |         | 
|------------------------------ |  | ----------------------- | --------- | ---- |  | ------- | 
|                               |  | Year ended December 31, |          
|                               |  |                         |          
|                               |  | 2004                    |           | 2005 | 
|                               |  |                         |           |      | 
|                               |  |                         |           |      |  |         | 
|Expected dividend yield        |  |                         | 0%        |      |  | 0%      | 
|Expected volatility            |  |                         | 75.4%     |      |  | 78.9%   | 
|Risk-free interest rate        |  |                         | 2.8%      |      |  | 3.9%    | 
|Average Expected life of up to |  |                         | 4.5 years |      |  | 6 years | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Pro-forma
  compensation expense under SFAS 123, among other computational differences,
  does not consider potential pre-vesting forfeitures. Because of these
  differences, the pro-forma stock based compensation expense presented above
  for the prior years ended December 31 2004 and 2005 under SFAS 123 and the
  stock based compensation expense recognized during the current year ended
  December 31 2006 under SFAS 123(R) are not directly comparable.

- 20 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         | The Company
  estimates the fair value of stock options granted using the
  Black-Scholes-Merton option-pricing model. The option-pricing model requires
  a number of assumptions, of which the most significant are, expected stock
  price volatility, and the expected option term. Expected volatility was
  calculated based upon actual historical stock price movements over the most
  recent periods ending December 31, 2006, equal to the expected option term.
  The expected option term represents the period that the Companys stock
  options are expected to be outstanding and was determined based on historical
  experience of similar options, giving consideration to the contractual terms
  of the stock options. The Company has historically not paid dividends and has
  no foreseeable plans to issue dividends. The risk-free interest rate is based
  on the yield from U.S. Treasury zero-coupon bonds with an equivalent term.
  The following weighted assumptions were used in the model for 2006:

|                        |  |          
|----------------------- |  | ---------
|                        |  | 2006     
|                        |  |          
|                        |  |          
|Expected dividend yield |  | 0%       
|Expected volatility     |  | 67.3%    
|Risk-free interest rate |  | 4.6%     
|Expected option term    |  | 4.5 years
|Forfeiture rate         |  | 3.3%     

| |                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | During the year ended December 31 2006, the Company recognized
  stock-based compensation expense related to employee stock options in the
  amount of $ 2,268, as follows:

|                                         |  |                                  |       | 
|---------------------------------------- |  | -------------------------------- | ----- | 
|                                         |  | Year ended
  December 31,
  2006 |      
|                                         |  |                                  |      
|                                         |  |                                  |       | 
|Cost of
  revenue                        |  | $                                | 43    | 
|Research and
  development               |  |                                  | 666   | 
|Selling and
  marketing                  |  |                                  | 732   | 
|General and
  administrative             |  |                                  | 827   | 
|                                         |  |                                  |       | 
|                                         |  |                                  |       | 
|Total
  Stock-based compensation expense |  | $                                | 2,268 | 
|                                         |  |                                  |       | 

| |                                                                                                                                                                                          
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | During the
  years ended December 31 2004 and 2005, the Company recognized general and
  administrative stock-based compensation expense in the amount of $ 148 and
  $ 51, respectively.

- 21 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | Fair value of financial instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | The
  following methods and assumptions were used by the Company and its
  subsidiaries in estimating their fair value disclosures for financial
  instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | 1.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | The carrying
  amount of cash and cash equivalents, trade receivables, other accounts
  receivable, trade payables and other accounts payable approximates their fair
  values due to the short-term maturities of these instruments.
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | 2.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | The fair
  value of short-term marketable securities is based on quoted market prices.                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | 3.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | The fair
  value of derivative instruments is estimated by obtaining quotes from
  brokers.                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | Treasury Shares:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | The Company
  repurchases its Ordinary shares from time to time on the open market and
  holds such shares as Treasury shares. The Company presents the cost of
  repurchased Treasury shares as a reduction in shareholders equity. Upon
  reissuance of shares of treasury stock, the Company charges the excess of the
  repurchase cost over issuance price using the weighted-average method to retained earnings.                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | Derivative instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | The Company
  has instituted a foreign currency cash flow hedging program using put and
  call options to hedge against the risk of overall changes in cash flows
  resulting from forecasted foreign currency sales during the year. These
  option contracts are designated as cash flow hedges, as defined by Financial
  Accounting Standards Board Statement No. 133, Accounting for Derivative
  Instruments and Hedging Activities (SFAS 133).                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | SFAS 133
  requires companies to recognize all of its derivative instruments as either
  assets or liabilities in the statement of financial position at fair value.
  The accounting for changes in the fair value (i.e., gains or losses) of a
  derivative instrument depends on whether it has been designated and qualifies
  as part of a hedging relationship and further, on the type of hedging
  relationship.                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | For those
  derivative instruments that are designated and qualify as hedging
  instruments, the company must designate the hedging instrument, based upon
  the exposure being hedged, as a fair value hedge, cash flow hedge or a hedge
  of a net investment in a foreign operation.                                                                                                                                                                                                                                                                                                                                                                                                                
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                                      
|         | For
  derivative instruments that are designated and qualify as a cash flow hedge
  (i.e., hedging the exposure to variability in expected future cash flows that
  is attributable to a particular risk), the effective portion of the gain or
  loss on the derivative instrument is reported as a component of other
  comprehensive loss and reclassified into earnings in the same period or
  periods during which the hedged transaction affects earnings. The remaining
  gain or loss on the derivative instrument in excess of the cumulative change
  in the present value of future cash flows of the hedged item, if any, is
  recognized in current earnings during the period of change.

- 22 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 2:- | SIGNIFICANT ACCOUNTING POLICIES (Cont.)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | All other
  derivatives which do not qualify for hedge accounting under FAS 133, are
  recognized on the balance sheet at their fair value, with changes in the fair
  value carried to the statements of income included in the financial expenses.                                                                                                                                                                                                                                                                                                                                                                                                                          
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | The Company
  recognized net income (loss) from derivative instruments of $ (437), $ 324 and
  $ 12 during the years ended December 31, 2004, 2005 and 2006, respectively. The
  amount of $ (203), ($ 132) and ($ 23) were offset against the revenues in the
  statement of income during the years ended December 31, 2004, 2005 and 2006,
  respectively and an amount of $ (234), $ 456 and $ 35 was included in financial
  income, net, during the years ended December 31, 2004, 2005 and 2006,
  respectively.                                                                                                                                                       
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | The balance
  in accumulated other comprehensive loss related to derivative instruments as
  of December 31, 2006 is expected to be recognized in earnings over the next
  year.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | Impact of recently issued accounting standards:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | In September
  2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS No.
  157). SFAS No. 157 defines fair value, establishes a framework for measuring
  fair value in generally accepted accounting principles and expands disclosures
  about fair value measurements. SFAS No. 157 is effective for financial
  statements issued for fiscal years beginning after November 15, 2007 and
  interim periods within those fiscal years. The Company is currently
  evaluating the impact that SFAS No. 157 will have on its consolidated
  financial statements.                                                                                            
|         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|         | In February
  2007, the FASB issued SFAS No. 159 (SFAS No. 159). SFAS No. 159 permits
  companies to choose to measure certain financial instruments and certain
  other items at fair value. SFAS No. 159 requires that unrealized gains and
  losses on items for which the fair value option has been elected be reported
  in earnings. SFAS No. 159 is effective for financial statements issued for
  fiscal years beginning after November 15, 2007 and interim periods within
  those fiscal years, although earlier adoption is permitted. The Company is
  currently evaluating the impact that SFAS No. 159 will have on its
  consolidated financial statements.

- 23 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                         
|-------- | ------------------------------------------------------------------------
|NOTE 3:- | MARKETABLE SECURITIES                                                   
|         |                                                                         
|         | The
  following is a summary of available-for-sale marketable securities

|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 
|------------------------- |  | ----------------- | ------ | -------------------------- | - | --------------------------- |  | --------------------------------- | -- |  | - | ------ | 
|                          |  | December 31, 2006 |       
|                          |  |                   |       
|                          |  | Cost              |        | Gross
  unrealized
  gains |   | Gross
  unrealized
  losses |  | Estimated
  fair
  market
  value |   
|                          |  |                   |        |                            |   |                             |  |                                   |   
|                          |  |                   |        |                            |   |                             |  |                                   |   
|Government
  bonds        |  | $                 | 24,089 |                            | $ | 80                          |  | $                                 | 22 |  | $ | 24,147 | 
|Auction rate
  securities |  |                   | 27,000 |                            |   |                            |  |                                   |   |  |   | 27,000 | 
|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 
|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 
|                          |  | $                 | 51,089 |                            | $ | 80                          |  | $                                 | 22 |  | $ | 51,147 | 
|                          |  |                   |        |                            |   |                             |  |                                   |    |  |   |        | 

|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 
|------------------------- |  | ----------------- | ------ | -------------------------- | - | --------------------------- |  | --------------------------------- | --- |  | - | ------ | 
|                          |  | December 31, 2005 |       
|                          |  |                   |       
|                          |  | Cost              |        | Gross
  unrealized
  gains |   | Gross
  unrealized
  losses |  | Estimated
  fair
  market
  value |    
|                          |  |                   |        |                            |   |                             |  |                                   |    
|                          |  |                   |        |                            |   |                             |  |                                   |    
|Government
  bonds        |  | $                 | 27,110 |                            | $ |                            |  | $                                 | 201 |  | $ | 26,909 | 
|Equity
  securities       |  |                   | 927    |                            |   | 479                         |  |                                   |    |  |   | 1,406  | 
|Auction rate
  securities |  |                   | 20,500 |                            |   |                            |  |                                   |    |  |   | 20,500 | 
|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 
|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 
|                          |  | $                 | 48,537 |                            | $ | 479                         |  | $                                 | 201 |  | $ | 48,815 | 
|                          |  |                   |        |                            |   |                             |  |                                   |     |  |   |        | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In November
  2004 and July 2005, the Company invested in U.S. government bonds with
  maturities of up to three and two years, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | In June and
  July 2006 the Company sold its investments in equity securities for total
  consideration of $ 1,372. The net adjustment to unrealized gains (losses) on
  available-for-sale marketable securities was included as a separate component
  of shareholders equity accumulated other comprehensive income (loss) and
  amounted to $ 223, $ (302) and $ (56) in 2004, 2005 and 2006 respectively.                                                                                                                                                                                                                                                                                                                      
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | According to
  Staff Accounting Bulletin No. 59 (SAB No. 59) and EITF 03-1, The Meaning
  of Other-Than-Temporary Impairment and Its Application to Certain
  Investments, for any marketable securities whose value declined during the
  period, management is required to evaluate whether the decline is other than
  temporary. In 2005, a decline in value that was considered other than
  temporary of one of the Companys available-for-sale securities resulting in
  reversing the accumulated unrealized loss of $ 117 relating to these
  investments. The amount was classified as financial expenses in the
  consolidated statements of income as of December 31, 2005. In 2006, no such
  decline was identified.

- 24 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                          
|-------- | -----------------------------------------------------------------------------------------
|NOTE 3:- | MARKETABLE SECURITIES (Cont.)                                                            
|         |                                                                                          
|         | Aggregate
  maturities of Government bonds for years subsequent to December 31, 2006 are:

|     |  |               |        |                                  |   |        | 
|---- |  | ------------- | ------ | -------------------------------- | - | ------ | 
|     |  | Amortizedcost |        | Estimated
  fair 
  market value |  
|     |  |               |        |                                  |  
|     |  |               |        |                                  |   |        | 
|2007 |  | $             | 24,206 |                                  | $ | 24,147 | 
|     |  |               |        |                                  |   |        | 

|         |                                               
|-------- | ----------------------------------------------
|NOTE 4:- | OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES

|                         |  |              |       |      |   |       | 
|------------------------ |  | ------------ | ----- | ---- | - | ----- | 
|                         |  | December 31, |      
|                         |  |              |      
|                         |  | 2005         |       | 2006 |  
|                         |  |              |       |      |  
|                         |  |              |       |      |  
|Loans to employees       |  | $            | 191   |      | $ | 376   | 
|Prepaid expenses         |  |              | 1,877 |      |   | 2,361 | 
|Government
  authorities |  |              | 955   |      |   | 1,114 | 
|Advances for
  suppliers |  |              | 205   |      |   | 200   | 
|Other                    |  |              | 289   |      |   | 202   | 
|                         |  |              |       |      |   |       | 
|                         |  |              |       |      |   |       | 
|                         |  | $            | 3,517 |      | $ | 4,253 | 
|                         |  |              |       |      |   |       | 

|         |            
|-------- | -----------
|NOTE 5:- | INVENTORIES

|                                         |  |              |       |      |   |       | 
|---------------------------------------- |  | ------------ | ----- | ---- | - | ----- | 
|                                         |  | December 31, |      
|                                         |  |              |      
|                                         |  | 2005         |       | 2006 |  
|                                         |  |              |       |      |  
|                                         |  |              |       |      |  
|Raw
  materials, parts and supplies, net |  | $            | 3,047 |      | $ | 3,169 | 
|Work-in-progress                         |  |              | 1,431 |      |   | 1,253 | 
|Finished
  products                      |  |              | 2,520 |      |   | 2,877 | 
|                                         |  |              |       |      |   |       | 
|                                         |  |              |       |      |   |       | 
|                                         |  | $            | 6,998 |      | $ | 7,299 | 
|                                         |  |              |       |      |   |       | 

| |                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------
| | A write-off
  in the amount of $ 275, $ 422 and $ 336 was made by the Company in the years
  2004, 2005 and 2006 respectively.

- 25 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                              
|-------- | -----------------------------
|NOTE 6:- | INVESTMENT IN OTHER COMPANIES

|                                                              |  |              |         |      |   |          | 
|------------------------------------------------------------- |  | ------------ | ------- | ---- | - | -------- | 
|                                                              |  | December 31, |        
|                                                              |  |              |        
|                                                              |  | 2005         |         | 2006 |  
|                                                              |  |              |         |      |  
|Investment in Tamir Fishman Ventures II,
  LLC (see a below)  |  | $            | *)5,299 |      | $ | *) 4,413 | 
|Investment in IDesia.Ltd. (see b below)                       |  |              | 1,100   |      |   | 1,100    | 
|Investment in Athena Smartcard solutions
  Ltd. (see c below) |  |              |        |      |   | 250      | 
|                                                              |  |              |         |      |   |          | 
|                                                              |  |              |         |      |   |          | 
|                                                              |  | $            | 6,399   |      | $ | 5,763    | 
|                                                              |  |              |         |      |   |          | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | *) | Net of
  impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | a. | Investment
  in Tamir Fishman Ventures II, LLC                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | Through
  December 31, 2006, the Company had invested an aggregate amount of $ 8,097 in
  Tamir Fishman Ventures II, LLC (Tamir Fishman). The Company does not have
  the ability to exercise significant influence and therefore the investment
  was stated at cost. See also Note 11c regarding the Companys commitment to
  make additional investments in Tamir Fishman.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | During 2004,
  2005 and 2006, based on managements most recent analysis, no impairment
  losses have been identified.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | In 2005 and
  2006, as a result of exit transactions for portfolio companies of Tamir
  Fishman, the Company received a distribution of $ 910 and $ 1,736 in cash. Distributions received in 2005 and 2006 were recorded as a return of
  investment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | b. | Investment
  in IDesia Ltd..                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |    | In April
  2004, the Company entered into a convertible loan agreement with IDesia Ltd.
  (IDesia), an Israeli company engaged in the development of biometric
  identity recognition technology. Pursuant to the agreement, the Company
  invested an aggregate amount of $ 1,100 in IDesia (including expenses in the
  amount of $ 50). This investment consisted of a $ 550 convertible loan (the
  Convertible Loan), which would automatically converted into Series A
  preferred shares of IDesia upon the achievement of certain agreed upon
  milestones. Concurrently with the conversion of the loan, the Company
  invested the additional $ 500 by purchasing additional Series A preferred
  shares of IDesia. At December 31, 2004, the Company owned 19.9% of the share
  capital of IDesia. and accounted for this investment under the cost method.

- 26 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                      
|-------- | -------------------------------------
|NOTE 6:- | INVESTMENT IN OTHER COMPANIES (Cont.)

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |    | During the
  fourth quarter of 2005 IDesia entered into a new Convertible Series A
  Preferred Share Purchase Agreement (the SPA) with a new third party
  investor (the Investor). At the Closing of the SPA, IDesia issued to the
  Company, for no additional consideration, additional Convertible Series A
  Preferred Shares, in such way that the aggregate number of Preferred Shares
  held by the Company at the original 2004 investment of $ 1,050 represents
  27.04% of the share capital of IDesia. The investment is stated at cost,
  since the investment in Preferred shares is not in-substance Common stock
  (see Note 2).                                                                                                                                                                                                                                                                                                            
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | In October
  2005, the Company signed a license and OEM agreement with IDesia. Under this
  agreement IDesia will develop, manufacture, provide and license to the
  Company certain Chip-Sets as specified in the agreement. According to the
  agreement the Company advanced IDesia $ 200 in consideration for the
  Chip-Sets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | c. | Investment
  in Athena Smartcard Solutions Ltd.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | In November 2006 the Company entered into
  an agreement with K.K. Athena Smartcard Solutions Ltd., a Japanese company
  (Athena), whereby the Company was granted an option allowing it to invest
  up to $ 745 in Athena at any time until June 30, 2007, in consideration for
  the issuance of shares of Athena. The option is exercisable in three
  instalments of $ 248 each. Each instalment represents 2.3% of Athenas
  fully diluted share capital. If the Company will complete the three
  instalments, it will hold 27.9% of Athenas share capital.
  An exercise notice for the first instalment was submitted by Aladdin upon
  signing of the agreement. As of December 31, 2006, the Company holds 23.5% of
  Athenas share capital (see Note 2).The Company has invested in
  Athena previously but Athena has incurred losses over the years and Aladdin
  has accordingly reduced its investments and loans in Athena to zero in 2004.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |    | In October
  2006, the Company entered into License Agreement with Athena. Pursuant to
  this agreement Athena granted Aladdin a worldwide perpetual non revocable,
  transferable, non-exclusive license to use any intellectual property rights,
  including without limitation patents, trade secrets, trademarks and
  copyrights in the Licensed Software for the amount of $ 250. Aladdin can
  solely use the license and market, sublicense, distribute and sell it as
  embedded in or integrated with the Aladdin products. The Company recorded
  this amount in the prepaid expenses according to the relative fair value.                                                                                                                                                                                                                                                                                                                          

- 27 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                            
|-------- | ---------------------------
|NOTE 7:- | PROPERTY AND EQUIPMENT, NET

|                                   |  |                |        |      |   |        | 
|---------------------------------- |  | -------------- | ------ | ---- | - | ------ | 
|                                   |  | December
  31, |       
|                                   |  |                |       
|                                   |  | 2005           |        | 2006 |  
|                                   |  |                |        |      |  
|Cost:                              |  |                |        |      |   |        | 
|Computers and peripheral equipment |  | $              | 13,136 |      | $ | 14,927 | 
|Office furniture and equipment     |  |                | 1,971  |      |   | 2,363  | 
|Motor vehicles                     |  |                | 462    |      |   | 301    | 
|Leasehold improvements             |  |                | 1,657  |      |   | 3,732  | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                | 17,226 |      |   | 21,323 | 
|                                   |  |                |        |      |   |        | 
|Accumulated depreciation:          |  |                |        |      |   |        | 
|Computers and peripheral equipment |  |                | 11,367 |      |   | 12,463 | 
|Office furniture and equipment     |  |                | 1,453  |      |   | 1,576  | 
|Motor vehicles                     |  |                | 258    |      |   | 174    | 
|Leasehold improvements             |  |                | 1,067  |      |   | 1,415  | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                | 14,145 |      |   | 15,628 | 
|                                   |  |                |        |      |   |        | 
|                                   |  |                |        |      |   |        | 
|Depreciated cost                   |  | $              | 3,081  |      | $ | 5,695  | 
|                                   |  |                |        |      |   |        | 

|         |                                                                                                                                       
|-------- | --------------------------------------------------------------------------------------------------------------------------------------
|         | Depreciation
  expenses for the years ended December 31, 2004, 2005 and 2006 amounted to
  $ 1,463, $ 1,409 and $ 1,833, respectively.
|         |                                                                                                                                       
|NOTE 8:- | INTANGIBLE ASSETS, NET                                                                                                                
|         |                                                                                                                                       
|         | a.                                                                                                                                    

|                                |  |                |       |      |   |       | 
|------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|                                |  | December
  31, |      
|                                |  |                |      
|                                |  | 2005           |       | 2006 |  
|                                |  |                |       |      |  
|Subject
    to amortization     |  |                |       |      |   |       | 
|Cost:                           |  |                |       |      |   |       | 
|Current technology (1)          |  | $              | 1,054 |      | $ | 1,054 | 
|Customer list (2)               |  |                | 1,151 |      |   | 1,151 | 
|Domain name (3)                 |  |                | 430   |      |   | 430   | 
|Patent (4)                      |  |                | 550   |      |   | 550   | 
|Educational products (5)        |  |                |      |      |   | 2,508 | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|                                |  |                | 3,185 |      |   | 5,693 | 
|                                |  |                |       |      |   |       | 
|Accumulated amortization:       |  |                |       |      |   |       | 
|Current technology (1)          |  |                | 933   |      |   | 1,054 | 
|Customer list (2)               |  |                | 246   |      |   | 410   | 
|Domain names (3)                |  |                | 223   |      |   | 358   | 
|Patent (4)                      |  |                | 288   |      |   | 326   | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|                                |  |                | 1,690 |      |   | 2,148 | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|Amortized cost                  |  | $              | 1,495 |      | $ | 3,545 | 
|                                |  |                |       |      |   |       | 
|                                |  |                |       |      |   |       | 
|Not
    subject to amortization |  |                |       |      |   |       | 
|Cost:                           |  |                |       |      |   |       | 
|Domain name (6)                 |  |                | 500   |      |   | 500   | 
|                                |  |                |       |      |   |       | 
|Intangible assets, net          |  |                | 1,995 |      |   | 4,045 | 
|                                |  |                |       |      |   |       | 

- 28 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                               
|-------- | ------------------------------
|NOTE 8:- | INTANGIBLE ASSETS, NET (Cont.)

| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Current
  technology - is being amortized over a period of five years and was fully
  amortized in 2006                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (2) | Customer
  list - is being amortized over a period of seven years and will be fully
  amortized in 2011. See also Note 1b for the acquisition of Aladdin Espana.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (3) | Domain names
  - On May 27,
  2004, the Company and Aladdin Systems Holdings Inc. (ASH) entered into a
  settlement agreement (the Agreement). Under the terms of the Agreement, the
  Company agreed to pay ASH $ 550 for the purchase of domain names and for
  reimbursing ASH for the cost of implementing a name change and a re-branding.
  As a result of the Agreement, the Company recorded an amount of $ 430 which
  relates to the acquired domain names, which will be amortized over a period
  of 3 years (will be fully amortized in 2007). The allocation of the
  intangible assets acquired in the Agreement was determined by the Company
  which was assisted by a third-party valuation firm. Out of the $ 550, the
  Company recorded in 2004 an amount of $ 120 as general and administrative
  expenses.
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (4) | Patent - is
  being amortized over its useful life and will be fully amortized in 2012.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (5) | As of
  December 31, 2006 the Company has accumulated a total amount of approximately
  $ 2,508 in direct expenses for developing and producing Training in regards to
  certain tender.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | (6) | In November
  2004, the Company purchased the URL Aladdin.com for the amount of $ 500.
  According to management, this asset is deemed to have an indefinite useful
  life and is being reviewed annually for impairment.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

| |    |                                                                                                                                  
| | -- | ---------------------------------------------------------------------------------------------------------------------------------
| | b. | Amortization
  expenses for the years ended December 31, 2004, 2005 and 2006, amounted to
  $ 609, $ 558 and $ 458, respectively.
| |    |                                                                                                                                  
| | c. | Estimated
  amortization expenses for the next five years:                                                                       

|2007 |  | $ | 756   | 
|---- |  | - | ----- | 
|2008 |  |   | 1,041 | 
|2009 |  |   | 1,041 | 
|2010 |  |   | 553   | 
|2011 |  |   | 133   | 
|     |  |   |       | 

- 29 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|         |                                                                                                                                                                                                                                              
|-------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 9:- | GOODWILL                                                                                                                                                                                                                                     
|         |                                                                                                                                                                                                                                              
|         | As fully
  discussed in Note 14, the Company operates in two operating segments which
  are also considered by management as the Companys reporting units. The
  carrying amount of goodwill as of December 31, 2005 and 2006 is as follows:

|                                           |  |   |                                       |  |   |                                 |  |   |       | 
|------------------------------------------ |  | - | ------------------------------------- |  | - | ------------------------------- |  | - | ----- | 
|                                           |  |   | Software
  Security
  (DRM)
  segment |  |   | Enterprise
  Security
  segment |  |   | Total | 
|                                           |  |   |                                       |  |   |                                 |  |   |       | 
|Balance as
  of December 31, 2005 and 2006 |  | $ | 6,845                                 |  | $ | 840                             |  | $ | 7,685 | 
|                                           |  |   |                                       |  |   |                                 |  |   |       | 

|          |                                                |                                                                                                                                     
|--------- | ---------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------
|          |                                                | Goodwill acquired was allocated to reporting units based on the
  expected benefits of the business acquired to each reporting unit.
|          |                                                |                                                                                                                                     
|NOTE 10:- | ACCRUED EXPENSES AND OTHER ACCOUNTS
  PAYABLES

|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
|                                                                                                                                                                                                     |  | December
  31, |      
|                                                                                                                                                                                                     |  |                |      
|                                                                                                                                                                                                     |  | 2005           |       | 2006 |  
|                                                                                                                                                                                                     |  |                |       |      |  
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|Employees
  and payroll accruals                                                                                                                                                                     |  | $              | 4,215 |      | $ | 4,434 | 
|Income taxes
  payable                                                                                                                                                                               |  |                | 2,429 |      |   | 2,535 | 
|Accrued
  expenses *)                                                                                                                                                                                |  |                | 1,072 |      |   | 1,649 | 
|Deferred tax
  liability and other                                                                                                                                                                   |  |                | 83    |      |   |      | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|                                                                                                                                                                                                     |  | $              | 7,799 |      | $ | 8,618 | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 
|*) Accrued expenses as of December 31, 2006 include a sum of $374 which reflects
  participation in leashold improvement, the Company classified an amount of $1,369 as other long term liabilities. | 
|                                                                                                                                                                                                     |  |                |       |      |   |       | 

|          |                                        |                                                                                                                                                                                      
|--------- | -------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 11:- | COMMITMENTS AND CONTINGENT LIABILITIES
|          |                                        |                                                                                                                                                                                      
|          | a.                                     | Lease
  commitments:                                                                                                                                                                 
|          |                                        |                                                                                                                                                                                      
|          |                                        | The
  Companys and its subsidiaries premises and motor vehicles are leased under
  various operating lease agreements which expire on various dates, the latest
  of which is 2011.
|          |                                        |                                                                                                                                                                                      
|          |                                        | Minimum
  lease commitments, under non-cancelable leases as of December 31, 2006, are
  as follows:                                                                                  

|                          |  |            |       |                  |   |       |  |   |       | 
|------------------------- |  | ---------- | ----- | ---------------- | - | ----- |  | - | ----- | 
|                          |  | Facilities |       | Motor
  vehicles |   | Total | 
|                          |  |            |       |                  |   |       | 
|Year ended
  December, 31 |  |            |       |                  |   |       |  |   |       | 
|2007                      |  | $          | 2,044 |                  | $ | 1,122 |  | $ | 3,166 | 
|2008                      |  |            | 1,622 |                  |   | 756   |  |   | 2,378 | 
|2009                      |  |            | 1,548 |                  |   | 277   |  |   | 1,825 | 
|2010                      |  |            | 1,255 |                  |   | 2     |  |   | 1,257 | 
|2011                      |  |            | 834   |                  |   |      |  |   | 834   | 
|Later years               |  |            | 79    |                  |   |      |  |   | 79    | 
|                          |  |            |       |                  |   |       |  |   |       | 
|                          |  |            |       |                  |   |       |  |   |       | 
|                          |  | $          | 7,382 |                  | $ | 2,157 |  | $ | 9,539 | 
|                          |  |            |       |                  |   |       |  |   |       | 

- 30 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--------- | ---------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 11:- | COMMITMENTS AND CONTINGENT LIABILITIES (Cont.)
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | Facilities
  lease expenses for the years ended December 31, 2004, 2005 and 2006 were
  approximately $ 1,941, $ 1,785 and $ 2,065, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | Motor
  vehicle lease expenses for the years ended December 31, 2004, 2005 and 2006
  were approximately $ 1,081, $ 1,294 and $ 1,535, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | b.                                             | Litigation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | In April
  2005, the Company settled a patent infringement lawsuit. The lawsuit was
  originally brought by Andrew Pickholtz against the Company and its U.S.
  subsidiary on May 19, 2004 in the U.S. District Court for the Northern
  District of California, alleging that the Companys discontinued MicroGuard
  product and other Software Digital Rights Management products infringed an
  expired patent. An affiliate of Rainbow Technologies was subsequently added
  as a plaintiff.                                                                                                                                     
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | On April 6,
  2005, the parties reached a settlement agreement, under which the Company
  agreed to pay $ 2,000 to settle the lawsuit. The Company recorded the
  settlement cost as a one-time charge within its operating expenses. There
  will be no ongoing license or other fees payable by the Company in connection
  with the settlement.                                                                                                                                                                                                                                                                                    
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | c.                                             | Investment
  commitment:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | In February
  2000, the Company signed an agreement with Tamir Fishman. Pursuant to the
  agreement, the Company committed to invest up to $8,525 on demand from Tamir
  Fishman, out of which, as of December 31, 2006, the Company had already
  invested $ 8,097                                                                                                                                                                                                                                                                                                                                                                   
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|NOTE 12:- | TAXES ON INCOME                               
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | a.                                             | Reduction in
  Israeli tax rates:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | In June 2004
  and in July 2005, the Knesset (Israeli parliament) passed amendments to the
  Income Tax Ordinance (No. 140 and Temporary Provision), 2004 and (No. 147),
  2005 respectively, which determine, among other things, that the corporate
  tax rate is to be gradually reduced to the following tax rates: 2004 - 35%,
  2005 - 34%, 2006 - 31%, 2007 - 29%, 2008 - 27%, 2009 - 26% and 2010 and
  thereafter - 25%.                                                                                                                                                                                                   
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | b.                                             | Tax benefits
  under the Law for the Encouragement of Capital Investments, 1959 (the Law):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|          |                                                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                | The
  Companys production facilities have been granted Approved Enterprise
  status under the Law currently under seven separate investment programs.
  Pursuant to the Law, the Company has elected the alternative benefits track
  and has waived Government grants in return for a tax exemption. The main
  benefit arising from such status is the reduction in tax rates on income
  derived from Approved Enterprises. Consequently, the Company is entitled to
  a two-year tax exemption and five to eight years of tax at a reduced rate of
  10%-25%, based on the percentage of foreign investment in the Company.

- 31 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                
|--------- | ---------------
|NOTE 12:- | TAXES ON INCOME

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | By virtue of
  this law, the Company is entitled to claim accelerated depreciation on
  equipment used by the Approved Enterprise during five tax years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | For the
  Companys seven investment programs, the tax benefits are as follows: Income
  derived from the investment programs, is tax exempt for the first two years
  of the 10-year tax benefit period, and is entitled to a reduced tax rate of
  10%-25% during the remaining benefit period (based on the percentage of
  foreign ownership in each taxable year).                                                                                                                                                                                                                                                                                                                                              
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | The period
  of tax benefits detailed above is subject to time limits of the earlier of 12
  years from commencement of production, or 14 years from receiving the
  approval. Accordingly, the period of benefits relating to all investment
  programs will expire in the years 2005 through 2015.                                                                                                                                                                                                                                                                                                                                                                                                                 
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | In 1996, the
  Company relocated its manufacturing activity to a new plant which was
  established in a region defined as a Priority A Development Region. This
  development region entitles Aladdin Israel to higher tax benefits than the
  tax benefits existing where the Companys offices and research and
  development center are located. The main benefit is that the Company is
  tax-exempt for a benefit period of 10 years.                                                                                                                                                                                                                                                                       
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | The
  allocation of the income tax between the priority regions is calculated by a
  formula that was authorized by Israel Tax Authority.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | On April 1,
  2005, an amendment to the Investment Law came into effect (the Amendment)
  and has significantly changed the provisions of the Investment Law. The
  Amendment limits the scope of enterprises which may be approved by the
  Investment Center by setting criteria for the approval of a facility as a
  Privileged Enterprise, such as provisions generally requiring that at least
  25% of the Privileged Enterprises income will be derived from export.
  Additionally, the Amendment enacted major changes in the manner in which tax
  benefits are awarded under the Investment Law so that companies no longer
  require Investment Center approval in order to qualify for tax benefits.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | However, the
  Investment Law provides that terms and benefits included in any certificate
  of approval already granted will remain subject to the provisions of the law
  as they were on the date of such approval.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | As of
  December 31, 2006, retained earnings included approximately $ 44,016 in
  tax-exempt profits earned by the Companys Approved and Privileged
  Enterprises. The Company has decided not to declare dividends out of such
  tax-exempt income. Accordingly, no deferred income taxes have been provided
  on income attributable to the Companys Approved Enterprise.                                                                                                                                                                                                                                                                                                                                    
| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | If the
  retained tax-exempt income is distributed, it would be taxed at the corporate
  tax rate applicable to such profits as if the Company had not elected the
  alternative tax benefits (10% to 25%) and an income tax liability of up to
  approximately $ 6,602 would be incurred as of December 31, 2006.                                                                                                                                                                                                                                                                                                                                                                                                   

- 32 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--------- | ----------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | The
  entitlement to the above benefits is conditional upon the Companys
  fulfillment of the conditions stipulated by the above law, regulations
  published thereunder and the instruments of approval for the specific
  investments in Approved Enterprises. In the event of failure to comply with
  these conditions, the benefits may be cancelled and the Company may be
  required to refund the amount of the benefits, in whole or in part, including
  interest.                                                                                                                                                                                                                                
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Management
  believes that as of December 31, 2006, the Company met all of the
  aforementioned conditions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Income from
  sources other than the Approved Enterprise during the benefit period will
  be subject to tax at the statutory corporate tax rate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Since the
  Company is operating under more than one approved program and since part of
  its taxable income is not entitled to tax benefits under the aforementioned
  law and is taxed at the statutory corporate tax rate of 31% (see also Note
  12a) its effective tax rate is the result of a weighted combination of the
  various applicable rates and tax exemptions, and the computation is made for
  income derived from each program on the basis of formulas specified in the
  law and in the approvals.                                                                                                                                                                                        
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          | c.                      | Measurement
  of taxable income under the Income Tax (Inflationary Adjustments) Law, 1985:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Until the
  year 2005, results for tax purposes are measured and reflected in real terms
  in accordance with the change in Israels Consumer Price Index (CPI). As
  explained in Note 2, the consolidated financial statements are presented in
  U.S. dollars. The differences between the change in Israelis CPI and in the
  NIS/dollar exchange rate causes a further difference between taxable income
  and the income before taxes reflected in the consolidated financial
  statements. In accordance with paragraph 9(f) of SFAS No. 109, the Company
  has not provided deferred income taxes on the difference between the
  functional currency and the tax bases of assets and liabilities.
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          | d.                      | Measurement
  of taxable income:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          |                         | Commencing
  in taxable year 2006, the Company has elected to measure its taxable income
  and file its tax return under the Israeli Income Tax Regulations (Principles
  Regarding the Management of Books of Account of Foreign Invested Companies
  and Certain Partnerships and the Determination of Their Taxable Income),
  1986.  Accordingly, commencing taxable
  year 2006, results for tax purposes are measured in terms of earnings in
  dollar.                                                                                                                                                                                                                                                  
|          |                         |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|          | e.                      | Tax benefits
  under Israels Law for the Encouragement of Industry (Taxation), 1969:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|         
|          |                         | The Company
  is an Industrial company, as defined by the Law for the Encouragement of
  Industry (Taxes), 1969 and as such, is entitled to certain tax benefits,
  mainly amortization of costs relating to know-how and patents over eight
  years and accelerated depreciation.                                                                                                                                                                                                                                                                                                                                                                                                                           

- 33 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                        
|--------- | -----------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)

| |    |                                               
| | -- | ----------------------------------------------
| | f. | Income
  before taxes is comprised as follows:

|         |  |                         |       |      |   |        |  |   |        | 
|-------- |  | ----------------------- | ----- | ---- | - | ------ |  | - | ------ | 
|         |  | Year ended December 31, |      
|         |  |                         |      
|         |  | 2004                    |       | 2005 |   | 2006   | 
|         |  |                         |       |      |   |        | 
|         |  |                         |       |      |   |        |  |   |        | 
|Domestic |  | $                       | 6,572 |      | $ | 8,809  |  | $ | 13,583 | 
|Foreign  |  |                         | 3,173 |      |   | 4,793  |  |   | 3,147  | 
|         |  |                         |       |      |   |        |  |   |        | 
|         |  |                         |       |      |   |        |  |   |        | 
|         |  | $                       | 9,745 |      | $ | 13,602 |  | $ | 16,730 | 
|         |  |                         |       |      |   |        |  |   |        | 

| |    |                                                                                                                        
| | -- | -----------------------------------------------------------------------------------------------------------------------
| | g. | The income
  tax provision (benefit) for the years ended December 31, 2004, 2005 and 2006
  consisted of the following:

|                                |  |   |     |  |   |       |   |   |       |  
|------------------------------- |  | - | --- |  | - | ----- | - | - | ----- | -
|Current                         |  | $ | 957 |  | $ | 1,785 |   | $ | 3,062 |  
|Taxes in respect of prior years |  |   |    |  |   | 264   |   |   | (9    | )
|Deferred                        |  |   |    |  |   | (803  | ) |   | (354  | )
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  | $ | 957 |  | $ | 1,246 |   | $ | 2,699 |  
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  |   |     |  |   |       |   |   |       |  
|Domestic                        |  | $ | 723 |  | $ | 583   |   | $ | 2,933 |  
|Foreign                         |  |   | 234 |  |   | 663   |   |   | (234  | )
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  |   |     |  |   |       |   |   |       |  
|                                |  | $ | 957 |  | $ | 1,246 |   | $ | 2,699 |  
|                                |  |   |     |  |   |       |   |   |       |  

- 34 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                         |                                                                                                                                                                                                                                                                                                                     
|--------- | ----------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)
|          |                         |                                                                                                                                                                                                                                                                                                                     
|          | h.                      | Deferred
  income taxes:                                                                                                                                                                                                                                                                                            
|          |                         |                                                                                                                                                                                                                                                                                                                     
|          |                         | Deferred
  income taxes reflect the net tax effects of temporary differences between the
  carrying amounts of assets and liabilities for financial reporting purposes
  and the amounts used for income tax purposes. Significant components of the
  Companys deferred tax liabilities and assets are as follows:

|                                                                                |  |              |        |      |   |        |  
|------------------------------------------------------------------------------- |  | ------------ | ------ | ---- | - | ------ | -
|                                                                                |  | December 31, |       
|                                                                                |  |              |       
|                                                                                |  | 2005         |        | 2006 |  
|                                                                                |  |              |        |      |  
|Deferred tax assets (short term):                                               |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Reserves and allowances                                                         |  | $            | 1,202  |      | $ | 1,489  |  
|Net operating loss carry forwards in
  subsidiaries                             |  |              | 9,127  |      |   | 8,924  |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Net deferred tax assets before valuation
  allowance                            |  |              | 10,329 |      |   | 10,413 |  
|Valuation allowance                                                             |  |              | (7,953 | )    |   | (7,292 | )
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Total deferred tax assets                                                       |  |              | 2,376  |      |   | 3,121  |  
|                                                                                |  |              |        |      |   |        |  
|Deferred tax liability from unrealized gain
  on available- for-sale securities |  |              | (53    | )    |   |       |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Total deferred tax liability                                                    |  |              | (53    | )    |   |       |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              |        |      |   |        |  
|Net deferred tax assets                                                         |  | $            | 2,323  |      | $ | 3,121  |  
|                                                                                |  |              |        |      |   |        |  
|Domestic:                                                                       |  |              |        |      |   |        |  
|Current deferred tax asset                                                      |  | $            | 767    |      | $ | 1,013  |  
|Current deferred tax liability, net                                             |  |              | (53    | )    |   |       |  
|Non current deferred tax asset                                                  |  |              | 434    |      |   | 476    |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              | 1,148  |      |   | 1,489  |  
|                                                                                |  |              |        |      |   |        |  
|Foreign:                                                                        |  |              |        |      |   |        |  
|Current deferred tax asset, net                                                 |  |              | 391    |      |   | 514    |  
|Non current deferred tax asset                                                  |  |              | 784    |      |   | 1,118  |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  |              | 1,175  |      |   | 1,632  |  
|                                                                                |  |              |        |      |   |        |  
|                                                                                |  | $            | 2,323  |      | $ | 3,121  |  
|                                                                                |  |              |        |      |   |        |  

| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Current deferred tax
  liability, net, is included within accrued expenses and other liabilities in
  the balance sheets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| |  | In
  assessing the realization of deferred tax assets, management considers whether
  it is more likely than not that all or some portion of the deferred tax
  assets will not be realized. The ultimate realization of the deferred tax
  assets is dependent upon the generation of future taxable income during the
  periods in which temporary differences are deductible and net operating
  losses are utilized. Based on consideration of these factors, the Company has
  established a valuation allowance of $ 7,953 and $ 7,292 at December 31,
  2005 and 2006, respectively.

- 35 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                         |                                                                                                                                                                                                                                                                                                                
|--------- | ----------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 12:- | TAXES ON INCOME (Cont.)
|          |                         |                                                                                                                                                                                                                                                                                                                
|          |                         | The
  Companys subsidiaries in the United Kingdom, Netherlands and Germany have
  estimated total available carry-forward tax losses of $ 1214, $ 2,091 and
  $ 7,906, respectively, to offset against future tax profits for an indefinite
  period.                                                         
|          |                         |                                                                                                                                                                                                                                                                                                                
|          |                         | The
  Companys subsidiaries in the United States and in France have estimated
  total available carry-forward tax losses as of December 31, 2006 of $15,380
  and $321, respectively, to offset against future tax profits for periods of
  15 to 20 years and five years, respectively.                      
|          |                         |                                                                                                                                                                                                                                                                                                                
|          |                         | Utilization
  of U.S. net operating losses may be subject to substantial annual limitations
  due to the change in ownership provisions of the Internal Revenue Code of
  1986 and similar state provisions. The annual limitation may result in the
  expiration of net operating losses before utilization.
|          |                         |                                                                                                                                                                                                                                                                                                                
|          | i.                      | A reconciliation
  between the theoretical tax expense, assuming all income is taxed at the
  statutory tax rate applicable to income of the Company and the actual tax
  expense as reported in the statement of income, is as follows:                                                                       

|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |       |  
|------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------- | ----------------------- | ------ | ----- | - | ------ | ----- | - | ------ | ----- | -
|                                                                                                  |                                                                                       | Year ended December 31, |       
|                                                                                                  |                                                                                       |                         |       
|                                                                                                  |                                                                                       | 2004                    |        | 2005  |   | 2006   |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |      
|Income before taxes, as reported in the
  consolidated statements of income                       |                                                                                       | $                       | 9,745  |       | $ | 13,602 |       | $ | 16,730 |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|Statutory tax rate                                                                                |                                                                                       |                         | 35     | %     |   | 34     | %     |   | 31     | %    
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|Expense computed at the statutory tax rate                                                        |                                                                                       | $                       | 3,411  |       | $ | 4,625  |       | $ | 5,186  |      
|Decrease in taxes resulting from Approved
  Enterprise and Privileged Enterprise benefits (1) |                                                                                       |                         | (353   | )     |   | (1,813 | )     |   | (1,774 | )    
|Tax adjustment in respect of foreign
  subsidiary different tax rate                              |                                                                                       |                         | 20     |       |   | 17     |       |   | (10    | )    
|Change in valuation allowance                                                                     |                                                                                       |                         | (284   | )     |   | 15     |       |   | (661   | )    
|Utilization of loss carry-forward                                                                 |                                                                                       |                         | (1,798 | )     |   | (1,261 | )     |   | (1,001 | )    
|Items for which no deferred tax was recorded                                                      |                                                                                       |                         | (214   | )     |   | (918   | )     |   | (396   | )    
|Taxes in respect of prior years                                                                   |                                                                                       |                         |       |       |   | 264    |       |   | (9     | )    
|Stock compensation relating to options per
  SFAS 123(R)- Non-deductible expenses                 |                                                                                       |                         |       |       |   |       |       |   | 695    |      
|Other non-deductible expenses                                                                     |                                                                                       |                         | 159    |       |   | 320    |       |   | 501    |      
|Other                                                                                             |                                                                                       |                         | 16     |       |   | (3     | )     |   | 168    |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|Actual tax expense                                                                                |                                                                                       | $                       | 957    |       | $ | 1,246  |       | $ | 2,699  |      
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|(1)                                                                                               | Per share amounts (basic) of the tax
  benefit resulting from Approved Enterprise   |                         | $      | (0.03 | ) | $      | (0.13 | ) | $      | (0.12 | )
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |      
|                                                                                                  | Per share amounts (diluted) of the tax
  benefit resulting from Approved Enterprise |                         | $      | (0.03 | ) | $      | (0.12 | ) | $      | (0.12 | )
|                                                                                                  |                                                                                       |                         |        |       |   |        |       |   |        |       |  

- 36 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|--------- | -------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | SHAREHOLDERS EQUITY
|          |                     
|          | a.                   | The Ordinary
  shares confer upon their holders the right to receive notice to participate
  and vote in general meetings of the Company, and the right to receive
  dividends, if declared.                                                                                                                                                                                                                                                                                                                                                                                                            
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | b.                   | In October
  2001, the Company initiated a share repurchase program, in which the Company
  is authorized to purchase up to $ 3,000 of its outstanding Ordinary shares,
  through an open-market transaction. As of December 31, 2002, the Company
  purchased 224,100 of its outstanding Ordinary shares, at a weighted average
  price per share of $ 5.20. During 2004, all the shares were reissued from the
  share repurchase program.                                                                                                                                                            
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Such
  repurchases of Ordinary shares are accounted for as Treasury shares, and
  result in a reduction of shareholders equity. When treasury shares are
  reissued, the Company accounts for the re-issuance in accordance with
  Accounting Principles Board Opinion No. 6 Status of Accounting Research
  Bulletins (APB No. 6) and charges the excess of the repurchase cost over
  issuance price using the weighted average method to retained earnings. In case
  the repurchase cost is lower than the issuance price, the Company credits the
  excess cost to additional paid-in capital.
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | c.                   | In March
  2005, the Company closed its secondary public offering of its Ordinary shares
  on Nasdaq. The Company issued 2,000,000 Ordinary shares, in consideration of
  approximately $ 38,778, net of issuance expenses in the amount of $ 4,127.                                                                                                                                                                                                                                                                                                                                                    
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | d.                   | As a result
  of a grant of 100,000 options to the Companys Chief Executive Officer, the
  Company recorded in 2004 deferred compensation in the amount of $ 153, out of
  which an amount of $ 87, $ 51 and $ 15 was recorded as compensation expenses in
  the years 2004, 2005 and 2006, respectively.                                                                                                                                                                                                                                                                                              
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          | e.                   | Employee
  Share Option Plans:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Between 1993
  and 2006, the Company implemented several Employee Share Options Plans (the
  plans). Total number of options authorized for grant under the plans
  amounted to 3,523,750. As of December 31, 2006, an aggregate of 282,636
  options of the Company are still available for future grants.                                                                                                                                                                                                                                                                                           
|          |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|          |                      | Under the
  Companys plans, full-time employees, officers and directors of the Company
  may be granted options to acquire Ordinary shares. The options granted are at
  an exercise price that equals the fair market value or the price of the
  shares at the date of grant. The options generally vest over a period of two
  to four years from the date of grant, and expire no later than five or ten
  years from the date of grant. Any options that are canceled or forfeited
  before expiration become available for future grants.                                                        

- 37 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                              |                                                                                                                                  
|--------- | ---------------------------- | ---------------------------------------------------------------------------------------------------------------------------------
|NOTE 13:- | SHAREHOLDERS EQUITY (Cont.)
|          |                              |                                                                                                                                  
|          |                              | A summary of
  the Companys stock option activity and related information for the year
  ended December 31, 2006, is as follows:

|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|-------------------------------- |  | -------------------- | --------- | -------------------------------------- | - | ----------------------------------------------------------------- |  | ----------------------------- | ---- |  | - | ----- | 
|                                 |  | Number of 
  options |           | Weighted-
  average
  exercise
  price |   | Weighted-
  average
  remaining
  contractual
  term (in
  years) |  | Aggregate
  intrinsic
  value |     
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |     
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Outstanding at January 1, 2006   |  |                      | 1,089,206 |                                        | $ | 8.81                                                              |  |                               |      |  |   |       | 
|Granted                          |  |                      | 367,400   |                                        | $ | 17.56                                                             |  |                               |      |  |   |       | 
|Exercised                        |  |                      | (198,425  | )                                      | $ | 4.21                                                              |  |                               |      |  |   |       | 
|Forfeited                        |  |                      | (151,050  | )                                      | $ | 15.43                                                             |  |                               |      |  |   |       | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Outstanding at December 31, 2006 |  |                      | 1,107,131 |                                        | $ | 11.63                                                             |  |                               | 7.27 |  | $ | 9,107 | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Vested and expected to vest      |  |                      | 991,951   |                                        | $ | 10.95                                                             |  |                               | 7.12 |  | $ | 8,807 | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 
|Exercisable at December 31, 2006 |  |                      | 531,230   |                                        | $ | 5.24                                                              |  |                               | 5.94 |  | $ | 7,611 | 
|                                 |  |                      |           |                                        |   |                                                                   |  |                               |      |  |   |       | 

| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The weighted-average
  grant-date fair value of options granted during the twelve months ended
  December 31, 2006 was $ 10.04. The aggregate intrinsic value in the table
  above represents the total intrinsic value (the difference between the fair
  market value of the Company ordinary shares on December 31, 2006 and the
  exercise price, multiplied by the number of in-the-money options) that would
  have been received by the option holders had all option holders exercised
  their options on December 31, 2006. Total intrinsic value of options
  exercised for the twelve months ended December 31, 2006 was $3,030. As
  of December 31, 2006, there was $ 3,366 of total unrecognized compensation
  cost related to non-vested share-based compensation arrangements granted
  under the Companys stock option plans. That cost is expected to be
  recognized over a weighted-average period of 3.55 years. Total grant-date
  fair value of vested options for the twelve months ended December 31, 2006
  was approximately $2,253.
| |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  | Cash
  received from exercise of options for the years ended December 31, 2004, 2005
  and 2006 were approximately $ 3,642, $ 485 and $ 835, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

- 38 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                              |                                                                                                              
|--------- | ---------------------------- | -------------------------------------------------------------------------------------------------------------
|NOTE 13:- | SHAREHOLDERS EQUITY (Cont.)
|          |                             
|          |                              | A summary of
  the Companys share option activity under the plans for the years 2004, 2005
  are as follows:

|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|------------------------------------------ |  | ------------------- | --------- | ------------------------------------- | - | ------------------- |  | ------------------------------------- | --------- | - | - | ----- | 
|                                           |  | 2004                |           | 2005                                  |  
|                                           |  |                     |           |                                       |  
|                                           |  | Number
  of options |           | Weighted
  average
  exercise
  price |   | Number
  of options |  | Weighted
  average
  exercise
  price |          
|                                           |  |                     |           |                                       |   |                     |  |                                       |          
|                                           |  |                     |           |                                       |   |                     |  |                                       |          
|Outstanding - beginning of the year        |  |                     | 1,938,195 |                                       | $ | 3.73                |  |                                       | 1,072,454 |   | $ | 5.57  | 
|Granted                                    |  |                     | 157,100   |                                       | $ | 15.10               |  |                                       | 230,950   |   | $ | 20.33 | 
|Exercised                                  |  |                     | (940,234  | )                                     | $ | 3.91                |  |                                       | (139,527  | ) | $ | 3.48  | 
|Forfeited                                  |  |                     | (82,607   | )                                     | $ | 3.68                |  |                                       | (74,671   | ) | $ | 7.80  | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|Outstanding - end of the year              |  |                     | 1,072,454 |                                       | $ | 5.57                |  |                                       | 1,089,206 |   | $ | 8.81  | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 
|Options exercisable at the end of the year |  |                     | 453,712   |                                       | $ | 3.22                |  |                                       | 588,519   |   | $ | 4.39  | 
|                                           |  |                     |           |                                       |   |                     |  |                                       |           |   |   |       | 

| |  |                                                                                                                     
| |  | --------------------------------------------------------------------------------------------------------------------
| |  | The options
  outstanding as of December 31, 2006, have been separated into exercise price
  categories, as follows:

|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 
|--------------------------- | --------------- | --------------------------------------------------- |  | ----------------------------------------------------------- |  | ------------------------------------- |  | --------------------------------------------------- | ----- | ---------------------------------------------------------------- |  | ------- |  | - | ----- | 
|Range of
  exercise
  price |                 | Options
  outstanding
  as of
  December 31,
  2006 |  | Weighted
  average
  remaining
  contractual
  life (years) |  | Weighted
  average
  exercise
  price |  | Options
  exercisable
  as of
  December 31,
  2006 |       | Weighted
  average
  exercise
  price of
  options
  exercisable | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  | 
|$                           | 1.20-
  2.67    |                                                     |  | 258,393                                                     |  | 6                                     |  | $                                                   | 1.75  |                                                                  |  | 249,668 |  | $ | 1.72  | 
|$                           | 3.50-
  4.80    |                                                     |  | 121,488                                                     |  | 4                                     |  | $                                                   | 4.40  |                                                                  |  | 113,188 |  | $ | 4.37  | 
|$                           | 8.51
  - 8.52   |                                                     |  | 132,550                                                     |  | 7                                     |  | $                                                   | 8.51  |                                                                  |  | 112,849 |  | $ | 8.51  | 
|$                           | 13.05-
  15.50  |                                                     |  | 137,700                                                     |  | 8                                     |  | $                                                   | 14.45 |                                                                  |  | 45,025  |  | $ | 14.59 | 
|$                           | 16.23
  - 18.00 |                                                     |  | 262,600                                                     |  | 9                                     |  | $                                                   | 17.43 |                                                                  |  | 2,500   |  | $ | 18.00 | 
|$                           | 20.50
  - 24.27 |                                                     |  | 194,400                                                     |  | 8                                     |  | $                                                   | 21.58 |                                                                  |  | 8,000   |  | $ | 24.27 | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 
|                            |                 |                                                     |  | 1,107,131                                                   |  |                                       |  | $                                                   | 11.63 |                                                                  |  | 531,230 |  | $ | 5.24  | 
|                            |                 |                                                     |  |                                                             |  |                                       |  |                                                     |       |                                                                  |  |         |  |   |       | 

| |    |                                                                                                                                                                                                              
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | f. | Dividends:                                                                                                                                                                                                   
| |    |                                                                                                                                                                                                              
| |    | In the event
  that cash dividends are declared in the future, such dividends will be paid
  in NIS. Based on its BOD decision the Company does not intend to pay cash
  dividends in the foreseeable future.

- 39 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                               
|--------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------
|NOTE 14:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | Commencing
  January 2004, the Company has two reportable segments related to continuing
  operations. The Software Security Digital Rights Management (DRM) Division
  develops and markets the following products: HASP HL and HASP NET,
  hardware-based software security systems, and HASP SL, a software marketing,
  licensing and distribution platform. Both the software and the hardware
  products allow software publishers to manage licensing and distribution of
  their software theft and piracy.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | The
  Enterprise Security Division develops and markets the USB-based eToken
  hardware device for user authentication and the eSafe line of content
  security solutions that protect PCs and networks against viruses, worms, spam
  and non-productive Internet-born content.                                                                                                                                                                                                                                   
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | The segments
  are managed separately because each segment requires different technology and
  marketing strategies. The Software Security (DRM) Division and Enterprise
  Security Division include some international sales mainly to the United
  States, Europe, and Japan.                                                                                                                                                                                                                                    
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|          | a.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | The following
  presents segment results of operations for the years ended December 31, 2004,
  2005 and 2006:

|                                             |  |                         |        |      |   |        |   |   |           |  
|-------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | --------- | -
|                                             |  | Year ended December 31, |       
|                                             |  |                         |       
|                                             |  | 2004                    |        | 2005 |   | 2006   |  
|                                             |  |                         |        |      |   |        |  
|Revenues
  from external customers:          |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 50,650 |      | $ | 56,578 |   | $ | 60,556    |  
|Enterprise security                          |  |                         | 18,471 |      |   | 25,195 |   |   | 28,482    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  revenues                      |  | $                       | 69,121 |      | $ | 81,773 |   | $ | 89,038    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Gross
  profit:                              |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 41,109 |      | $ | 46,708 |   | $ | 51,264    |  
|Enterprise security                          |  |                         | 14,231 |      |   | 18,094 |   |   | 17,761    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  gross profit                  |  | $                       | 55,340 |      | $ | 64,802 |   | $ | 69,025    |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Operating
  income:                          |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 17,779 |      | $ | 20,501 |   | $ | 24,135    |  
|Enterprise security                          |  |                         | (7,949 | )    |   | (7,951 | ) |   | (10,929   | )
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  operating income              |  | $                       | 9,830  |      | $ | 12,550 |   | $ | *) 13,206 |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Depreciation
  and amortization:             |  |                         |        |      |   |        |   |   |           |  
|Software security (DRM)                      |  | $                       | 1,304  |      | $ | 1,176  |   | $ | 1,402     |  
|Enterprise security                          |  |                         | 768    |      |   | 791    |   |   | 889       |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|                                             |  |                         |        |      |   |        |   |   |           |  
|Consolidated
  depreciation and amortization |  | $                       | 2,072  |      | $ | 1,967  |   | $ | 2,291     |  
|                                             |  |                         |        |      |   |        |   |   |           |  

- 40 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                         |    |                                                                                                                              
|--------- | ------------------------------------------------------- | -- | -----------------------------------------------------------------------------------------------------------------------------
|NOTE 14:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION (Cont.)
|          |                                                         |    |                                                                                                                              
|          |                                                         | *) | The impact
  of the stock-based compensation expense related to employee stock options in
  the amount of $ 2,253 as follows:

|                                         |  |                                  |       | 
|---------------------------------------- |  | -------------------------------- | ----- | 
|                                         |  | Year ended
  December 31,
  2006 |      
|                                         |  |                                  |       | 
|                                         |  |                                  |       | 
|Software
  security (DRM)                |  | $                                | 1,235 | 
|Enterprise
  security                    |  |                                  | 1,018 | 
|                                         |  |                                  |       | 
|                                         |  |                                  |       | 
|Total
  Stock-based compensation expense |  | $                                | 2,253 | 
|                                         |  |                                  |       | 

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | b. | The Company
  does not allocate assets to its reportable segments, as assets generally are
  not specifically attributable to any particular segment. Accordingly, asset
  information by reportable segment is not presented. Where the underlying
  assets can be specifically attributed to a segment, the related depreciation
  and amortization have been classified accordingly. The remaining depreciation
  is allocated based on a percentage of revenue. Total revenues are attributed
  to geographic areas based on the location of customers:

|                                                 |  |                         |        |      |   |        |  |   |        | 
|------------------------------------------------ |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|                                                 |  | Year ended December 31, |       
|                                                 |  |                         |       
|                                                 |  | 2004                    |        | 2005 |   | 2006   | 
|                                                 |  |                         |        |      |   |        | 
|Revenues
  from sales to unaffiliated customers: |  |                         |        |      |   |        |  |   |        | 
|Israel                                           |  | $                       | 2,381  |      | $ | 2,927  |  | $ | 4,306  | 
|United States                                    |  |                         | 19,721 |      |   | 26,789 |  |   | 23,426 | 
|Europe (excluding Germany)                       |  |                         | 18,724 |      |   | 21,471 |  |   | 26,725 | 
|Germany                                          |  |                         | 15,384 |      |   | 17,129 |  |   | 19,702 | 
|Japan                                            |  |                         | 9,212  |      |   | 9,345  |  |   | 8,354  | 
|Others                                           |  |                         | 3,699  |      |   | 4,112  |  |   | 6,525  | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  | $                       | 69,121 |      | $ | 81,773 |  | $ | 89,038 | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|Long-lived
  assets:                             |  |                         |        |      |   |        |  |   |        | 
|Israel                                           |  | $                       | 7,200  |      | $ | 7,638  |  | $ | 8,134  | 
|United States                                    |  |                         | 2,632  |      |   | 2,605  |  |   | 2,567  | 
|Germany                                          |  |                         | 263    |      |   | 210    |  |   | 359    | 
|Europe (excluding Germany)                       |  |                         | 2,146  |      |   | 2,048  |  |   | 1,875  | 
|Japan                                            |  |                         | 231    |      |   | 260    |  |   | 239    | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  |                         |        |      |   |        |  |   |        | 
|                                                 |  | $                       | 12,472 |      | $ | 12,761 |  | $ | 13,174 | 
|                                                 |  |                         |        |      |   |        |  |   |        | 

- 41 -

---



|                                                          
|----------------------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.                            
|AND ITS SUBSIDIARIES                                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                
|                                                          
|U.S. dollars in thousands, except share and per share data

|          |                                                         |                                                                                             
|--------- | ------------------------------------------------------- | --------------------------------------------------------------------------------------------
|NOTE 14:- | SEGMENTS OF THE COMPANY AND RELATED INFORMATION (Cont.)
|          |                                                        
|          | c.                                                      | Total
  revenues from outside customers are distributed among the following product
  lines:

|            |  |                         |        |      |   |        |  |   |        | 
|----------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|            |  | Year ended December 31, |       
|            |  |                         |       
|            |  | 2004                    |        | 2005 |   | 2006   | 
|            |  |                         |        |      |   |        | 
|            |  |                         |        |      |   |        |  |   |        | 
|HASP tokens |  | $                       | 49,707 |      | $ | 55,969 |  | $ | 60,299 | 
|eSafe       |  |                         | 10,911 |      |   | 11,162 |  |   | 12,166 | 
|eToken      |  |                         | 7,560  |      |   | 14,032 |  |   | 16,316 | 
|Others      |  |                         | 943    |      |   | 610    |  |   | 257    | 
|            |  |                         |        |      |   |        |  |   |        | 
|            |  |                         |        |      |   |        |  |   |        | 
|            |  | $                       | 69,121 |      | $ | 81,773 |  | $ | 89,038 | 
|            |  |                         |        |      |   |        |  |   |        | 

|          |                                        |                         
|--------- | -------------------------------------- | ------------------------
|NOTE 15:- | SELECTED STATEMENTS OF OPERATIONS DATA
|          |                                        |                         
|          | a.                                     | Financial
  income, net:

|                                                         |  |                         |      |      |   |        |   |   |       |  
|-------------------------------------------------------- |  | ----------------------- | ---- | ---- | - | ------ | - | - | ----- | -
|                                                         |  | Year ended December 31, |     
|                                                         |  |                         |     
|                                                         |  | 2004                    |      | 2005 |   | 2006   |  
|                                                         |  |                         |      |      |   |        |  
|Financial
  income:                                      |  |                         |      |      |   |        |   |   |       |  
|Interest on marketable securities                        |  | $                       | 25   |      | $ | 616    |   | $ | 1,384 |  
|Interest                                                 |  |                         | 370  |      |   | 1,244  |   |   | 2,017 |  
|Gain from derivative instruments                         |  |                         |     |      |   | 456    |   |   | 35    |  
|Gain from sale of marketable securities                  |  |                         |     |      |   |       |   |   | 183   |  
|Foreign currency transaction differences                 |  |                         | 140  |      |   |       |   |   |      |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         | 535  |      |   | 2,316  |   |   | 3,619 |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|Financial
  expenses:                                    |  |                         |      |      |   |        |   |   |       |  
|Impairment of available-for-sale marketable
  securities |  |                         |     |      |   | (117   | ) |   |      |  
|Loss from derivative instruments                         |  |                         | (234 | )    |   |       |   |   |      |  
|Foreign currency transaction differences                 |  |                         |     |      |   | (993   | ) |   | (176  | )
|Other                                                    |  |                         | (248 | )    |   | (168   | ) |   | (203  | )
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         | (482 | )    |   | (1,278 | ) |   | (379  | )
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  |                         |      |      |   |        |   |   |       |  
|                                                         |  | $                       | 53   |      | $ | 1,038  |   | $ | 3,240 |  
|                                                         |  |                         |      |      |   |        |   |   |       |  

- 42 -

---



|                                          
|------------------------------------------
|ALADDIN KNOWLEDGE SYSTEMS LTD.            
|AND ITS SUBSIDIARIES                      
|NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                                          
|U.S. dollars in thousands                 

|          |                                                |                                                                                              
|--------- | ---------------------------------------------- | ---------------------------------------------------------------------------------------------
|NOTE 15:- | SELECTED STATEMENTS OF OPERATIONS DATA (Cont.)
|          |                                                |                                                                                              
|          | b.                                             | Net earnings
  per share:                                                                    
|          |                                                |                                                                                              
|          |                                                | The following
  table sets forth the computation of basic and diluted net earnings per share:

|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|-- | ----------------------------------------------------------------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
|   |                                                                                                                   |  | Year ended December 31, |       
|   |                                                                                                                   |  |                         |       
|   |                                                                                                                   |  | 2004                    |        | 2005 |   | 2006   | 
|   |                                                                                                                   |  |                         |        |      |   |        | 
|1. | Numerator:                                                                                                        |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Net income                                                                                                        |  | $                       | 8,788  |      | $ | 12,356 |  | $ | 14,031 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Numerator for basic and diluted net
  earnings per share                                                          |  | $                       | 8,788  |      | $ | 12,356 |  | $ | 14,031 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|2. | Denominator:                                                                                                      |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Weighted average number of shares                                                                                 |  |                         | 11,940 |      |   | 13,899 |  |   | 14,596 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Denominator for basic net earnings per
  share                                                                    |  |                         | 11,940 |      |   | 13,899 |  |   | 14,596 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Effect of dilutive securities:                                                                                    |  |                         |        |      |   |        |  |   |        | 
|   | Employee stock options                                                                                            |  |                         | 1,060  |      |   | 681    |  |   | 482    | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Dilutive potential Ordinary shares                                                                                |  |                         | 1,060  |      |   | 681    |  |   | 482    | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 
|   | Denominator for diluted net earnings per
  share - adjusted weighted average shares, assuming exercise of options |  |                         | 13,000 |      |   | 14,580 |  |   | 15,078 | 
|   |                                                                                                                   |  |                         |        |      |   |        |  |   |        | 

|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|NOTE 16:- | SUBSEQUENT EVENTS (NOT AUDITED)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | In July
  2006, the FASB issued FASB Interpretation 48, Accounting for Income Tax Uncertainties (FIN 48).
  FIN 48 defines the threshold for recognizing the benefits of tax return
  positions in the financial
  statements as more-likely-than-not to be sustained with the taxing
  authority. The recently issued literature also provides guidance on
  derecognition, measurement and classification of income tax uncertainties,
  along with accounting for any related interest and penalties. FIN 48 also
  includes guidance concerning accounting for income tax uncertainties in
  interim periods and increases the level of disclosures associated with any
  recorded income tax uncertainties. FIN 48 is effective for fiscal years
  beginning after December 15, 2006. The differences between the amounts
  recognized in the statements of financial position prior to the adoption of
  FIN 48 and the amounts reported upon adoption will be accounted for as a
  cumulative-effect adjustment recorded to the beginning balance of retained
  earnings.
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | The adoption
  of FIN 48 is expected to have insignificant impact on the Companys
  Consolidated financial statements in the total estimated amount of $ 182.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | On April 1,
  2007, the Companys board of directors authorized the use of our available
  cash for the repurchase of the Companys ordinary shares. According to the
  terms of the buy back program approved by the board, the Company is authorized
  to repurchase its ordinary shares utilizing up to $10 million or to
  repurchase such number of ordinary shares not to exceed 500,000 shares. On
  June 11, 2007, the Companys board of directors increased the extent of the
  buy back program by an additional $10 million. The combined total
  authorization now stands at $20 million. As of June 20, 2007, the Company
  repurchased 464,973 shares utilizing approximately $10 million.                                                                                                                                                                                                                                                                                                                                                                             
|          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|          | In April
  2007, The Consortium for Indian Information Technology Education, referred to
  as CIITE, selected the Companys eToken authentication solution to secure its
  vast network of e-Learning resources throughout India and eSafe content
  solution. Over the next three years, the Companys eToken will be provided to
  CIITEs students wishing to access the CIITE Educational Portal.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

- 43 -

---



|12
          York Gate
        Regents
          Park
        London
          NW1 4QS
        United
          Kingdom | Telephone
        +44
          (0)20 7486 0111
        Fax
        +44
          (0)20 7935 6852 | Email
        email@blickrothenberg.com
        Web
        www.blickrothenberg.com | 
|------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | 



REPORT OF INDEPENDENT AUDITORSTo the shareholders ofALADDIN EUROPE LTD

We have audited the accompanying balance
    sheets of Aladdin Europe Ltd ("the Company"), as of December 31, 2005 and
    2006, and the related statements of operations and changes in shareholders'
    equity and cash flows for each of the three years in the period ended December
    31, 2006. These financial statements are the responsibility of the Company's
    management. Our responsibility is to express an opinion on these financial
    statements, based on our audits.

We conducted our audits in accordance with
    the standards of the Public Company Accounting Oversight Board (United States).
    Those standards require that we plan and perform the audit to obtain reasonable
    assurance about whether the financial statements are free of material misstatement.
    An audit includes consideration of internal control over financial reporting
    as a basis for designing audit procedures that are appropriate in the circumstances,
    but not for the purpose of expressing an opinion on the effectiveness of
    the Company's internal control over financial reporting. Accordingly, we
    express no such opinion. An audit also includes examining, on a test basis,
    evidence supporting the amounts and disclosures in the financial statements.
    An audit also includes assessing the accounting principles used and significant
    estimates made by management, as well as evaluating the overall financial
    statement presentation. We believe that our audits provide a reasonable basis
    for our opinion.

In our opinion, the financial statements
    referred to above present fairly, in all material respects, the financial
    position of the Company as of December 31, 2005 and 2006 and the results
    of their operations and cash flows for each of the three years in the period
    ended December 31, 2006, in conformity with U.S. generally accepted accounting
    principles.

|BLICK ROTHENBERG      |  | 12 York Gate 
|--------------------- |  | -------------
|Chartered Accountants |  | Regents Park
|Registered Auditors   |  | London       
|                      |  | NW1 4QS      
|July 2, 2007          |  |              



|Bob
          Rothenberg MBE
        Angela Beech*
        Steven Bruck
        Martin Donn*
        Charles Gibbon
        Rajiv Gunesh | Anne
          Healy-McAdam*
        Darren Jordan
        Martin Korn
        Colin Lehmann
        Simon Mayston
        John Newman | Alan
          Pearce*
        David Rothenberg
        Andrew Sanford
        Mike Scoltock
        Nilesh Shah
        Tim Shaw | Chris
          Shepherd
        Simon Wagman
        *Non Chartered Accountant | 
|---------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------- | 
|                                                                                                                                         |                                                                                                                                       
|Blick
          Rothenberg is authorised and regulated by the Financial Services Authority
          to carry on Investment business    

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