Teknowledge (TEKCQ) 10QSB 2007 Q1 Quarterly report (small business)

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-QSB

 (Mark One)

[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007

[  ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____________to____________

Commission File Number: 0-14793

TEKNOWLEDGE CORPORATION

(Exact name of small business issuer as specified in its charter)

Delaware	94-2760916
(State of Incorporation)	(I.R.S. Employer Identification No.)

1800 Embarcadero Road, Palo Alto, California 94303

(Address of principal executive offices)(Zip Code)

(650) 424-0500

(Issuer’s telephone number)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X]      No [ ]

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date.

Class	Outstanding at May 10, 2007
Common Stock, $0.01 par value	5,735,754

TABLE OF CONTENTS

			Page No.
	PART I.	FINANCIAL INFORMATION
Item 1.		Condensed Consolidated Financial Statements (Unaudited)
		Condensed Consolidated Balance Sheets as of March 31, 2007 and December 31, 2006	3
		Condensed Consolidated Statements of Operations and Comprehensive Income (Loss)
		for the three months ended March 31, 2007 and 2006	4
		Condensed Consolidated Statements of Cash Flows for three months ended
		March 31, 2007 and 2006	5
		Notes to the Condensed Consolidated Financial Statements	6
Item 2.		Management's Discussion and Analysis of Financial Condition and Results of	13
Item 3.		Controls and Procedures	26
	PART II.	OTHER INFORMATION
Item 1.		Legal Proceedings	27
Item 6.		Exhibits and Reports on Form 8-K	27
Signatures			28

Exhibits 31.1 and 31.2 (the 302 certifications)	29
Exhibits 32.1 and 32.2 (the 906 certifications)	31

PART I. FINANCIAL INFORMATION

Item 1: Condensed Consolidated Financial Statements

TEKNOWLEDGE CORPORATION

 CONDENSED CONSOLIDATED BALANCE SHEETS

	March 31, 2007			December 31, 2006
	(unaudited)				(1)
ASSETS
Current assets:
Cash and cash equivalents	$	1,394,776		$	771,112
Receivables:
Billed, net of allowance of $4,500 and $7,100, respectively		151,052			361,439
Unbilled & other receivables		423,509			275,434
Total receivables		574,561			636,873
Prepaids and other current assets		87,889			137,001
Total current assets		2,057,226			1,544,986
Long term government unbilled receivable		211,000			227,000
Fixed assets, at cost:
Computer and other equipment		3,275,335			3,275,335
Software		440,540			440,540
Furniture and fixtures		33,124			33,124
Leasehold improvements		6,428			6,428
Total fixed assets at cost		3,755,427			3,755,427
Less:  Accumulated depreciation and amortization		(3,747,894	)		(3,744,921	)
Fixed assets, net		7,533			10,506
Total assets	$	2,275,759		$	1,782,492
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
Current liabilities:
Accounts payable	$	244,856		$	229,261
Payroll and related liabilities		246,219			208,919
Government rate reserve		2,248,306			2,248,305
Other accrued liabilities		74,726			97,213
Total current liabilities		2,814,107			2,783,698
Contingencies (see Note 10)
Stockholders' deficiency:
Preferred stock, $.01 par value, authorized 2,500,000 shares, including		-			-
Series A Convertible Preferred Stock, none issued
Common stock, $.01 par value, authorized 25,000,000 shares,
5,735,754 shares issued and outstanding in 2007 and 2006		57,358			57,358
Additional paid-in capital		1,926,916			1,926,521
Accumulated deficit since January 1, 1993		(2,522,622	)		(2,985,085	)
(following quasi-reorganization)
Total stockholders' deficiency		(538,348	)		(1,001,206	)
Total liabilities and stockholders' deficiency	$	2,275,759		$	1,782,492

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

(1)   The information in this column was derived from the Company’s audited consolidated financial statements for the year ended December 31, 2006.

TEKNOWLEDGE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND

COMPREHENSIVE INCOME (LOSS)

(Unaudited)

	Three Months ended March 31,
	2007			2006
Revenues:
Software services and licenses	$	302,452		$	608,040
Total revenues		302,452			608,040
Cost of revenues:
Software services and licenses		189,999			286,943
Patent licenses		8,016			15,645
Total cost of revenues		198,015			302,588
Gross profit		104,437			305,452
Operating expense:
General and administrative		425,449			484,527
Research and development		337,763			315,490
Sales and marketing		2,756			1,671
Gain on sale of assets		(1,050,000	)		-
Total operating expenses (income)		(284,032	)		801,688
Income (loss) from operations		388,469			(496,236	)
Interest and other income (expense), net		73,994			21,317
Net income (loss) and comprehensive income (loss)		462,463			(474,919	)
Earnings (loss) per share:
- Basic	$	0.08		$	(0.08	)
- Diluted	$	0.08		$	(0.08	)
Shares used in computing earnings (loss) per share:
- Basic		5,735,754			5,735,754
- Diluted		5,739,240			5,735,754

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

TEKNOWLEDGE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Three Months ended March 31,
	2007			2006
Cash flows from operating activities:
Net income (loss)	$	462,463		$	(474,919	)
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Depreciation and amortization		2,973			5,571
Amortization of warrants and options		395			9,570
Gain on sale of assets		(1,050,000	)		-
Provision for doubtful accounts		(2,600	)		(38,137	)
Decrease (increase) in operating assets:
Receivables		80,912			35,570
Prepaids and other current assets		49,111			27,703
Increase (decrease) in operating liabilities:
Accounts payable		15,595			16,472
Other accrued liabilities		14,815			(3,338	)
Net cash used in operating activities		(426,336	)		(421,508	)
Cash flows from investing activities:
Proceeds from sale of asset		1,050,000			-
Purchase of fixed assets		-			(2,640	)
Net cash provided by (used in) investing activities		1,050,000			(2,640	)
Cash flows from financing activities:
Net decrease in cash and cash equivalents		623,664			(424,148	)
Cash and cash equivalents at beginning of period		771,112			2,168,508
Cash and cash equivalents at end of period	$	1,394,776		$	1,744,360
Supplemental disclosure of cash flow information:
Cash paid for interest	$	-		$	-
Cash paid for income taxes	$	-		$	-

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

TEKNOWLEDGE CORPORATION

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.     Basis of Presentation

Teknowledge Corporation (“the Company”) has prepared the unaudited condensed consolidated financial statements included herein, pursuant to the rules and regulations of the Securities and Exchange Commission and accounting principles generally accepted in the United States of America (US GAAP). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with US GAAP have been condensed or omitted pursuant to such rules and regulations. These interim statements should be read in conjunction with the financial statements and the notes thereto included in the Company’s annual report on Form 10-KSB for the fiscal year ended December 31, 2006. In the opinion of management, these interim statements include all adjustments consisting of normal, recurring adjustments, which are necessary for a fair presentation of results for such periods. The results of operations for any interim period presented herein are not necessarily indicative of results that may be achieved for the entire fiscal year ending December 31, 2007.

2.     Accounts receivable

Historically, the majority of the Company’s accounts receivable are from the U.S. Federal Government, with most of the remainder from financial services companies. This varies, depending on periodic fluctuations in government contracts and financial services integration projects. Credit is extended based on evaluation of a customers’ financial condition, and collateral is not generally required. Accounts receivable are generally due within 30 days and are stated amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the contractual payment terms are considered past due. The Company determines its allowance by considering a number of factors, including the length of time trade accounts receivable are past due, the Company’s previous loss history, the customer’s current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole. The Company writes-off accounts receivable when they become uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. The Company has not experienced a credit loss from a government customer nor does it anticipate such losses, and has not provided an allowance for doubtful accounts against government receivables. The Company has established a rate reserve to cover potential losses associated with adjustments to its unaudited government rates.

3.      Capitalized software development costs

Teknowledge capitalizes software development costs once technological feasibility is reached and continuing until general commercial availability of the product. During the three months ended March 31, 2007 and 2006, software development costs of $0 and $0 were capitalized respectively. Amortization costs were $0 for the three months ended March 31, 2007 and $0 for the three months ended March 31, 2006. The Company’s policy is to amortize capitalized software development costs by the greater of (a) the ratio of current gross revenues for a product to anticipated gross revenues over the estimated life of that product, or (b) the straight-line method over the estimated economic life of the product, which is estimated at three years. The Company capitalizes software development costs in anticipation of future revenue principally from the sale of licenses, maintenance, and related services. The Management evaluates the financial performance of its software at least quarterly to measure the performance against plan objectives and specific sales prospects. This is to ensure that these software development costs are being recorded at the lower of unamortized cost or net realizable value.

4.     Earnings (Loss) Per Share

 Basic earnings (loss) per share are calculated by dividing net income (loss) by the weighted average shares of common stock outstanding during the period. Diluted earnings (loss) per share is calculated by dividing net income (loss) by the weighted average shares of outstanding common stock plus the effect of potentially dilutive common stock securities during the period. Potentially dilutive securities consist of shares issuable upon the exercise of outstanding common stock options and warrants. These securities amounted to 3,486 shares for the three months ended March 31, 2007.  All potentially dilutive securities have been excluded from the calculation of the diluted net loss per share for the three-month period ended March 31, 2006, as their inclusion would be anti-dilutive. These securities amounted to 1,270,287 shares for the three months ended March 31, 2006.

A summary of the net income (loss) per share calculation for the three month periods ended March 31, 2007 and 2006 is as follows (in thousands, except per share amounts):

	Three Months Ended March 31,
	2007		2006
	(in thousands, except per share amounts)
Net income (loss) available to common shareholders:
Numerator: Net income (loss)	$	462	$	(475	)
Denominator for basic net income (loss) per share:
Weighted average common shares outstanding		5,736		5,736
Effect of dilutive securities:
Diluted weighted average common shares		5,739		5,736
Basic net income (loss) per share	$	0.08	$	(0.08	)
Diluted net income (loss) per share	$	0.08	$	(0.08	)

5.     Stock-Based Compensation

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004) (“SFAS No. 123R”), “Share-Based Payment,” which requires companies to measure and recognize compensation expense for all stock-based payments at fair value starting at grant date. All of the Company’s stock compensation is accounted for as an equity instrument.  The Company previously applied Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations and provided the pro forma disclosures of SFAS No. 123, “Accounting for Stock Based Compensation.”

Prior to the Adoption of SFAS No. 123R

Teknowledge previously accounted for stock-based compensation using the intrinsic value method in accordance with the provisions of Accounting Principle Board Opinion No. 25, “Accounting for Stock Issued to Employees,” as allowed by SFAS No. 123, “Accounting for Stock Based Compensation” (“SFAS No. 123”) as amended by SFAS No. 148, “Accounting for Stock Based Compensation — Transition and Disclosures, an Amendment of SFAS No. 123.” Under the intrinsic value method, Teknowledge did not recognize any compensation expense when the exercise price of stock options issued to employees and directors was equal to the fair market value of our common stock at the time the options were granted.

Impact of the Adoption of SFAS No. 123R

For purposes of calculating stock-based compensation expense, the fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option pricing model and the following assumptions:

	Three Months Ended March 31,
	2007	2006
Risk-free interest rate	5%	4.5%
Expected life of option	1.0 year	1.0 year
Expected dividends	0%	0%
Volatility	166%	90%
Weighted average fair value at grant date	N/A	N/A

The unrecorded deferred stock-based compensation balance related to stock options as of January 1, 2006 was $5,000 before estimated forfeitures and will be reclassified into additional paid-in-capital as it is expensed, as is required by the adoption of SFAS No. 123R. In the Company’s pro forma disclosures prior to the adoption of SFAS No. 123R, the Company accounted for forfeitures upon occurrence. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates. The Company has elected to use actual forfeitures during 2006 and 2007 in order calculate the remaining unrecorded deferred stock-based compensation balance. The Company has calculated that the stock-based compensation for awards not expected to vest is $1,000, and therefore, the unrecorded deferred stock-based compensation balance related to stock options has been adjusted to approximately $4,000 after forfeitures.

During the quarter ended March 31, 2007, the Company granted no options to non-employee Board of Directors and no employee options that vest over a period of five years.  In the first quarter of 2007, the Company recorded $395 of stock-based compensation related to stock options.

As of March 31, 2007, the unrecorded deferred stock-based compensation balance related to stock options was $1,000 and will be recognized over an estimated weighted average amortization period of 4.25 years.

Stock-Based Compensation Plans             

The Company’s stock option plan for employees is called the Teknowledge Corporation 1998 Stock Option Plan (the “1998 Plan”) and the stock option plan for Directors is called the 2002 Teknowledge Plan for Non-Employee Directors (the “Directors’ Plan”).

The aggregate number of shares issued under the 1998 Plan may not exceed 2,345,101 shares of common stock and 1,181,182 shares were available for future grant as of March 31, 2007. The Board of Directors has granted options to employees that are either incentive stock options (“ISO”) or non-statutory stock options (“NSO”). For ISO, the exercise price of the common stock options may not be less than the fair market value on the date of grant. For NSO, the exercise price of the common stock may not be less than 85% of the fair market value of the common stock on the date of grant. Options that were granted in 2006 vest immediately or by December 31, 2006. For  2004 and prior, the options vest in quarterly increments starting the second year of a four-year term and expire ten years after the grant date. Management will utilize cash bonuses instead of issuing options.

The aggregate number of shares issued under the Directors’ Plan may not exceed 250,000 shares of common stock and 151,976 shares were available for future grant as of March 31, 2007. Under this plan, non-employee directors are entitled to receive annual option grants to purchase 3,000 shares of common stock on their initial election to the Board and thereafter on the anniversary date of their election to the Board. The Company, under the Directors’ Plan may grant options to purchase common stock in lieu of cash payments for directors’ fees. Options, which are granted at fair market value, are exercisable one year after the grant date and expire ten years from the grant date.

As of March 31, 2007 the following number of shares of common stock have been reserved for future issuance under both Plans:

Teknowledge Corporation 1998 Stock Option Plan	1,181,182
2002 Stock Option Plan for Non-Employee Directors	151,976
	1,333,158

	Options			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life		Aggregate Intrinsic Value (000s)
Outstanding at December 31, 2004		1,000,095		$	3.52
Granted		1,141,596		$	0.39
Exercised		-			-
Forfeited		(929,564	)	$	2.54
Outstanding at December 31, 2005		1,212,127		$	1.34
Granted		30,810		$	0.21
Exercised		-			-
Forfeited		(67,744	)	$	2.29
Outstanding at December 31, 2006		1,175,193		$	1.26		7.2	$	4
Granted		-		$	-
Exercised		-			-
Forfeited		-		$	-
Outstanding at March 31, 2007		1,175,193		$	1.26		7.2	$	4
Vested and expected to vest
at March 31, 2007		1,174,884		$	1.26		7.2	$	4
Exercisable at March 31, 2007		1,166,973		$	1.26		7.2	$	4

The following table summarizes information about stock options outstanding at March 31, 2007:
	Options Outstanding			Options Vested & Exercisable
Range of Exercise Prices		Weighted Average Contractual Life	Weighted Average Exercise Price		Weighted Average Exercise Price
($'s)	Options	(Years)	($'s)	Options	($'s)
0.05  -  1.00	851,649	8.7	0.36	844,649	0.36
1.01  -  2.00	18,416	6.4	1.42	17,666	1.43
2.01  -  3.00	104,321	3.0	2.13	104,321	2.13
3.01  -  4.00	58,807	3.2	3.77	58,337	3.77
4.01  -  5.00	136,000	3.5	4.85	136,000	4.85
5.01  - 12.00	6,000	3.0	6.85	6,000	6.85
0.05  - 8.15	1,175,193	7.2	1.26	1,166,973	1.26

6.     Revenue Recognition 

The Company derives revenue from research and development contracts with the U.S. Government and from sales of software products and services from its Financial Solutions segment. Revenue is also generated from Patent and Technology Licensing.

(a)   Contract Revenue

The Company principally uses the percentage-of-completion method of accounting for contract revenues for both government and commercial projects. The percentage-of-completion method is based on total costs incurred to date compared with estimated total costs upon completion of contracts. The Company charges all losses on contracts to operations in the period when the loss is known. For contracts that do not meet the criteria for the percentage-of-completion method, the Company recognizes contract revenue on a completed contract basis. Fifteen percent of the fee for government contracts is retained and may be billed after the final indirect rates are submitted to the government. The final indirect rates are not submitted to the government until they have been reviewed and approved by the Defense Contract Audit Agency (“DCAA”). Revenue on the retained fee is recognized as earned but not billed until the final indirect rates have been approved by the DCAA. As of March 31, 2007, the Company calculated that it had approximately $211,000 of unbilled retained fees on its completed government contracts that will be collected in future periods. The Company has not received final overhead rate approval from government agencies for costs incurred during the fiscal years 2001 through 2004. Accordingly, the Company has recorded a rate adjustment reserve of $2,248,000 related to potential adjustments to the Company’s indirect overhead rates.

(b)   Software License and Services              

The Company derives revenue as follows: (i) sale of software licenses to end users, and (ii) services which include consulting, training, and post-contract customer support (“PCS”). The policy outlined below establishes the standards for ensuring that the Company recognizes revenue consistently, and in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”), as amended by SOP 98-9, Modification of SOP 97-2, “Software Revenue Recognition with Respect to Certain Transactions.”

Under SOP 97-2, the Company records revenue from licensing of software products to end-users when both parties sign a license agreement, the fee is fixed or determinable, collection is reasonably assured and delivery of the product has occurred. When the agreements include PCS, these amounts are recognized ratably over the period of the contracts, which is generally twelve months.

Generally, the Company provides payment terms that range from thirty to ninety days from the invoice date, although payment terms could be extended to six months under special circumstances. Accordingly, payment terms that exceed six month are not considered fixed or determinable and revenue is recognized as payments become due.

When contracts contain multiple elements, and for which vendor specific objective evidence (“VSOE”) of fair value exists for the undelivered elements, the Company recognizes revenue for the delivered elements based upon the residual method. VSOE is generally the price for products sold separately or the renewal rate for PCS. Undelivered elements consist primarily of PCS and other services such as consulting, mentoring and training. Services are generally not considered essential to the functionality of the software. The Company recognizes revenue allocated to PCS ratably over the period of the contracts, which is generally twelve months. For revenue related to consulting services, the Company recognizes revenue as the related services are performed. In instances where services are deemed essential to the software, both the software license fee and consulting fees are recognized using the percentage-of-completion method of contract accounting as required under SOP 81-1, “Accounting for Performance of Construction-Type and Certain Production-Type Contracts.”

The portion of fees related to either products or services rendered, which are not due under our Company’s standard payment terms are reflected in unbilled receivables.

Significant management judgments and estimates must be made in connection with determination of the revenue to be recognized in any accounting period. If the Company made different judgments or utilized different estimates for any period, material differences in the amount and timing of revenue recognized could result.

If the Company enters into a licensing agreement with a party as a result of a patent and intellectual property settlement, revenue is recognized at the time the agreement is signed. License revenues are established from a standard pricing structure that determines the price of the license in relation to the settlement amount. If the amount of the settlement is greater than the standard license price or does not result in a licensing agreement, then the amount of the settlement that does not relate to a license will be included in other income.

7.     Segment Reporting

The Company operates three reporting segments, Financial Solutions, Government Contract R&D, and Patents and Technology Licensing. In 2006, Patents and Technology Licensing has become significant enough to merit its own separate reporting segment. The Government Contract R&D segment includes research and development work in the following technical areas: computer software security, web-based training systems, distributed systems and knowledge systems. Technical personnel in the Government Contract R&D segment are sponsored by the government, and are organized into groups that support specific technical contracts and projects. The chief decision maker, the Company’s CEO, views the operating segments as a matrix of technical personnel, management, engineering services, technology, and other resources. The Company does not account for or report to the CEO its assets or capital expenditures by operating segment. Operating costs and expenses are managed by segment. Decisions about resource allocation are based primarily on contract requirements and utilization rates of the employees. Performance assessment for managers in any operating segment is based primarily on technical performance and overall profitability of the Company.

Financial information about segments (in thousands):

	Financial Solutions		Government Contract R&D		Patent & Technology licensing			Total
Three months ended March 31, 2007:
Revenues	$	151	$	151	$	-		$	302
Cost of revenues		74		116		8			198
Gross profit (loss)	$	77	$	35	$	(8	)	$	104
Three months ended March 31, 2006:
Revenues	$	328	$	280	$	-		$	608
Cost of revenues		192		95		16		$	303
Gross profit (loss)	$	136	$	185	$	(16	)	$	305

Revenues from customers in the United States represented approximately 77 percent and 88 percent for the three months ended March 31, 2007 and 2006, respectively. During the three months ended March 31, 2007, approximately 50 percent of the total revenue was attributed to one agency of the Federal government and 24 percent of total revenue was attributed to two Financial Solutions customers. No other customers accounted for greater than 10 percent of total revenues.

8.      Disposal of Capitalized Software Asset

Financial Solutions.  On August 22, 2005, Teknowledge concluded the sale of its TekPortal technology, an asset from its Financial Solutions business unit, to Intuit Inc. for $7,000,000. As part of the technology sale, Intuit was granted a license to each of Teknowledge’s six active patents, and acquired Teknowledge’s pending patent on OFX technology. Teknowledge retained ownership of all of its current customer contracts and patents. The Company also received a license to apply TekPortal “dual-use” application software in the military, intelligence, and homeland security arenas. $1,050,000 of the gross proceeds of the asset sale was held in escrow as a reserve for indemnification claims for a period of eighteen months.  The Company recorded proceeds of $5,950,000 that was partially offset by the disposal of the software asset’s book value of $2,012,000 and asset sale related legal and other direct expenses totaling $174,000.   The funds held in escrow were released in full on March 1, 2007 and were recorded as a gain on the sale of assets. 

9.      Going Concern

The Company had a working capital deficiency for the period ended March 31, 2007, with a stockholders’ deficiency of $538,000.  Accordingly, the Company's ability to continue as a going concern is in substantial doubt and is dependent on the Company generating cash flows that are adequate to sustain the operations of the business and maintain its obligations with respect to secured and unsecured creditors, none of which is assured. The consolidated financial statements do not give effect to any adjustments which would be necessary should the Company be unable to continue as a going concern and, therefore, be required to realize its assets and discharge its liabilities in other than the normal course of business and at amounts different from those reflected in the consolidated financial statements.

Management is currently implementing strategies designed to increase revenues, contain costs and improve the financial results of the Company’s operations.  For example, having demonstrated the value of its patent portfolio in 2006 with the sale of a $1,000,000 patent license, the Company is now focusing some of its resources on selling patent licenses in 2007. Additionally, the Company recently signed several value-added reseller agreements with major storage hardware suppliers that can be used to augment its proprietary technology and help grow a robust professional services division.

10.      Contingencies

Legal Proceedings

On April 1, 2006, Teknowledge filed a lawsuit against the United States Government in the United States Court of Federal Claims. Teknowledge is requesting that the court rule as improper a contracting officer’s decision dated January 19, 2006 that Teknowledge must account for all Software Amortization costs as direct costs of the Financial Services overhead pool, and that Teknowledge may, pursuant to the Federal Acquisition Regulation (FAR), account for 31% of the Software Amortization costs as indirect costs of the government overhead pool and recover those costs. No trial date has been set. A Pretrial Scheduling Order was filed on October 10, 2006 mandating that the parties submit a Joint Status Report by October 15, 2007.

On October 6, 2006, Teknowledge was served with a lawsuit from Large Systems Specialists, Inc., a contractor of Teknowledge. The lawsuit was filed in the Superior Court of California, Santa Clara County, and claims breach of contract and requests damages in the amount of $343,583.  The lawsuit is a result of Teknowledge contesting an invoice submitted on June 29, 2006 in the amount of $252,265.00. The invoice was submitted under a consulting services agreement and related software maintenance services agreement, and was submitted for alleged under-billing by Large Systems Specialists, Inc for the period February 4, 2003 to June 16, 2006. On October 31, 2006, Teknowledge invoked the arbitration clause of the subject agreements and stipulated to a Stay of Action Pending Arbitration. It is anticipated that an arbitration on the matter will be schedule during the second quarter of 2007.

The Company may be subject to legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on the Company’s consolidated results of operations or consolidated financial position.

11.     Recent Accounting Pronouncements

In June 2006, FASB issued FASB Interpretation FIN No. 48, "Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109", to address the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.  FIN No. 48 goes into effect for fiscal years beginning after December 15, 2006.  The Company has determined that FIN No. 48 has no material impact on our financial position, results of operations, or cash flows.

In June 2006, the FASB Emerging Issues Task Force ("EITF") issued EITF Issue No. 06-2, "Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences", to address whether certain compensation costs associated with a sabbatical or other similar benefit arrangement should be accrued over the requisite service period.  EITF Issue No. 06-2 goes into effect for fiscal years beginning after December 15, 2006.  We have determined that the change does not have a material impact on our financial position, results of operations or cash flows.

In September 2006, the Financial Accounting Standards Board ("FASB") issued FAS No. 157, "Fair Value Measurements." This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.  FAS No. 157 goes into effect for fiscal years beginning after November 15, 2007.  We have not yet determined the final impact, if any, that the adoption of FAS No. 157 will have on our financial position; however, we do not anticipate the change will have a material impact on our financial position, results of operations or cash flows.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 is effective for fiscal years ending on or after November 15, 2006 and addresses how financial statement errors should be considered from a materiality perspective and corrected. The literature provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Historically, there have been two approaches commonly used to quantify such errors: (i) the “rollover” approach, which quantifies the error as the amount by which the current year income statement is misstated, and (ii) the “iron curtain” approach, which quantifies the error as the cumulative amount by which the current year balance sheet is misstated. The SEC Staff believes that companies should quantify errors using both approaches and evaluate whether either of these approaches results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The Company adopted SAB No. 108 in the fourth quarter of fiscal year 2006 and we have determined that it did not have a material impact on its consolidated financial statements.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto.

Forward Looking Statements

The following contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions identify such forward-looking statements. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those indicated in the forward-looking statements. Forward-looking statements made in this report relate to cash reserves required to support ongoing operations, commercial revenue increases and backlog, new business opportunities, demand for software and services, generation of revenue from intellectual property and the value of the Company’s patent portfolio, counter-terrorism applications, market acceptance of the Company’s products and services, demand for the Company’s products and services by the government, employees and management, patent and technology licensing, intent to broaden customer base, plans to develop new products and services, effectiveness of security measures, as well as expected revenue, cash and profitability, ability to realize backlog, recoverability of capitalized software, availability of equity capital and financing, effects of competition, R&D, consolidation in the financial services industry, government regulation, collections on customer receivables, and effects of recently issued accounting pronouncements. All forward-looking statements involve risks and uncertainties, and actual results could differ materially from those set forth in the forward-looking statements contained herein as a result of competition, general or financial services market conditions, government agency funding limitations, other factors relating to government contracting including overhead rate determination, the ability to attract and retain technical and management personnel, commercial opportunities, financing, and other factors described below in “Risks That May Affect Future Results of Operations and/or Stock Price,” and in other documents we file with the Securities and Exchange Commission. Unless required by law, we do not undertake any obligation to update any forward-looking statements or risk factors.

Overview of Significant Matters

Financial Position

At March 31, 2007, Teknowledge had $1,395,000 in cash in the bank, albeit with significant reserves on the books.  In addition, during the first quarter of 2007, Teknowledge invested $338,000 in internally sponsored R&D, including its new ActionWeb^TM product line. After significantly reducing overhead expense and paying off our loans, we are now well into Stage II of our recovery plan – rebuilding our revenue base and making our operations profitable again.

Teknowledge did not achieve profitability for the 2006 year, but the formula for doing so has not changed. It plans to return to profitability using a tried and true methodology - decreasing expenses and increasing revenues.  We have already taken additional steps to decrease significantly our labor, rent, medical, and legal expenses. We are servicing our remaining TekPortal maintenance customers, and we transferred many maintenance customers to Intuit as planned. We continue to do services work for Intuit. We have new practices in place that are designed to increase revenue, increase engineering skills, and reduce our downside risk on new services contracts.

Teknowledge is implementing its plan to combine its software under development with next-generation data storage hardware and software integration solutions. Teknowledge won a Phase II Deductive Spreadsheets SBIR for $700,000 in 2006. We wrote a Phase I Helicopter Associate SBIR proposal in 2006, and were notified of a win on this Phase I proposal during the first quarter of 2007. We have several additional proposals in for new government contract work. We are conducting, with the government, the second stage of a field evaluation of our software wrappers security technology. We are also building a new ActionWeb based web services system that utilizes our alerts technologies. This is a next generation product designed to make it easier for large numbers of customers to deal with the torrent of data rushing at them by using a simple, knowledge-based web service for managing their information logistics.

Teknowledge is the right company to implement the ActionWeb product. For almost a quarter century, we have been continuously improving our ability to deliver knowledge-based software and services solutions. We already have most of the software pieces in place, either through contract work we have already done, or through third party license arrangements. We plan to reverse the traditional software development allocation of resources, and spend a large part of our attention working with customers to make their user experience rewarding, rather than just building software and hoping that customers will find it and like it. Teknowledge has been working with distributed computing and web services for almost a decade, and has next generation wrapping, alerts, ontology, and security related software. Teknowledge has a pioneering patent on distributed information logistics, which is about getting the right information to the right people at the right time. We believe that Teknowledge can do more than just deliver data. We can use our knowledge-based inference services to make informed judgments about the meaning and significance of critical pieces of information. Our intent is to combine our software with third party hardware to provide compelling value to customers.  Teknowledge plans to continuously improve its ability to deliver software and hardware integration services. In addition, we plan to deliver value-added web services that help customers monitor critical variables in their operations, and enable them to act on changes to those variables in a timely manner.

The Company experienced a decline in operating revenue during the first three months of 2007 as compared to the same period in 2006. Government Contract R&D revenue is still down, pending several new prospects that may result in additional R&D revenues. In the meantime, the Company continues to decrease its overhead and general and administrative (“G&A”) expenses. It is now focusing on winning billable integration services contracts and providing a stable ActionWeb platform for further product development.

Government Contract R&D

Teknowledge’s Government Contract R&D segment works in cutting edge research areas that we believe have significant application potential. The techniques for managing knowledge systematically have progressed significantly in the past two decades, and we are just beginning to unlock the business potential of systems that encode and process knowledge. The World Wide Web provides a high-powered distribution mechanism for these technologies, and much of the work Teknowledge does is focused on leveraging web-based opportunities. However, knowledge is still managed chaotically in most large organizations, with rapid change and turnover taking a toll on productivity. Today, computers mostly respond to us by executing our commands, rather than as interactive colleagues or associates that model who we are, the application domains that we work in, or the generic tasks that we perform. Teknowledge has been developing systems that address some of these features in web-based tutoring and semantic search application domains. We believe this remains a fruitful research area, and a substantial long-term opportunity for our business.

Teknowledge has successfully completed a Phase I DARPA Small Business Innovation Research (“SBIR”) contract it won in 2004 to develop a prototype of a deductive spreadsheet that adds symbolic or concept processing to commercial spreadsheets like Microsoft Excel^®. We believe this is an exciting proposition in a society where many people are uncomfortable with mathematical thinking or combining equations with qualitative reasoning. Teknowledge’s prototype spreadsheet is able to solve problems with nonmathematical concepts that embody nouns, verbs, plans and constraints. This is potentially a big opportunity with significant application specializations and extensions. Teknowledge has already built a demonstration system, and it started a Phase II $700K contract in the second quarter of 2006. There are opportunities to commercialize this technology as a plug-in application to Excel. Consistent with our evolving business model for leveraging selectively the software developed under R&D contracts, we may seek to license the technology to one or more companies that wish to embed the technology, or have significant sales pull, customer base, and marketing muscle.

Some of Teknowledge’s software development is supported by competitive contracts from the most sophisticated R&D sponsors in the world. Specifically, Teknowledge continues to improve its software wrappers, which have many security applications in protecting computers from new worms and viruses that may not have a known signature in an antivirus database. The Company has also developed a Standard Upper Ontology and Middle Ontology. These are ways of expressing knowledge formally that can be specialized for sophisticated semantic search solutions on the web, as well as computer-based problem solving and training solutions. Teknowledge continues to strengthen its model-based software capabilities, which can be used to design and configure software components to support target models of configurable products such as software radios and component software systems. The Company has also delivered prototype training software functionality that includes probabilistic Bayesian belief networks for modeling students or game users based on an analysis of their interactions with the computer. These and other R&D software capabilities put Teknowledge in a position to utilize next-generation functionality as infrastructure for government contracts, as well as potential commercial products, licenses, and applications.

Safe software wrappers encapsulate software modules, monitor their outputs and provide reporting and control over interfaces to other system resources. This software is more than a prototype and less mature than a product. It has many potential applications, including the ability to “lock down” a set of corporate computers and protects them from new viruses and worms that initially have no known operational signature. This system can monitor critical resources, identify potentially harmful instructions, and lock down selectively the access to critical resources. Teknowledge developed this capability several years ago, and has been improving it in new applications. This system could be used specifically to wrap email clients such as Microsoft Outlook^® and prevent attached viruses and worms from executing malicious instructions on the client machine.

Teknowledge has retained a limited right to license TekPortal software in intelligence, military, and homeland security application domains. One commercial customer sponsored a project in 2005 to use TekPortal software to aggregate images from multiple photo web sites. This application also has significance for aggregating images of potential terrorists and making them available to one or more agency web sites, with a variety of processing tools and permissions. There are also potential opportunities to leverage TekPortal in government security contract work that aggregates financial and other information for carefully selected targets.

Teknowledge generated $151,000 in government contract R&D revenue in the first quarter of 2007, compared to $280,000 in the first quarter of 2006. Most of this decrease was due to considerably lower backlog in 2007 and increased competition for government sponsored advanced R&D contracts. Replacing these large contracts rapidly is difficult due to increased competition for software R&D programs, long lead-times and potential funding delays. Teknowledge has submitted several new contract proposals to the government, which may or may not result in new awards. There are some signs of long-term improvement in new software R&D opportunities going forward, including interest in semantic web systems that utilize artificial intelligence techniques, advanced cyber security applications that leverage our software wrapper technology, and software systems that learn. In addition, we have launched a multi-year federal systems strategy to expand beyond contract R&D into integrating application solutions that can be fielded. The contract opportunities are much larger for integrated application solutions. In addition, the product potential is greater utilizing proven contract deliverables for fielded applications. There are far more government customers available for solution-oriented application integration than for R&D Teknowledge did win a $700,000 Phase II Deductive Spreadsheets SBIR and some small follow-on contracts in 2006, but it will take time to win new large government application integration contract awards, and awards take months to turn into funded contracts.  Teknowledge will continue to propose on both prime and subcontract opportunities, and to deliver on R&D. While there may be a temporary decrease in government revenues, we believe that by addressing our financial position, investing in internal R&D, and writing competitive proposals for larger deployment programs, over time Teknowledge’s government sponsored applications development contracts business may regrow into a substantial revenue and technology generating business.

Financial Solutions

Since the September 2005 sale of the TekPortal asset to Intuit Inc., Financial Solutions revenues for 2006 were down from 2005, as expected. Teknowledge transferred many of its TekPortal maintenance customers to Intuit in 2006, and in conjunction with Intuit personnel, we are continuing to provide support services for other current banking customers. Most of these current financial customers will eventually transition to Intuit’s new versions of the software.  We believe that we have excellent integration services capabilities, and strong customer references. We are planning to build out and train a team to provide new storage related integration services to financial and other institutions. Teknowledge is currently developing an initiative to combine its new ActionWeb software with next-generation data storage hardware and software integration solutions.

Patent and Technology Licensing

During 2006, Teknowledge demonstrated the value of its patent portfolio by selling $1,000,000 in patent licenses. Patent agreement results over the past few years speak to real value in the #6,029,175 (‘175) patent. Our patent lawsuits against Inktomi, Akamai, and Cable & Wireless were related to the information caching claims in the ‘175 patent titled: “Automatic Detection of Changed Files By A Network Software Agent.” This patent also includes claims in the area of information alerts. Teknowledge sued Microsoft, Yahoo, and AOL/Time Warner for infringing on the alerts-related claims in the ‘175 patent. Teknowledge settled all of its extant patent lawsuits. The Microsoft case was settled in the third quarter of 2005.

Management believes that the Company’s patents are valid and have significant value. The Company believes that there are a large number of other potential infringers of the ‘175 patent. Teknowledge also has one patent pending related to its safe software wrappers. If granted, this could prove to be a valuable addition to Teknowledge’s patent portfolio. These opportunities are some of the reasons why we created a separate reporting segment for patents and technology licenses. We have taken most of the downside cost risk out of the current lawsuits by engaging the law firm of Goldstein and Faucett on a contingency payment basis. There is the risk that the patents will be invalidated and/or that legal proceedings will determine that no infringement is present for the defendants.  However, the fact that so many substantial companies have reviewed our ‘175 patent and each has chosen to purchase licenses at a time when the Company was under considerable financial stress, is an indicator of the strength of this patent. Teknowledge is now in a stronger financial position after the $7 million transaction with Intuit, and we intend to pursue infringers with renewed vigor.

Opportunities to Improve Our Cash Position

Teknowledge continues to pursue actively several possibilities for improving its cash position, but most are dependent on a variety of external factors. There can be no guarantee that any of these alternatives will occur in the appropriate timeframe, or at all. Teknowledge is considering the following actions to increase the Company’s cash resources and further improve its balance sheet. First, we are continuing to decrease our non-essential operating expenses in 2007, while retaining our core capabilities. Second, we are exploring deeper relationships with several of our partners, including potential investment, or joint venture. Third, Teknowledge may sell a key technology asset, such as one or more patents, its Safe Software Wrappers technology, or other software. These sales could permit the Company to build or acquire additional new products or lines of business. Fourth, the Company could potentially buy a smaller private company that comes with an equity investment in the combined company. Given the relatively small size of Teknowledge, any one or a combination of these actions could make a significant difference to the Company’s financial position.

We continue to work aggressively towards delivering increased value. However, Silicon Valley companies must reinvent themselves every two years or so. This is our time for renewal and growth. We are taking the following specific steps: 1) applying for new government R&D applications in cyber-security and information logistics, 2) expanding our patents licensing program beyond Akamai, Yahoo, AOL, Microsoft, and Intuit, 3) launching knowledge-based web services for information logistics, 4) combining next-generation data storage hardware and software in its new integration solutions and 5) continuing to explore ways to improve our cash position further.

Teknowledge plans to survive and thrive long enough to harvest our significant potential upside. We are passionate about our work, and committed to delivering Teknowledge’s business value to our customers and stakeholders.

Results of Operations

Three months ended March 31, 2007 and 2006

Revenues

Revenues for the three months ended March 31, 2007 were $302,000, compared to $608,000 for the three months ended March 31, 2006. The Company has experienced an approximately 50 percent decline in revenue from products and services performed by the government and commercial segments in Q1 2007 compared to the first quarter of 2006. Revenues from Financial Solutions accounted for 50 percent of total revenues compared to 54 percent for the comparable period in 2006. Revenue from Government Contract R&D was 50 percent of total revenue in the three months ended March 31, 2007, compared to 46 percent in the first quarter of 2006. Revenue from Patent and Technology Licensing was 0 percent in the first quarter of 2007 and 0 percent of the first quarter of 2006’s revenue.  The Company was unsuccessful in 2006 and the first three months of 2007 in replacing all of the government contracts that were completed during the year, largely because of changing government priorities and vigorous competition.

The decrease in government revenue of $129,000 is attributed to a decline in government contracts from the comparable period.  The Company is seeking new government contracts to replace the government contracts that ended in 2006 and has submitted proposals to the government that are currently under consideration.

Government Contract R&D revenue for the three months ended March 31, 2007 was $151,000, a 46 percent decrease in revenue from $280,000 in the comparable quarter in 2006.  Some of Teknowledge’s contracts ended in 2006 and were not  replaced with new contracts. Replacing these large contracts was more difficult than expected for several reasons. First, much of the post 9-11 increase in defense spending was focused on supporting war efforts directly, rather than on software R&D. Second, a higher percentage of the budget of some of our key government sponsors has focused on funding a few large teams with total solution packages, and competition for these contracts has increased. In order to be more competitive, Teknowledge’s role has sometimes shifted from contractor to subcontractor; further reducing revenue production. Third, the component solution contract dollars available have often been awarded in smaller increments through the Small Business Innovation Research programs. The future demand for government-sponsored contract R&D services will depend on a number of factors, including the quantity of competitive contract awards and sponsor priorities. In 2007, 50 percent of total revenues for the three months ended March 31, 2007 were from the Department of the Air Force, compared to 36 percent for the first quarter of in 2006.

Financial Solutions revenue for the three months ended March 31, 2007 was $151,000, representing a 54 percent or $177,000 decrease in revenues from the comparable quarter in 2006. Customer demand did not meet expectations in the first quarter. Financial Solutions revenues from license sales to customers were $0, compared to $13,000 in the first quarter of 2006.

In addition to product license and service opportunities, the Company is actively pursuing patent and technology licensing agreements with large companies that may be infringing on the Company’s patents. During the first quarter of both 2006 and 2007, the Company recorded zero revenue from intellectual property licensing activity.

��

Revenues from the Financial Solutions segment equaled the revenue from the government segment in the first quarter of 2007. The Company anticipates that during the fiscal year 2007 the segment with the most revenue may fluctuate from quarter to quarter, depending on the specifics of business opportunities, contract wins, market cycles, and intellectual property settlements or rulings.

Costs and Expenses

Cost of revenues was $198,000 for the three months ended March 31, 2007, compared to $303,000 for the three months ended March 31, 2006. Cost of revenues were 35 percent of total revenues for the three months ended March 31, 2007, compared to 50 percent for the three months ended March 31, 2006. In the first quarter of 2007, the Company spent $94,000 less on labor and labor related costs and $6,000 less on outside support costs on contracts. The Company plans to contain its spending until it can improve its overall backlog.

General and administrative (“G&A”), costs were $425,000 for the three months ended March 31, 2007, compared to $485,000 for the three months ended March 31, 2006. Total G&A expenses decreased about 12 percent over the three months ending March 31, 2006 or $60,000.  This decrease in G&A costs is primarily the result of accounting and legal fees. G&A expenses for the three months ended March 31, 2007, were 141 percent of total revenue compared to 80 percent of total revenue for the three months ended March 31, 2006. Due to a change in the product mix between government and commercial contracts, less G&A expense was absorbed by the Government contracts. Because of flexible overhead rate application in the government cost structure, government contracts are able to absorb a proportionate share of G&A expenses; however, commercial contracts are not as flexible in their pricing structure, therefore leaving them less able to absorb an increase in the G&A allocation. As revenue increases, the Company anticipates that general and administrative expenses will decline as a percentage of total revenue.

Sales and marketing expenses were $3,000 for the three months ended March 31, 2007, compared to $2,000 for the three months ended March 31, 2006. Sales and marketing costs were 1 percent of total revenues in the first quarter of 2007 versus zero percent in the comparable period of 2006. The Company’s sales and marketing efforts include applications engineering and technical support, direct sales efforts, as well as trade shows, demonstrations, and other traditional marketing activities. Teknowledge is now developing new software and a team to provide hardware and software integration services to financial and other institutions. Sales and marketing expenses are expected to grow in proportion to the growth in commercial revenues in the future.

The Company-sponsored internal R&D expenses for new software product prototypes were $338,000 for the three months ended March 31, 2007, compared to $315,000 for the three months ended March 31, 2006. In addition to the government sponsored R&D, the Company does not expect to capitalize additional costs in the development of the TekPortal products in 2007. Teknowledge invested $0 in the first quarter ended 2007, compared to $0 in first quarter of 2006, in the internal development of TekPortal software that was capitalized. R&D expenses for the three months ended March 31, 2007 and 2006 were 112 percent and 52 percent of total revenue, respectively. The majority of the Company’s long-term R&D expenditures are funded externally through government projects (and recorded as cost of revenues), which are expected to provide new technology and intellectual property. Teknowledge retains intellectual property rights on its contract R&D work.

The Company reported a gain on the sale of assets of $1,050,000 for the quarter ended March 31, 2007.  The gain resulted from the release of escrow related to the sale of the Company’s TekPortal product to Intuit in August 2005.

Other Income and Expenses

Interest and other income was $74,000 for the three months ended March 31, 2007, compared to $21,000 for the three months ended March 31, 2006. Interest expense for the first quarter was $0 in both 2006 and 2007. The Company had no outstanding debt on March 31, 2006 and 2007.

 The effective tax rate was zero percent for both the three months ended March 31, 2007 and 2006, respectively. An effective tax rate of zero percent for the current quarter is the result of the Company’s net operating loss carry forward and valuation allowance against the deferred tax assets.

Bookings and Backlog

 At March 31, 2007, the expected order backlog was approximately $794,000, which consisted of new orders for which work has not yet begun and revenue remaining to be recognized on work in progress. Of the March 31, 2007 backlog, 76 percent is from Government Contract R&D customers, while 24 percent is from Financial Solutions customers. The Financial Solutions segment contributed 50 percent of revenue during the three-month period ended March 31, 2007. The Financial Solutions percentage contribution to backlog is lower than from government customers because commercial contracts are typically less than nine months in duration. Approximately 59 percent of the backlog consists of government-sponsored programs that were awarded but not yet authorized for funding at March 31, 2007. The government normally funds a contract in incremental amounts for the tasks that are currently in production. The Company has received additional funding on two government contracts. If addition follow on funding is not received in a timely manner, the Company may experience an interruption in its planned billing and cash collections during the hiatus period between funding increments. Excluding expected new work, the Company expects 66 percent of the current backlog to be fulfilled during 2007.

Liquidity and Capital Resources

As of March 31, 2007, Teknowledge had approximately $1,395,000 in cash and cash equivalents, a decrease of $349,000 or 20 percent from the comparable cash and cash equivalents in first quarter ended 2006 of $1,744,000. The decrease in net cash at March 31, 2007 is attributed to ongoing operating losses. The Company used net cash of $426,000 for its operating activities for the three months ended March 31, 2007, compared to the use of $422,000 in the same period for 2006. The Company received $1,050,000 from investing activities in first quarter of 2007 compared to using $3,000 in 2006 for the same period. In the first quarter of both 2006 and 2007, financing activities provided no cash.

Teknowledge’s traditional sources of cash are revenues from continuing government and commercial services operations, intellectual property and patent licensing, and credit facilities to stimulate future growth; however, there can be no assurance that the Company will be able to locate and obtain additional financing acceptable to the Company or at all. Based on its current cash position, available credit, and projected cash flows from operations, management believes the Company may not have sufficient funds to support operations for the next nine-month period unless it can increase business revenues substantially, secure additional funding, or obtain supplemental financing.

Critical Accounting Policies and Estimates

Certain accounting policies are particularly important to the portrayal of the Company’s financial position and results of operations. These policies require the application of significant judgment by our management team. As a result, they are subject to an inherent degree of uncertainty. In applying those policies, management uses its judgment to determine the appropriate assumptions to be used in the determination of estimates. Those estimates are based on the Company’s historical experience, terms of existing contracts, observance of trends in the industry, information provided by its customers, and information available from other outside sources, as appropriate. Teknowledge’s significant accounting policies and estimates include:

·   Revenue recognition;

·   Allowance for doubtful accounts;

·   Software development costs; and

·   Determination of government indirect rate reserves.

Revenue Recognition

Revenue on software licenses and services is recognized when persuasive evidence of an arrangement exists, the price is fixed or determinable, delivery has occurred, and there is a reasonable assurance of collection on the resulting receivable. Teknowledge may record license revenues as a result of legal settlements if the settlement provides for the issuance of a license. Teknowledge customarily obtains written purchase authorizations from customers for a specific product at a fixed price and considers delivery to have occurred at the time of shipment. The software is delivered to the customer electronically or on a compact disk. Revenue is typically recognized on delivery of product software; however, if the software is subject to customer acceptance or contract terms that do not satisfy all of the above-mentioned criteria, revenue is recognized upon customer acceptance or when all revenue recognition criteria have been met. Occasionally, customer contracts contain refund or warranty clauses that could affect revenue recognition. Teknowledge evaluates these clauses carefully; however, the Company has not experienced a refund or warranty recall and the likelihood of such an event is not predictable nor is it judged material at this time. Revenue from software consulting services is generally recognized on a time and materials basis; however, depending on the terms of the contract, the service element may be recognized on a percentage-of-completion basis. Revenue recognized under the percentage-of-completion basis requires the use of project cost estimates. Project cost estimates are revised periodically and changes affecting the amount of revenue recognized are recorded when they become known. Revenue from R&D contracts is generally recognized over applicable contractual periods as specified by each contract and as costs related to the contracts are incurred.

Allowance for Doubtful Accounts

Teknowledge provides an allowance for doubtful accounts based on historical payment experience for its nongovernmental customers, age of unpaid amounts, and a review of significant past due accounts. Estimates of uncollectible amounts are revised each period and changes are recorded when they become known. The Company generally does not provide an allowance for receivables from government customers because the Company has historically experienced virtually no collection issues.  The Company has established a rate reserve to cover potential losses associated with adjustments to its audited government rates.

Software Development Costs

The eligible costs incurred in the development of our commercial software are capitalized. Teknowledge periodically reviews these costs to ensure they are recorded at the lower of net amortized cost or net realizable value. Net realizable value is determined using estimated future cash flows related to sales of the underlying technology. Had different assumed cash flows been used, materially different amounts of the carrying amount of these costs could have been reported.

Teknowledge evaluates the expected future revenues from software products before undertaking software development. Only those projects that are considered potentially profitable after including the costs to develop the software are pursued beyond the planning stage. The Company capitalizes software development costs from the point of technological feasibility and after completion of the detail program design. All costs incurred prior to determination of technological feasibility are expensed. Teknowledge solicits feedback from its customers to help identify potential enhancements that add value to key products. The Company in turn evaluates these potential enhancements to determine which, if any, will be incorporated into the next version. The software development process proceeds from module to module until the product manager determines that an adequate number of functionalities have accumulated to earn release status. A typical version may encompass up to a dozen functional modules, most of which could be used separately, but which are not practical to market individually because of cost and market constraints. The Company may add high-value, low-risk development modules to address particular customer needs, but only after assessing technical risk and program design issues. These optional features are considered low-risk development enhancements to the original functionality.

The Company completed V3.2 of TekPortal in the second quarter of 2005 and it was released to customers. Capitalized costs include direct and indirect labor costs and applicable overhead, but exclude G&A costs. The Company regularly examines its procedures for accumulating economic life of the product, which is estimated at three years. Capitalized software development costs are reviewed and evaluated periodically to determine recoverability. Should the Company determine that all or part of its capitalized software development costs are not recoverable, an adjustment to the capitalized software costs would be charged to income in the period such determination is made. Management evaluated the performance of its TekPortal product through December 31, 2004, and determined that an adjustment to the net realizable value of the development asset was required because the licenses, maintenance, and related services revenues, net of future costs of completing and disposing of the product, including maintenance and required customer support, did not meet management’s financial objectives. As a consequence, the unamortized value of previously capitalized software development costs at December 31, 2004 was reduced by $1,753,000. The Company began amortizing V3.2 of TekPortal in June 2005. At August 22, 2005, the Company concluded the sale of its TekPortal software asset and transferred the development software to Intuit Inc. As a consequence of the sale, the unamortized value of TekPortal versions 3.2 and the version 3.3 of $2,012,000 was disposed as part of the net sale of the TekPortal software asset in the third quarter of 2005.

Determination of Government Indirect Rate Reserves

The Company’s revenues, costs, and earnings on government contracts are determined based on direct cost and estimated overhead “indirect” rates derived from forecasted annual costs. The Company’s actual experience in headcount growth, billable efficiency, and costs typically vary from original estimates and necessitate periodic adjustments to overhead rates and revenues. Such adjustments are made on a cumulative basis whereas the resulting revenue and income effects are recognized in the period of the adjustments. The Company is also subject to periodic reviews of prior year costs and expenses by audit agencies of the Federal Government. As a result of these audits, the Company may be exposed to annual cost adjustments that are applied on a retroactive basis to the government contracts completed in prior years. These adjustments can have a negative or positive effect on the results of operations and cash reserves in the period in which the adjustment is realized. In order to address the possible exposure to rate adjustments in prior years, Teknowledge established a rate adjustment reserve for potential government cost recovery for the then open and unaudited years of 2001-2005. The cumulative reserve, including earned retained fee of $211,000, is $2,248,000 at March 31, 2007.

On September 30, 2004, the government suspended payment on three of Teknowledge’s contracts pending repayment of projected differences between the “actual” overhead rates used in the billings and the proposed overhead rates submitted to the government for the years 2001-2003. Based on the original rate data Teknowledge provided to the government for those years, the government audit agency, DCAA, indicated that Teknowledge owes $813,000 in gross charges. Prior to this, Teknowledge requested a review of the treatment of subcontractor costs in the previously submitted overhead cost proposals. Teknowledge believes the prior treatment unfairly allocated substantial amounts of internal G&A expenses to outside subcontractors and has requested an equitable redistribution of these costs to a separate pool for the unaudited years. A similar treatment has already been approved for 2004, but the government has so far denied Teknowledge’s request to make the change effective for all the unaudited years. The change in the treatment of subcontractor costs, if accepted by the government, could reduce the overall exposure to the Company by $1,022,000. On October 5, 2004, the government released for payment the three contracts that were on suspension, contingent on the establishment of a long-term payment schedule between the two parties. The payment terms and conditions will be determined after a review of the Company’s financial viability, and its cash reserves and forecast cash flows from all sources through 2006. The Company believes it could have adequate cash resources to establish a mutually workable payment schedule, depending on the agreements reached, and the Company’s financial position at that time. The Company is prepared to make good faith payments while it negotiates for the successful resolution of the treatment of the subcontractor costs and any related rate issues. These payments would be charged against the rate reserve and not earnings.

During the fourth quarter of 2004, the government issued a preliminary audit report and findings for the overhead costs incurred in 2001. The government questioned the Company’s treatment of amortization on previously capitalized software development costs for the Company’s dual-use TekPortal product. The Company allocated approximately 30 percent of 2001 amortization costs to the government segment, which the Company believed was a fair allocation to the government for the benefit from the technology developed in 2000. The government subsequently rejected this argument, denying any allocation to the government either directly or indirectly because of the product’s short history of largely commercial sales and other technical issues. At the time the product V1.0 was originally developed in 2001, the Company intended to sell its product to commercial and government customers. As evidence of this intent, the Company provided the auditors copies of two government proposals that utilized TekPortal’s information aggregation software. In addition, the Company has a long history, going back to the 1980s, of selling previously developed products like M.4 to the government. Therefore, the Company believes that it was reasonable to assume that the government would benefit in the development of Teknowledge products and that allocating 30 percent of the development costs was a realistic consideration based on Teknowledge’s long history of product development. This is also consistent with the government’s interest in encouraging government contractors to develop from internal R&D, commercial products that can be utilized for government purposes. The government excluded 100 percent of TekPortal development costs, claiming since there were no TekPortal sales to the government during the applicable period; therefore, the production costs should not have been allocated to the government. The government position appears to be inconsistent with the intent of FAS86, which describes a process of allocating costs over estimated revenues that the Company believes would apply to revenues from the potential sales of the TekPortal software in the government arena. The Company contests the government’s exclusion of a portion of TekPortal software development costs.

The Company periodically evaluates its exposure from the government’s suggested cost treatment of software development costs for the audited years of 2001-2003 and the unaudited years of 2004-2006, assuming all amortization costs were included in the G&A base pool. At December 31, 2004, after consulting with outside counsel, and given the relative absence of court precedent in this area, management determined there was a potential estimated cost exposure, as a result of a negative outcome from the aforementioned issue, of $1,500,000. The Company believes that a considerably lower amount is entirely possible and it plans to negotiate with the government for the most favorable result. In the third quarter of 2005, the Company requested from the government that an Alternative Dispute Resolution (“ADR”) procedure be established to evaluate the outstanding issues and to accelerate the review process. The government responded with a combination of two notices, one dated December 6, 2005 and the other January 19, 2006 indicating that Teknowledge should pay the outstanding balance on the $810,000 referenced above as part of the 2001 audit results.  On April 20, 2006, the Company filed a complaint in the United States Court of Federal Claims under the Contract Disputes Act of 1978 challenging the government’s Notice of Intent to Disallow Costs for 2001.  The complaint seeks to reverse the decision of the Defense Contract Management Agency’s (“DCMA”) Administrative Contracting Officer’s (“ACO”) in disallowing $285,000 in reimbursable overhead costs for 2001 related to the amortization of the Company’s capitalized software development costs.  If the Company prevails in this lawsuit, a substantial portion of the government rate reserve may be reversed, as it is related to the capitalized software amortization expense in question.

The Company continues to discuss alternative solutions with the government, including ADR, a long-term payment schedule, and a beneficial software licensing agreement; however, it is impossible to determine at this time the ultimate outcome of negotiations and the legal alternatives available to the Company. The Company has established a reserve to offset a potential negative outcome for the open years of 2001-2006. The Company believes that this reserve is reasonable; however, the final outcome may be more or less than this amount. Because this matter is based on the specific treatment of generally allowable costs, no penalties or interest charges are anticipated.

Recent Accounting Pronouncements

In June 2006, FASB issued FASB Interpretation FIN No. 48, "Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109", to address the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.  FIN No. 48 goes into effect for fiscal years beginning after December 15, 2006.  The Company has determined that FIN No. 48 has no material impact on our financial position, results of operations, or cash flows.

In June 2006, the FASB Emerging Issues Task Force ("EITF") issued EITF Issue No. 06-2, "Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences", to address whether certain compensation costs associated with a sabbatical or other similar benefit arrangement should be accrued over the requisite service period.  EITF Issue No. 06-2 goes into effect for fiscal years beginning after December 15, 2006.  We have determined that the change does not have a material impact on our financial position, results of operations, or cash flows.

In September 2006, the Financial Accounting Standards Board ("FASB") issued FAS No. 157, "Fair Value Measurements." This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.  FAS No. 157 goes into effect for fiscal years beginning after November 15, 2007.  We have not yet determined the final impact, if any, that the adoption of FAS No. 157 will have on our financial position; however, we do not anticipate the change will have a material impact on our financial position, results of operations or cash flows.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 is effective for fiscal years ending on or after November 15, 2006 and addresses how financial statement errors should be considered from a materiality perspective and corrected. The literature provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. Historically, there have been two approaches commonly used to quantify such errors: (i) the “rollover” approach, which quantifies the error as the amount by which the current year income statement is misstated, and (ii) the “iron curtain” approach, which quantifies the error as the cumulative amount by which the current year balance sheet is misstated. The SEC Staff believes that companies should quantify errors using both approaches and evaluate whether either of these approaches results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. The Company adopted SAB No. 108 in the fourth quarter of fiscal year 2006 and we have determined that it did not have a material impact on its consolidated financial statements.

Risks That May Affect Future Results of Operations and/or Stock Price

Current cash flow may be insufficient to support current and future operations

To support current and future operations, the Company is dependent upon revenues, credit facilities and its ability to obtain financing. Revenues decreased by 50 percent in the first quarter of 2007 to $302,000, compared to $608,000 in the first quarter of 2006. The ability of the Company to grow its revenues will depend on the Company’s success in winning new government R&D contracts, selling commercial services and maintenance support to existing and new customers. As of March 31, 2007, Teknowledge had $1,395,000 in cash and cash equivalents, a decrease of $349,000 over the comparable period in 2006. The decrease in net cash at March 31, 2007 is attributed principally to ongoing operating losses.  The Company used net cash of $426,000 from its operating activities for the three months ended March 31, 2007, compared to $422,000 used in the same period during 2006. The Company generated $1,050,000 from investing activities in first quarter of 2007 compared to $3,000 used in the first quarter of 2006. In the first quarter of 2006 and 2007, financing activities provided no cash. Teknowledge intends to establish a new credit line with a bank. The Company’s available cash and anticipated credit facilities may not be adequate to sustain the business over the next 9 months. Future growth is likely to be dependent on the Company’s success at improving revenues and cash flow.

Teknowledge is actively pursuing new contracts and integration services business, as well as patent and technology licenses. However, there can be no assurance that the Company will be able to generate increased revenue from new software and integration services or by licensing its patents and technology. The Company may not be able to develop successful new products and services, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements. The Company may be required to eliminate costs by reducing headcount further, which could result in less sales or development activities and adversely impact operations. In the event the Company raises capital by issuing equity securities from authorized shares, such financing will decrease the percentage equity ownership of existing stockholders, and depending on the price, at which the equity securities are sold, may result in significant economic dilution. The Board of Directors is also authorized under the Company’s Certificate of Incorporation to issue preferred stock with preferences and privileges senior to those of the common stockholders without common stockholder approval, though subject to applicable government regulations and stockholder approval rules. If the Company issues preferred stock in a financing, the rights of existing stockholders could be adversely impacted.

The market for software and software services is highly competitive and changing rapidly

The market for the Company’s services and software continues to evolve rapidly and is populated by substantial competitors who are continuously developing competing software products and services. As is typical for a new and rapidly evolving industry, demand and market acceptance for products and services are subject to a high level of uncertainty. As a result, many competitors have merged or dropped out of the market. Further, aspects of the business (including security, privacy, reliability, cost, ease of use, and quality of services) are undergoing rapid change. The Company is exposed to a higher risk of default and slower collections from small non-government clients, compared to relatively reliable government customers. Teknowledge is addressing this difference by broadening its customer base.

Teknowledge plans to grow its commercial business by selling through partnerships and by expanding into additional value-added capabilities or service offerings. Additional new ActionWeb product development will require incremental additional investments and that could strain technical, financial, and operational resources. The Company’s gross margins in new business areas may be lower than in its government contract business, and it may not be able to expand or maintain operations in a cost-effective or timely manner. Demand for the Company’s new and developing ActionWeb product line is currently unknown.  If customers do not receive new products or services favorably, it could hurt the Company’s reputation and delay future expansion.

Within the software and integration services industry, Teknowledge believes some companies are consolidating, creating larger competitors with greater resources and a broader range of products. Some of Teknowledge’s competitors and potential competitors may have significant advantages over the Company, including extensive name recognition and marketing power, preferred vendor status with the Company’s existing and potential customers, and significantly greater financial, technical, marketing and other resources. These factors may give them the ability to offer free products or services to gain market share or to respond more quickly to new or changing opportunities, technologies, and customer requirements. The Company’s competitors may also highlight public disclosures of the Company’s previous adverse financial position, or package their products in a manner that may discourage potential customers from purchasing the Company’s products. Existing and potential competitors may establish cooperative relationships with each other or with third parties, or adopt unsustainable or aggressive pricing policies to gain market share. Security, privacy, reliability, cost, ease of use, and quality of service are the key competitive factors, and competitors are changing the way in which they are developing these factors; these changes may adversely affect cost of sales or the market acceptance of the Company’s software.

The demand for the Company’s services will depend upon broad acceptance of new methods of accessing and utilizing information over the Internet. An unstable economy and the resulting uncertainty can defer purchasing decisions by financial and other institutions, and there can be no assurance that these conditions will improve or that demand will return to previous levels. As the market continues to change, there can be no assurance that the Company will be able to recruit or retain the technical staff to develop and bring products to market, that these products will gain market acceptance, or generate significant revenue or profits. If Teknowledge’s products and services markets develop more slowly than expected, become saturated with competitors, or if the Company’s products do not achieve market acceptance, the Company’s business, financial condition, and results of operations may be materially and adversely affected.

Teknowledge’s customers are subject to economic changes that could reduce demand for the Company’s services. Industry consolidation, war, unforeseen events, recession, inflation, or acts of terrorism could occur and reduce consumer demand for the Company’s services. Any event of this kind, or implementation for any reason by customers of cost reduction measures, could result in significant decreases in demand for our products and services. Mergers and acquisitions are pervasive in today’s industries. Teknowledge’s existing or new customers may be acquired by or merged into other financial institutions, which already have their own software solutions or which may decide to terminate their relationship with the Company for other reasons. As a result, the Company’s revenue from related software services could decline if an existing customer is merged into or acquired by another company.

Outsourcing may affect demand for domestic software services

Most of Teknowledge’s software professionals have very specialized skills that are hard to replace. Some have U.S. government security clearances that are only open to U.S. citizens who are willing to undergo an extensive multi-year background investigation. Others have very specialized backgrounds in development and integration of complex software. Still others have very deep R&D backgrounds in artificial intelligence, training, or security. Teknowledge places a high value on employee loyalty, making it possible to develop trust with employees over a long period of time. None of these advantages are currently operating in the outsourcing market for software development. Outsourcing does provide software engineering skills at a fraction of the cost of U.S. based labor.  The use of outsourced labor appears to be more common practice in the commercial arena; however, the above factors, combined with increasing concern about information security risks in industry may serve to minimize the use of outsourcing for mission critical and security sensitive applications.

Increasing government regulation of the Internet could adversely affect the Company’s business

Numerous federal agencies have recently adopted rules and regulations protecting consumer privacy and establishing guidelines for institutions to follow in selecting technology vendors for solutions offered by the Company. The Company believes its business does not currently subject it to any of these rules or regulations that would adversely affect its business. However, these rules and regulations are new and may be interpreted to apply to the Company’s business in a manner that could make its business more onerous or costly. Moreover, institutions must generally comply with these laws and regulations, which may adversely impact demand for the Company’s products.

Teknowledge’s services must integrate with complex data processing systems

Teknowledge’s services must integrate third-party products with complex data processing systems at our customer’s facilities. The Company generally recognizes revenue on a percentage-of-completion basis, so its revenue is often dependent on its ability to complete implementations within the time periods that are established for its projects. Teknowledge relies on a combination of internal implementation teams and outsourced implementation teams for its implementations. If these teams encounter significant delays in implementing the Company’s solutions for a customer or fail to implement the solutions effectively or at all at a customer’s facility, the Company may not be able to recognize any revenue from the contract or be required to recognize a loss from the contract, if revised project cost estimates exceed revenue from the contract. In addition, Teknowledge may incur monetary damages or penalties if we are not successful in completing projects on schedule.

Teknowledge’s software may contain undetected errors or defects

Teknowledge has a quality assurance program to test its complex software, but its software could still contain undetected errors or defects that may be discovered at any point in the life of the product. The Company has in the past discovered and corrected software errors. After implementation, errors may be found from time to time in the Company’s new or enhanced software or services, or in products or services it resells for strategic partners. These errors could cause the Company to lose revenues or cause a delay in market acceptance of its solutions or could result in liability for damages or injury to its reputation. The Company’s software is often used in transaction processing systems that include other vendors’ products and, as a result, its products must integrate successfully with these existing systems. System errors, whether caused by the Company’s software or the software of another vendor, could adversely affect the market acceptance of its software, and any necessary modifications could cause the Company to incur significant expenses. Since the Company’s software is used to deliver services that are integral to its customers’ businesses, errors, defects, or other performance problems could potentially result in financial or other damages to its customers. The Company and its partners do conduct tests of its software, but any product liability litigation arising from errors, defects, or problems, even if it were unsuccessful, would be time-consuming and costly to defend. Existing or future laws or unfavorable judicial decisions could potentially negate any limitation of liability provisions that are included in the Company’s license agreements.

Teknowledge’s network infrastructure could be vulnerable to security breaches

Despite the Company’s security measures, the core of its network infrastructure could be vulnerable to unforeseen computer problems and security breaches. Network or Internet security problems could harm the Company’s reputation and business. Although the Company has taken steps to mitigate much of the risk, it may in the future experience interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees, or others. Unknown security risks may result in liability to the Company and also may deter financial organizations from utilizing the Company’s services. Although the Company intends to continue to implement and establish security measures, there can be no assurance that measures it has implemented will not be circumvented in the future, which could have a material adverse effect on its business, financial condition, or results of operations. The occurrence of any of these problems could reduce product demand from potential customers and cause existing customers to terminate their license or data center contracts with the Company. These problems could also require the Company to spend significant capital to remedy any failure and could subject it to costly litigation with clients or their end users.

Teknowledge may not adequately defend against unauthorized use of its proprietary technology

The Company’s success depends upon its proprietary technology and information. The Company relies on a combination of patent, copyright, trademark and trade secret laws, and confidentiality procedures to protect its proprietary technology and information. It is difficult to police unauthorized use of software and litigation is costly and time consuming. The steps the Company has taken to protect its services and products may not prevent misappropriation of its technology. Any misappropriation of the Company’s proprietary technology or information could reduce any competitive advantages it may have or result in costly litigation. The laws of some foreign countries may not protect the Company’s proprietary technology as well as the laws of the United States. The Company’s ability to protect its proprietary technology abroad may not be adequate.

Service revenue is partially dependent on government-sponsored contract R&D

Much of Teknowledge’s service revenue has historically been derived from government-sponsored contract R&D projects. However, current backlog is low, and dependence on R&D contracts can be risky because the contracts are subject to administrative, legislative, and political interruptions or terminations, which may jeopardize the flow of funds. There can be no assurance that the government will continue to seek services at the current level in the future. Although the Company expected an increase in proposals related to homeland security in 2004-2006, the level of Broad Area Announcement requests for advanced software R&D proposals in its target areas was lower than expected. There can be no assurance there will be an increase in relevant software R&D opportunities in the future. The Company faces increased competition for government projects and this may continue until the general economy improves.

The typical cost-type government contract that Teknowledge performs has a regulated fixed fee, which limits the Company from improving profit margins on these contracts. In addition, Federal Acquisition Regulations exclude from reimbursement “unallowable” expenses, which the Company considers a regular part of the business, such as advertising expense. In addition, almost all of Teknowledge’s government contracts contain termination clauses which permit contract termination if the Company defaults or at the contracting party’s discretion.

Periodic rate changes and audits on government contracts may cause cost adjustments

The majority of Teknowledge’s service revenue has historically been derived from government-sponsored contract R&D projects. Dependence on R&D contracts can be risky because the contracts are subject to administrative, legislative, and political interruptions, which may jeopardize the flow of funds. There can be no assurance that the Company’s proposals will be competitive, or that the government will continue to seek services at the current level in the future. Another uncertainty is that the Company’s revenues, costs, and earnings on government contracts are determined based on estimated overhead rates derived from forecasted annual costs. The Company’s actual experience in headcount growth, billable efficiency, and costs inevitably varies somewhat from original estimates and necessitates periodic adjustments to overhead rates and revenues. An adjustment of a few percentage points may translate into several hundred thousand dollars in rate adjustments or reserves. Rate adjustments are made on a cumulative basis at least annually, but the resulting revenue and income effects are recognized in the period of the adjustments. The Company is also subject to periodic reviews of prior year costs and expenses by audit agencies of the Federal Government. As a result of these audits, the Company may be exposed to cost adjustments, which are applied on a retroactive basis to the government contracts completed in those years. These adjustments can have a significant negative or positive effect on the results of operations and cash reserves in the period in which the adjustment is realized. In order to address the possible exposure from prior year rate adjustments, Teknowledge has established a rate adjustment reserve for such contingencies, and the amount of the rate adjustment reserve is reviewed and adjusted at least annually. During 2004, the Defense Contract Audit Agency (“DCAA”) finished its preliminary audit of the 2001 overhead rates and identified potential cost recoveries, principally from the treatment of software amortization costs. The Company aggregated these costs for all open years from 2001-2005 to determine the appropriateness of the reserve. [See discussion of government overhead rate reserve in Part II, Item 6, “Critical Accounting Policies and Estimates”.] As a result of this review, Teknowledge determined that additional reserves of $1,500,000 should be accrued in 2004 to provide for a potential negative result if the Company is unsuccessful in its contract appeal process. The cumulative reserve at March 31, 2007 was $2,248,000.

Loss of a large customer may affect financial results

The Company has in the past, and probably will in the future, rely on large sales to certain customers. Loss of a single large customer could have a material impact on the sales revenue and profitability of the Company.

Teknowledge’s success depends on retaining sufficient technical staff and attracting additional technical staff

The Company recognizes that the loss of one or more key management and technical personnel, who are employed on an at-will basis, could adversely affect the Company’s business. The Company relies on its executives and business managers for the acquisition and negotiation of new business, the management of services contracts and product development, and the management of ongoing operations. A proportion of the technical support base for operations is provided by outside consultants, and it is anticipated that this trend will continue in the future. The use of outside consultants allows the Company to expand or constrict its operations quickly both inside and outside the U.S.

Teknowledge will incur increased costs as a result of the implementation of new rules, regulations, and pronouncements from the SEC, including the provisions of the Sarbanes-Oxley Act of 2002

Recently enacted and proposed changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, rules adopted or proposed by the SEC and new accounting pronouncements, will result in increased costs to us as we evaluate the implications of these laws, regulations and standards and respond to their requirements. In 2005, the Company was delisted from the Nasdaq SmallCap Market due to its low stockholders’ equity and past financial performance. Nonetheless, to maintain high standards of corporate governance and public disclosure, we intend to invest substantial resources to comply with evolving standards. This investment may result in increased G&A expenses and divert management time and attention from strategic revenue generation and cost management activities. In addition, these new laws and regulations could make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher premiums to obtain the same or similar coverage. The impact of these events could also make it more difficult for us to attract and retain qualified personal to serve on our board of directors, our board committees or as executive officers. We are taking steps to comply with the recently enacted laws and regulations in accordance with the deadlines by which compliance is required, but cannot predict or estimate the amount or timing of additional costs that we may incur to respond to their requirements.

Item 3. Controls And Procedures

(a) Evaluation of disclosure controls and procedures. Our principal executive officer and principal financial officer evaluated our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and principal financial officer concluded that these disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the requisite time periods.

In connection with its audit of the Company’s consolidated financial statements for the year ended December 31, 2005, Burr, Pilger & Mayer LLP (“BPM”), the Company’s registered public accounting firm, advised the Audit Committee and management of internal control matters with respect to certain financial reporting controls that they considered to be a material weakness, which is described below.  A material weakness is a control deficiency, or a combination of control deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The material weakness that we had identified at December 31, 2005 was as follows:

A material weakness existed in our control environment relating to inadequate staffing of our technical accounting function, including a lack of sufficient personnel with skills, training and familiarity with certain complex technical accounting pronouncements that have or may affect our financial statements and disclosures.

The Company considered these matters in connection with the year end closing process and the preparation of the December 31, 2006 consolidated financial statements included in this Form 10-KSB and also determined that no prior period financial statements were materially affected by such matters. In response to the observations made by BPM, in 2006 the Company implemented certain enhancements to its internal controls and procedures, which it believes addressed the matters raised by Burr, Pilger & Mayer LLP.

As described in Item 8A of our Form 10-KSB for the year ended December 31, 2003 and in our Form 8-K filed March 3, 2005 and amended on April 1, 2005, our previous independent auditor Grant Thornton LLP (“Grant Thornton”), advised our Audit Committee and management regarding certain internal control matters that they considered to be reportable conditions as that term is defined under standards established by the American Institute of Certified Public Accountants. In response to the comments made by Grant Thornton in 2003, the Company implemented certain enhancements to its internal controls and procedures in the second quarter of 2004, which it believes address the matters raised by Grant Thornton. The enhancements included review of policies and procedures for processing and controlling accounting transactions, closer supervisory and review of revenue recognition practices, improved monitoring and control of closing procedures, including certain high value reserves and accruals, and the migration of important purchasing, billing, and contract administration functions to the most experienced staff. Where applicable, the Company utilized available automated and manual controls to further enhance existing controls. Some responsibilities assigned to a single desk were redistributed to multiple employees to enhance control. The Company believes that the control initiatives that began in the second quarter 2004 were effective in addressing the concerns raised by the predecessor accountants.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On April 1, 2006, Teknowledge filed a lawsuit against the United States Government in the United States Court of Federal Claims. Teknowledge is requesting that the court rule as improper a contracting officer’s decision dated January 19, 2006 that Teknowledge must account for all Software Amortization costs as direct costs of the Financial Services overhead pool, and that Teknowledge may, pursuant to the Federal Acquisition Regulation (FAR), account for 31% of the Software Amortization costs as indirect costs of the government overhead pool and recover those costs. No trial date has been set. A Pretrial Scheduling Order was filed on October 10, 2006 mandating that the parties submit a Joint Status Report by October 15, 2007.

On October 6, 2006, Teknowledge was served with a lawsuit from Large Systems Specialists, Inc., a contractor of Teknowledge. The lawsuit was filed in the Superior Court of California, Santa Clara County, and claims breach of contract and requests damages in the amount of $343,583.  The lawsuit is a result of Teknowledge contesting an invoice submitted on June 29, 2006 in the amount of $252,265. The invoice was submitted under a consulting services agreement and related software maintenance services agreement, and was submitted for alleged under-billing by Large Systems Specialists, Inc for the period February 4, 2003 to June 16, 2006. On October 31, 2006, Teknowledge invoked the arbitration clause of the subject agreements and stipulated to a Stay of Action Pending Arbitration. It is anticipated that an arbitration on the matter will be scheduled during the second quarter of 2007.

The Company may be subject to legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on the Company’s consolidated results of operations or consolidated financial position.

Item 6. Exhibits

(a)     Exhibits:

Set forth below is a list of all exhibits filed herewith or incorporated by reference as part of this Quarterly Report on Form 10–QSB.

Exhibit No. Description

31.1	Certification of Principal Executive Officer pursuant to rule 13a-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002, dated May 16, 2007.
31.2	Certification of Principal Financial Officer pursuant to rule 13a-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002, dated May 16, 2007.
32.1	Certification of Principal Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 16, 2007.
32.2	Certification of Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, dated May 16, 2007.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

Dated: May 16, 2007	Teknowledge Corporation
	(Registrant)

By: /s/ Neil Jacobstein                        

Neil Jacobstein

Chairman of the Board of Directors

Chief Executive Officer and President

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated on May 16, 2007.

/s/ Neil Jacobstein	Chairman of the Board of Directors,	May 16, 2007
Neil Jacobstein	Chief Executive Officer and President
	(Principal Executive Officer)
/s/ Michael D. Kaplan	Vice President and	May 16, 2007
Michael D. Kaplan	Chief Financial Officer