Aladdin Knowledge Systems (ALDN) 20-F/A 2006 FY Annual report (foreign) (amended)

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

FORM 20-F/A
Amendment No.1

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

Commission File No. 1-8201

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

_______________________

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

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

Nasdaq Global Market
(Name of Exchange)

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

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

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of
December 31, 2006:

14,683,488 Ordinary Shares

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

o  Yes          x  No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x  Yes     o   No

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

o  Yes      x  No

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

o  Large Accelerated Filer           x  Accelerated Filer          o   Non-Accelerated Filer

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

Item 17o   Item 18 x  

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

o   Yes7 No x  

EXPLANATORY NOTE

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

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

Item 18: FINANCIAL STATEMENTS

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

Item 19: EXHIBITS

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

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

_________________

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

** Filed herewith.

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

SIGNATURES

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

ALADDIN KNOWLEDGE SYSTEMS LTD.
By:	/s/ Jacob (Yanki) Margalit
	Jacob (Yanki) Margalit
	Chief Executive Officer and
	Chairman of the Board

EXHIBITS INDEX

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

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

_________________

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

** Filed herewith.

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

ALADDIN KNOWLEDGE SYSTEMS LTD. AND ITS SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2006

IN U.S. DOLLARS

INDEX

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

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

REPORT OF INDEPENDENT PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of

ALADDIN KNOWLEDGE SYSTEMS LTD.

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

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

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

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

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

- 2 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands, except share and per share data

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

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

- 3 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

U.S. dollars in thousands, except share and per share data

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

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

- 4 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

U.S. dollars in thousands, except share and per share data

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

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

- 5 -

ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

U.S. dollars in thousands, except share and per share data

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

*) Composed as follows:

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

**) Represents an amount lower than $1.

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

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ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

U.S. dollars in thousands, except share and per share data

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

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

- 7 -

ALADDIN KNOWLEDGE SYSTEMS LTD.
AND ITS SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

U.S. dollars in thousands, except share and per share data

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

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

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

- 8 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

NOTE 1:- GENERAL

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

- 9 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

- 10 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 11 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 12 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

Intangible assets:

Intangible assets acquired are amortized over their useful lives using a method of amortization that reflects the pattern in which the economic benefits of the intangible assets are consumed or otherwise used up, in accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets”, (“SFAS No. 142”).

Indefinite-lived intangible assets are not amortized, but rather are subject to an annual impairment test.

Other intangible assets are amortized using the straight-line method over the following estimated useful life:

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

- 13 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 14 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 15 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 16 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 17 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 18 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 19 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

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

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

- 20 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

NOTE 2:-

SIGNIFICANT ACCOUNTING POLICIES (Cont.)

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

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

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

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

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

- 21 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 22 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 23 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

In November 2004 and July 2005, the Company invested in U.S. government bonds with maturities of up to three and two years, respectively.

In June and July 2006 the Company sold its investments in equity securities for total consideration of $ 1,372. The net adjustment to unrealized gains (losses) on available-for-sale marketable securities was included as a separate component of shareholders’ equity “accumulated other comprehensive income (loss)” and amounted to $ 223, $ (302) and $ (56) in 2004, 2005 and 2006 respectively.

According to Staff Accounting Bulletin No. 59 (“SAB No. 59”) and EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” for any marketable securities whose value declined during the period, management is required to evaluate whether the decline is other than temporary. In 2005, a decline in value that was considered other than temporary of one of the Company’s available-for-sale securities resulting in reversing the accumulated unrealized loss of $ 117 relating to these investments. The amount was classified as financial expenses in the consolidated statements of income as of December 31, 2005. In 2006, no such decline was identified.

- 24 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

	Amortized cost		Estimated fair market value
2007	$	24,206	$	24,147

NOTE 4:- OTHER ACCOUNTS RECEIVABLE AND PREPAID EXPENSES

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

NOTE 5:- INVENTORIES

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

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

- 25 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

NOTE 6:- INVESTMENT IN OTHER COMPANIES

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

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

- 26 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

- 27 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

NOTE 7:- PROPERTY AND EQUIPMENT, NET

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

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

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

- 28 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

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

- 29 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

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

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

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

- 30 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 31 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

NOTE 12:- TAXES ON INCOME

By virtue of this law, the Company is entitled to claim accelerated depreciation on equipment used by the “Approved Enterprise” during five tax years.

For the Company’s seven investment programs, the tax benefits are as follows: Income derived from the investment programs, is tax exempt for the first two years of the 10-year tax benefit period, and is entitled to a reduced tax rate of 10%-25% during the remaining benefit period (based on the percentage of foreign ownership in each taxable year).

The period of tax benefits detailed above is subject to time limits of the earlier of 12 years from commencement of production, or 14 years from receiving the approval. Accordingly, the period of benefits relating to all investment programs will expire in the years 2005 through 2015.

In 1996, the Company relocated its manufacturing activity to a new plant which was established in a region defined as a “Priority “A” Development Region”. This development region entitles Aladdin Israel to higher tax benefits than the tax benefits existing where the Company’s offices and research and development center are located. The main benefit is that the Company is tax-exempt for a benefit period of 10 years.

The allocation of the income tax between the priority regions is calculated by a formula that was authorized by Israel Tax Authority.

On April 1, 2005, an amendment to the Investment Law came into effect (“the Amendment”) and has significantly changed the provisions of the Investment Law. The Amendment limits the scope of enterprises which may be approved by the Investment Center by setting criteria for the approval of a facility as a Privileged Enterprise, such as provisions generally requiring that at least 25% of the Privileged Enterprise’s income will be derived from export. Additionally, the Amendment enacted major changes in the manner in which tax benefits are awarded under the Investment Law so that companies no longer require Investment Center approval in order to qualify for tax benefits.

However, the Investment Law provides that terms and benefits included in any certificate of approval already granted will remain subject to the provisions of the law as they were on the date of such approval.

As of December 31, 2006, retained earnings included approximately $ 44,016 in tax-exempt profits earned by the Company’s “Approved and Privileged Enterprises”. The Company has decided not to declare dividends out of such tax-exempt income. Accordingly, no deferred income taxes have been provided on income attributable to the Company’s “Approved Enterprise”.

If the retained tax-exempt income is distributed, it would be taxed at the corporate tax rate applicable to such profits as if the Company had not elected the alternative tax benefits (10% to 25%) and an income tax liability of up to approximately $ 6,602 would be incurred as of December 31, 2006.

- 32 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 33 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

NOTE 12:- TAXES ON INCOME (Cont.)

f. Income before taxes is comprised as follows:

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

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

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

- 34 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

Current deferred tax liability, net, is included within accrued expenses and other liabilities in the balance sheets.

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

- 35 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

- 36 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

- 37 -

ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

Cash received from exercise of options for the years ended December 31, 2004, 2005 and 2006 were approximately $ 3,642, $ 485 and $ 835, respectively.

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ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

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

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

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ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

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

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ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands, except share and per share data

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

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

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

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

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ALADDIN KNOWLEDGE SYSTEMS LTD.

AND ITS SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

U.S. dollars in thousands

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

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

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

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

REPORT OF INDEPENDENT AUDITORS

To the shareholders of

ALADDIN EUROPE LTD

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

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

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

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

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

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