Kasten Chase Applied Research Limited
TSX : KCA

Kasten Chase Applied Research Limited

March 31, 2006 07:25 ET

Kasten Chase Reports 2005 Financial Results

TORONTO, ONTARIO--(CCNMatthews - March 31, 2006) - Kasten Chase (TSX:KCA), a developer of storage security solutions, today reported its audited financial results for the year ending December 31, 2005.

Revenues for the year were $ 1.9 million compared to $ 3.7 million for 2004. The net loss in 2005 was $ 8.3 million, or $ 0.14 per share. The decrease in net loss over last year is largely due to a one-time goodwill impairment charge of $ 9.7 million incurred in 2004. The net loss one year ago totaled $ 17.2 million, or $ 0.30 per share.

"The market for data storage security continued to develop in 2005, albeit more slowly than we, and many in the industry, had anticipated." stated Michael Milligan, President and Chief Executive Officer of Kasten Chase. "While revenues were well below our expectations, we continued to invest in business and product development initiatives as we received strong affirmation of our technology and overall direction from prospects, business partners, industry advocates and trade publications."

For the fourth quarter of 2005, the Company reported revenues of $ 0.2 million and a net loss of $ 1.5 million or $ 0.03 per share. In 2004, the Company reported fourth quarter revenues of $ 0.5 million and a net loss of $ 2.3 million or $ 0.04 per share. At the end of 2005, the Company had $ 1.6 million in cash and no debt. As announced earlier this week, the Company has established a credit facility of up to $1.5 million.

Kasten Chase adopted and executed a very aggressive product and service development program in 2005 and was recognized for its product excellence as a result. Some milestones include:

- Kasten Chase's Assurency SecureData solution was awarded 'Best Storage Security Solution' in the prestigious Network Computing 2005 Well Connected Awards.

- Assurency SecureData was admitted to EMC's Select Program. Through this program, EMC customers can purchase SecureData directly from EMC.

- Kasten Chase extended its Assurency Business Services with the launch of the Storage Security Compliance Audit service in Q2.

- In December, Kasten Chase announced Assurency Keystone, a comprehensive, standards-based key management platform providing the capacity, scalability and interoperability to centrally manage encryption keys over distributed storage infrastructures.

- Recently, Kasten Chase and Optica Technologies announced the industry's first channel-based encryption solution for mainframe tape storage. With this announcement, mainframe users will now have access to a comprehensive storage security solution with key management and performance characteristics designed specifically for their environments.

"Looking forward to 2006, new disclosure requirements for breaches of personal information, growing concerns over privacy protection and identity theft, and the considerable expenses resulting from compromised storage media are motivating end-user organizations to consider storage security with increased urgency," continued Milligan. "With a broader product and services portfolio, offering more value to enterprise customers, we remain confident in the opportunity for our company."

Conference Call

The Company will host a conference call for analysts, shareholders, and members of the media at 8:00 a.m. ET today. The call will include an update on activities, as well as an overview of the Company's financial performance during the year. Management's presentation will be followed by a brief question and answer period.

Those wishing to participate are invited to dial in using the following numbers:

416-849-2726 (in the Toronto area)

1-866-544-4625 (outside of Toronto)

The call will also be Web cast live at www.kastenchase.com.

About Kasten Chase

Kasten Chase (TSX:KCA) delivers innovative data storage security solutions to mitigate information security risks, meet compliance obligations and reduce the cost and complexity of data storage operations. The core of the Company's award-winning, enterprise-class, storage security solution, is Assurency Keystone, a centralized, standards based key management platform that provides the capacity, scalability and interoperability to centrally manage encryption keys over distributed storage infrastructures, while integrating key management policies with data management processes for the protection, retention and sharing of information assets. Kasten Chase complements its award-winning technology with business services that assess information risk and audit compliance practices for enterprise storage. Kasten Chase is headquartered in Mississauga, Ontario and is a certified ISO 9001:2000 company.

For further information, please visit www.kastenchase.com



Dear Fellow Shareholders,

In 2005, the market for data storage security continued to develop, albeit more slowly than we had anticipated. Our company continued to invest in business and product development initiatives as we received strong affirmation of our overall direction from prospects, business partners and industry advocates. Over the year, we implemented course corrections as required to address new challenges and opportunities in the emerging marketplace. Strict expense management throughout the year preserved our cash until we were able to secure bridge financing in March 2006.

Market Developments

Security breaches, particularly those that put personal information at risk, continued to be a significant problem within the U.S. and elsewhere. In 2005, 152 security breaches were disclosed in the U.S. potentially affecting more than 57 million individuals.(1) The Federal Trade Commission estimates that 27 million Americans were victims of some kind of identity theft in the past five years. Other studies suggest one in 20 U.S. citizens has been hit by electronic fraud.(2)

In response to the growing number of security breaches affecting the privacy of personal information, a number of U.S. states enacted notification legislation last year. First introduced by California legislators in 2003, notification laws stipulate that organizations responsible for computerized personal information must disclose security breaches when unencrypted personal information is, or is reasonably believed to have been, acquired by unauthorized persons. These laws provide individuals with an 'early warning' that their personal information is at risk, allowing them to take steps to protect against identity theft and other types of fraud.

As a result of this new legislation, the public disclosure of security breaches was commonplace in 2005. While many of these incidents were due to malicious hacking, an increasing number related to the compromise of computer storage tapes. Bank of America, Ameritrade, Time Warner, Citigroup, City National Bank, Blue Cross Blue Shield, LaSalle Bank and Marriott International all experienced the damaging publicity and incurred the significant expense associated with a lost storage tape.

These disclosures illuminate the considerable business risk in storing sensitive, personal information on removable media. To mitigate risks, data encryption is emerging as a storage security best practice, and may soon be considered the 'reasonable standard of care' for protecting individuals' personal information stored on tape. In 2005, the use of encryption for tapes in transit or at offsite storage was advocated by Iron Mountain, the recognized leader in records management, and in updated information assurance standards such as the 2005 revision of ISO 17799. These endorsements provide critical affirmation of our value proposition and chosen direction.

Growing concerns over privacy protection and identify theft, regulatory compliance and the need for enhanced IT controls, and the considerable expenses resulting from security breaches, are motivating end-user organizations to consider storage security with increased urgency. We are seeing a significant increase in interest from a wide variety of prospects, particularly within the government, financial services and heathcare sectors.

We are also witnessing increased activity within the storage vendor community. A number of vendors embarked on programs to embed data encryption within their tape drives and other storage devices last year. We anticipated this market development when we architected Assurency SecureData with a separate key management platform and embeddable, high performance cryptography. With our architecture, we are well positioned to engage with storage vendors as an OEM supplier of cryptography and key management products and services.

As newer players enter the market, we anticipate that ultimately, encryption will become a ubiquitous commodity within the data storage infrastructure. The next and most important problem for enterprise customers is cryptographic key management. The ease with which thousands of encryption keys can be managed across a wide variety of applications within the data centre will meter customers' adoption of storage encryption. We introduced Assurency Keystone in December to tackle customers' key management challenges head-on.



(1) http://www.idtheftcenter.org/breaches.pdf

(2) United States Senate Committee on Commerce, Science, and
Transportation, Testimony of Paul B. Kurtz, Executive Director,
Cyber Security Industry Alliance, May 10, 2005.


Product Development

Kasten Chase adopted and executed a very aggressive product development program in 2005 and was recognized for its product excellence as a result.

In the first quarter, the company extended its Assurency SecureData solution to include end-to-end protection for content addressed storage (CAS). Assurency SecureData is the first and only storage security solution to protect CAS-based data archives, such as EMC's Centera.

In the second quarter, Assurency SecureData was awarded 'Best Storage Security Solution' in the prestigious Network Computing 2005 Well Connected Awards. Winning this award - over our direct competitors - confirmed the quality and performance of our solution. It also raised our company's profile with prospects, media and industry analysts.

Kasten Chase released the Assurency Crypto-Accelerator 2400 in Q2. The 2400 is a next generation cryptographic engine, providing high performance data encryption and compression. It is available as part of the Assurency SecureData solution or as an OEM component.

In Q4, Kasten Chase announced Assurency Keystone, a comprehensive key management platform addressing the rapidly growing enterprise commitment to storage-based data encryption. Based on open security standards, Keystone provides the capacity, scalability and interoperability to centrally manage encryption keys over distributed storage infrastructures with reduced operational overhead. With the release of Assurency Keystone, Kasten Chase is demonstrating that storage key management can exist as a shared service across the enterprise storage environment.

In early 2006, Kasten Chase and Optica Technologies announced the industry's first channel-based encryption solutions for mainframe tape storage. These new solutions integrate Kasten Chase's award-winning encryption and key management technologies with Optica's proven mainframe connectivity solutions. With this announcement, mainframe users will now have access to a comprehensive storage security solution with key management and performance characteristics designed specifically for their environments. We believe the mainframe market is largely under served by our competitors and represents a substantial opportunity for our company and our partner, Optica.

Sales and Marketing

We were equally aggressive in our pursuit of sales and new channels to market in 2005.

In June, Kasten Chase extended its sales force by signing a reseller agreement with Softchoice, one of North America's fastest growing technology resellers.

In August, the company hired two experienced sales people for the financial services market in New York. The financial services sector is proving to be one of the largest early adopters of data storage security.

In October, Kasten Chase was admitted to EMC's Select Program. Through this program, EMC customers can purchase Assurency SecureData directly from EMC. Initially, our focus will be on Assurency SecureData for content addressed storage.

Our alliance partnership with Sun following its acquisition of StorageTek continues to develop. Kasten Chase recently became a Principal Partner in the Sun Advantage Program.

Fiscal 2005

Without question, 2005 was a difficult year for our company. Revenues were disappointing, falling well below the targets we set for ourselves at the beginning of the year. While customer engagements increased, procurements did not proceed at the pace we expected.

Throughout 2005, we carefully balanced cash management with the need to invest in market opportunities. In Q3, we reduced headcount from 50 to 40 employees. We rationalized operations again in Q4, further reducing headcount to 25 employees. These reductions, affecting all levels within the organization, were required to reduce operating expenses, preserve cash and allow us to continue our pursuit of the data storage security market.

Looking Forward

In spite of the challenges of the past year, we remain optimistic about our future. We are confident in our strategic direction and in the management decisions we have made - including maintaining our capability to pursue our mainframe project and Assurency Keystone.

As mentioned, we were successful in establishing a credit facility to provide bridge financing in March 2006. This investment will help us meet financial obligations in the short term, and allow us to fully explore a range of opportunities to improve our financial position and ensure long term viability. As we have stated many times, successful execution of a financing or strategic alliance is required for Kasten Chase to continue operations in the normal course.

Generating revenues, enhancing Assurency Keystone, successful completion of the mainframe project and furthering our strategic industry relationships are the priorities for the company in 2006. While there is considerable risk and uncertainty, we believe that improving our balance sheet, while focusing on these priorities will provide us the greatest opportunity for success.

Your continued support over the past year is much appreciated and encouraging to those working so hard on your behalf.

Michael J. Milligan

Chief Executive Officer



Management's Discussion and Analysis

The following comments and analysis are intended to provide an overview of the results of operations and financial position of Kasten Chase Applied Research Limited (Kasten Chase or the Company) for the years ended December 31, 2005 and 2004. The financial data has been prepared in accordance with Canadian generally accepted accounting principles. Except as otherwise stated, the information contained herein is given as of March 27, 2006. Unless otherwise indicated, all amounts are in millions of Canadian dollars.

Forward-Looking Information

This Management's Discussion and Analysis may include forward-looking statements with respect to business plans, activities, prospects, opportunities and events anticipated or being pursued by the Company and the Company's future results.

Although the Company believes the assumptions underlying such statements to be reasonable, any of the assumptions may prove to be incorrect. The anticipated results or events upon which current expectations are based may differ materially from actual results or events. Therefore, undue reliance should not be placed on such forward-looking information.

The realization of outcomes referred to in such statements is subject to a number of risks and uncertainties, including but not limited to:

- the timing and course of development of market demand for data storage security solutions like the ones offered by the Company;

- the level of interest of potential customers, partners and investors in the Company and its products, services and technology;

- the availability of financing for the Company;

- the availability of funding for customer and partner purchases;

- the process and timing of decisions affecting the Company to be made by third parties over which the Company has little or no control or influence;

- the introduction of new technology or the development of data storage security solutions by companies with more resources and established market presence;

- the timing, cost and commercial development of new products and services;

- the potential loss of existing customers, partners, contractors, suppliers and key employees;

- developments in the data storage industry, including mergers and acquisitions, affecting the relative importance of data storage security initiatives;

- changes in economic, market (information technology, storage and capital markets) and competitive conditions, industry standards, and government laws and regulations; and,

- other risk factors (see Risks and Uncertainties).

The forward-looking information contained in this Management's Discussion and Analysis is current as of March 27, 2006. There should not be an expectation such information will be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise.

Overview

Kasten Chase develops and applies technology to provide information security.

Kasten Chase has developed and offers secure information management solutions for secure storage of data, secure workgroup collaboration, and secure remote access to enterprise networks.



The Company has two product portfolios:

1. Assurency® Secure Information Management Solutions
a. Assurency SecureData
b. Assurency Keystone
c. Assurency Business Services
d. CipherShare™

2. RASP Data Security™
a. RASP Secure Access®,
b. Enterprise RASP™
c. Workplace RASP™, and
d. RASP Secure Media™ and RASP Secure Media Plus™.


Assurency SecureData is a secure information management solution that provides data protection throughout the information lifecycle. It is based on a secure, scalable architecture and uses strong, fast encryption and enhanced key management to enable the secure storage of data, optimization of the use of storage resources, compliance and risk management.

Assurency Keystone is a comprehensive key management platform designed to address the rapidly growing enterprise commitment to storage-based data encryption. Based on open security standards, Keystone provides the capacity, scalability and interoperability to centrally manage encryption keys over distributed storage infrastructures.

Assurency Keystone provides enterprises with a centralized, standards-based, key management solution specifically for storage operations. Keystone manages storage keys throughout the information lifecycle, and integrates key management policies with data management processes for the protection, retention, and sharing of information assets.

Assurency Business Services is a collaborative, standards based suite of 'best practices' services for compliance management, risk assessment and business case analysis for the enterprise storage security market.

Assurency SecureData and Business Services address the emerging market for storage security and recognize that the implementation of such technology must be complemented by the development and on-going assessment of security policies and procedures. SecureData and Business Services are delivered to end users with and through storage vendors.

CipherShare addresses the need within organizations for secure communication and file sharing. CipherShare establishes a secure, self managed and collaborative work environment which can span the enterprise network and beyond to secure information and enhance workgroup productivity. CipherShare is delivered to the market through resellers.

The markets for Assurency SecureData, Keystone, Business Services and CipherShare are in the early stages of development. The Company has not yet generated significant new revenues from these products and services.

The RASP Data Security products enable secure remote access to U.S. Government classified Secret information. The RASP products were developed under the National Security Agency's (NSA) Remote Access Security Program (RASP). RASP Secure Access provides secure dial-up remote access using the public switch telephone network. Enterprise RASP provides secure remote local area network access for a larger number of users. Workplace RASP provides secure remote access for users from fixed locations. RASP Secure Media and RASP Secure Media Plus encrypt the operating system, system files, applications and data on a remote user's personal computer. RASP Data Security products are sold directly to end users, primarily U.S. Government departments and agencies.

The NSA's sunset date for RASP was December 31, 2005 which means after that date RASP Data Security products will not be authorized by the NSA for use in accessing classified information. The significant decline in RASP Data Security revenues as a result of the impact of the NSA's sunset date for RASP and the time it is taking for the data storage security market to emerge are causing the Company to generate significant losses and use cash in operations. To address this issue, the Company is exploring the full range of its strategic alternatives.

Recent Developments

Kasten Chase and Optica Technologies Incorporated recently announced a technology partnership to develop high-performance encryption solutions for mainframe tape storage. These new solutions integrate Kasten Chase's award-winning encryption and key management technologies with Optica's proven mainframe connectivity solutions.

The new encryption offerings will leverage Kasten Chase's universal storage key management platform, Assurency® Keystone, to ensure scalability and long-term recovery for encrypted mainframe storage tapes. Keystone has been designed to interface with third party security applications including interoperability with IBM's mainframe-based encryption services through the Integrated Cryptographic Services Facility (ICSF). This provides customers with the flexibility, scalability, and trust they require when implementing enterprise security strategies.

Providing robust, fully transparent data encryption for ESCON® (Enterprise Systems CONnection) and FICON® (Fiber CONnector) communication channels, the new solutions can be deployed without consuming mainframe processing cycles, disrupting existing storage infrastructures or introducing open systems protocols. These solutions enable enterprises to secure data stored on tape while preserving their significant investment in legacy ESCON and FICON tape drives. Optica and Kasten Chase are working closely with leading mainframe tape storage and infrastructure vendors to ensure complete interoperability.

In the third quarter, the Company announced its award-winning Assurency SecureData solution is available through the EMC Select Program. Through this program, customers can purchase a range of qualified storage security and infrastructure solutions directly from EMC. The EMC Select Program is designed to help customers easily acquire all the required components to deploy an end-to-end information lifecycle management (ILM) solution.

Overall Performance

Kasten Chase continues to experience decreasing revenues from its RASP Data Security products due to the impact of the NSA's sunset date for RASP of December 31, 2005. The decline in revenues was more severe than the Company had anticipated.

Revenues in 2005 decreased over 2004 by 48%.

During Q4 of 2003, the Company shifted its business development activities to place a greater emphasis on Assurency™ Secure Information Management Solutions. The Company completed the first 2 releases of its Assurency™ SecureData product in 2004. The Company expected more revenues in 2005 from the sale of SecureData and CipherShare; revenues were not generated as the market for storage security is developing more slowly than expected. During the early stages of the development of this market, revenues will continue to be difficult to predict. The Company believes this market will emerge in 2006.

At the end of 2005, the Company had cash and cash equivalents and short-term investments of $1.6 million. The Company used $7.5 million in operations compared to 2004 when the Company used $5.5 million. The current ratio is 3.0:1.



Selected Annual Information

2005 2004 2003

Revenues $ 1,943 $ 3,733 $ 7,601
Net loss (8,265) (17,240) (10,127)
Net loss per share (0.14) (0.30) (0.18)
Diluted loss per share (0.14) (0.30) (0.18)
Total assets 3,103 11,810 30,524
Total long-term liabilities - - -


As noted above, revenues from the sale of products in the RASP Data Security™ portfolio have decreased over the last 4 years as a result of the impact of the NSA's sunset date for RASP while revenues from the Assurency™ Enterprise Security portfolio have not developed as quickly as expected. Revenues in 2004 decreased by 51% over 2003 and 2005 revenues decreased by 48% over 2004.

Net loss in 2005 decreased by $9.0 million over 2004 due to the goodwill impairment charge of $ 9.7 million in 2004 and a restructuring charge of $0.6 million in 2005.

The net loss in 2004 increased by 70% over 2003 largely due to the goodwill impairment charge of $ 9.7 million and decreasing revenues. After removing the one-time charges for goodwill impairment and restructuring costs, normal operating expenses would be $9.2 million and $13.4 million for 2004 and 2003 respectively. Therefore, the effect of the restructuring performed in 2003 and other cost saving measures resulted in a reduction in operating expenses of approximately $4 million in 2004.

Total assets decreased over the last financial year by $8.7 million primarily as a result of the decrease in cash and cash equivalents of $7.5 million.

Total assets in 2004 decreased over 2003 by $18.7 million primarily as a result of the write-off of goodwill of $9.7 million and the decrease in cash and cash equivalents and short-term investments of $5.9 million.

Long-term liabilities are nil and the Company continues to be without debt financing

RESULTS OF OPERATIONS

Revenues

In 2005 and 2004, revenues were derived primarily from RASP Data Security products. Revenues remain very difficult to predict and significant fluctuations can occur from quarter to quarter as a result of many factors. (See Risks and Uncertainties below).



Product Portfolio 2005 2004
RASP Data Security $ 1.8 95 % $ 3.5 95 %
Assurency Enterprise
Security 0.1 5 % 0.2 5 %
----- ----- ----- -----
Total $ 1.9 100 % $ 3.7 100 %


Revenues for 2005 were $1.9 million compared to revenues of $3.7 million in 2004. This represents a decrease of 48% largely related to a decrease in the number of RASP systems sold. Assurency Enterprise Security revenues were lower than expected due to the slow market acceptance.

During 2005, the Company sold 10 RASP systems and recognized revenues from 20 new customers. RASP Data Security products are sold primarily to U.S. federal government departments and agencies. Sales to U.S. federal governments comprise 49% of total revenues in 2005 and 89% in 2004. During 2004, the Company sold 48 RASP systems.

In 2005, 29% of revenues were from products, 48% from development services, and 23% from maintenance and support services, including training. In 2004, 48% of revenues were from products, 25% from development services, and 27% from maintenance and support services, including training.

Expenses

Cost of Sales

The manufacture of Kasten Chase's products and the fulfillment of orders are outsourced to third parties.

Cost of sales includes third party costs to produce and manufacture products and fulfill orders, the bought-in costs of hardware components and products, the costs of software products, manuals, packaging, shipping costs, and facilities, together with compensation costs for the Company's production and order fulfillment personnel who work with the manufacturers and other suppliers.

Gross margin for 2005 was 64%. Gross margin for 2004 was 46%. Gross margin for 2004 was lower than expected due to lower revenues to absorb fixed costs like order fulfillment and inventory write-offs.

In the fourth quarter of 2004, an inventory valuation was performed which determined that the net realizable value of the inventory was lower than the recorded cost and an inventory write-off of $0.6 million relating to RASP components was recorded and charged to cost of sales.

Sales, Marketing and Customer Support

Kasten Chase has sales offices in Mississauga, Ontario and Sterling, Virginia. Marketing and customer support is based from the Company's Mississauga office. Sales, marketing and customer support expenses include compensation for personnel, travel, marketing programs and materials, advertising, public relations, trade shows, sales and customer support facilities and related tools.

Sales, marketing and customer support expenses for the year were $3.1 million compared to $2.9 million in 2004. Even though the total number of employees in sales, marketing and customer support decreased from 15 at the end of 2004 to 8 employees at the end of 2005, this decrease as a result of restructuring occurred in the latter part of the year.

Product Development

All of the Company's research and development is undertaken in Canada.

Research and development expenses were $3.7 million in 2005 compared to $3.3 million in 2004. This decrease stems from a decrease in personnel from 23 full time employees to 8 employees as a result of the restructuring.

These expenses include compensation for personnel, the costs of third party contractors, training, tools and travel. The Company focused its product development investment in 2005 to further develop, enhance and validate Assurency SecureData and complete security certifications. In the last quarter of 2004, the Company received FIPS 140-2 level 2 certification of its core cryptographic engine. The process for obtaining security certifications on other components continued.

General and Administrative

General and administrative expenses include compensation for senior executives and staff, travel costs, facilities and training for the finance, human resources and management information systems groups, costs associated with the Board of Directors and administrative expenses including insurance, auditing, legal and regulatory compliance.

In 2005, general and administrative expenses were $1.3 million compared to $1.7 million in 2004. The decrease is the result of cost savings associated with the restructuring in 2005 and other cost saving measures.

Also included in general and administrative expenses are foreign exchange gains or losses. In 2005, foreign exchange losses were nil compared to $0.1 million in 2004. (See Foreign Exchange below).

Amortization

In 2005, amortization was $1.0 million compared to $1.6 million in 2004. The acquired technology related to the Palladium Secure Modem used in RASP Data Security products is now fully amortized and therefore amortization has decreased. Due to the disposal of some assets in 2005 and end of life on other assets, amortization in 2006 is expected to decrease.

Goodwill Impairment

During the second quarter of 2004, the Company performed a goodwill impairment test in accordance with the CICA Handbook section 3062, Goodwill and Other Intangible Assets. The Company is required to evaluate goodwill annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. This review was triggered as a result of the decline in the market capitalization of the Company during the second quarter of 2004. Using the weighted average share price for the quarter multiplied by the weighted average number of shares outstanding for the quarter as an estimate of fair value, the Company's fair value fell below the carrying value of its net assets. As a result, it was necessary to measure goodwill impairment by allocating the estimate of fair value among net assets in a manner similar to a business combination.

Impairment is measured by comparing the resulting fair value of goodwill to its carrying amount. This required determining the fair value of tangible net assets and both recognized and unrecognized intangible net assets, including internally developed intangible assets. The fair value of recognized and unrecognized tangible and intangible net assets (excluding goodwill) was determined to exceed the estimate of the Company's fair value. As a result of this analysis, the implied fair value of goodwill was found to be nil and the Company recognized an impairment loss of $9,715.

Restructuring Costs

During the third quarter and fourth quarter of 2005, the Company reduced the number of full time employees by approximately 50%, reduced the amount of leased space by approximately 60% and incurred costs of $0.6 million.

During the second quarter of 2003, the Company reduced the number of full-time employees by approximately 20% and incurred one-time costs of $1.0 million in an attempt to preserve cash in the long term. The resulting savings from these changes were approximately $0.5 million per quarter. In 2004, an adjustment of $0.07 million for unpaid benefits was recorded.

Interest Income

Interest income was $0.1 million in 2005 compared to $0.2 million last year. This decrease represents the decrease in cash and cash equivalents and short-term investments from $9.1 million at the beginning of the year to $1.6 million at the end of 2005.

Net Loss

Net loss in 2005 was $8.3 million or $0.14 per share. In 2004, Kasten Chase reported a net loss of $17.2 million or $0.30 per share. Net loss decreased by $8.9 million over last year due to goodwill impairment of $9.7 million in 2004 offset by the restructuring charges $0.6 million in 2005.

After removing the goodwill impairment charge in 2004 and the restructuring costs in 2005, net loss increased by $0.1 million even though revenue decreased by 48%. This small increase in net loss is the result of cost saving measures offset by the decrease in revenues.

Employees

At December 31, 2005, Kasten Chase had 25 employees with 22 in Canada and 3 in the United States whereas at the end of 2004, the Company had 50 employees with 48 in Canada and 2 in the United States. During the third quarter, the Company reduced the number of employees by approximately 20% in an effort to reduce operating expenses. During the fourth quarter, the Company reduced the number of employees by approximately 38% in order to advance the reduction in operating expenses.

Liquidity and Capital Resources

The working capital ratios at December 31, 2005 and December 31, 2004 were 3.0:1 and 7.9:1, respectively. Current assets decreased by $7.9 million from $10.1 million to $2.2 million. Current liabilities decreased from $1.3 million at the end of 2004 to $0.7 million at December 31, 2005.

Cash and cash equivalents and short-term investments at the end of 2005 totaled $1.6 million compared to $9.1 million at the end of last year resulting in a decrease of $7.5 million in cash. The $7.5 million decrease in cash and cash equivalents and short-term investments was used in operations.

Cash used in operations increased to $7.5 million in 2005 compared to $5.5 million used in 2004. This $2.0 million increase in cash used is due to the following variety of items: a $0.5 million decrease in gross margin as a result of decreased revenues, a $0.6 million restructuring charge, a $0.4 million increase in product development, as well as non-cash working capital changes resulted in a source of $0.3 million in 2004 whereas in 2005 there was a use of cash of $0.2 million.

Inventory increased slightly from $0.3 million at the end of 2004 to $0.4 million at the end of the year. Inventory consists of products relating to the Assurency Enterprise Security portfolio.

On March 27, 2006, the Company negotiated a credit facility for $1.5 million. Any balances borrowed against the facility are due on demand and secured by a general security agreement against the Company's assets. Interest is charged at the Company's bank's prime lending rate. The credit facility is also secured by personal guarantees and other collateral from certain directors of the Company. In consideration for these personal guarantees, the Company will issue warrants to the directors, entitling them to acquire a maximum of 2,875,000 common shares of the Company at an exercise price of $0.30 over a term of 18 months. Funds from the revolving credit facility will be drawn by the Company and the warrants will be issued in tranches on the approval of a majority of the Company's independent directors and a majority of the directors providing the guarantees and other collateral. The first tranche of $0.25 million has been approved. The Company can redeem the warrants at any time at a purchase price of $0.21 per warrant. The fair value of the warrants will be expensed as the credit facility amounts are drawn.

The Company's current estimate is it likely has sufficient cash and short-term investments to continue operations until the end of April 2006. If the above credit facility is fully utilized, the Company's current estimate is it likely has sufficient cash and short-term investments to continue operations until the end of June 2006. In addition to managing operating expenses and the use of cash, the Company is pursuing specific opportunities to generate revenues from its SecureData and CipherShare offerings. The Company is also pursing alternatives ranging from raising additional capital and seeking strategic investments to merger and acquisition activity.

The consolidated financial statements have been prepared using generally accepted accounting principles on the going concern assumption the Company will continue in operation for the foreseeable future and will be able to realize its assets and satisfy its liabilities in the normal course of business. The Company's financial position is such that if the market for its Assurency® Secure Information Management solutions, including SecureData, Business Services and CipherShare, do not develop in a manner resulting in significant new revenues in 2006 or if the alternatives being pursued do not result in additional cash being provided or a sale of the Company, operations will not continue in the normal course.

Long-term Assets

Capital assets decreased from $0.8 million at the end of 2004 to $0.5 million at the end of December of 2005 as capital assets additions of $0.1 million was offset by the depreciation for the year. As well, some assets which were considered no longer useful were disposed of, written off or sold. Acquired technology decreased solely from amortization.

Capital Stock

The authorized capital consists of an unlimited number of common shares. At December 31, 2005 and 2004, the common shares issued and outstanding were 57,481,068.

Critical Accounting Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Significant estimates are used in determining the allowance for doubtful accounts, inventory valuation, the useful lives of intangible assets, including acquired technology. In making such estimates and assumptions, management: consults with employees knowledgeable in the area; gathers relevant information; where appropriate, seeks advice from qualified third parties; and, makes judgments, which in its opinion at that time, represent fair, balanced and appropriately conservative estimates and assumptions. Actual results could differ from these estimates.

Going Concern

These financial statements have been prepared on a going concern basis, which presume the realization of assets and discharge of liabilities in the normal course of business. The Company's ability to continue as a going concern is dependent upon achieving profitable operations and upon obtaining additional financing. While the Company is expending its best efforts in this regard, the outcome of these matters cannot be predicted at this time. These financial statements do not include any adjustments to the amounts and classification of assets and liabilities that might be necessary should the Company be unable to continue in business.

Inventory Provision

The Company maintains an inventory provision to account for obsolescence or having to sell inventory at net realizable values less than cost. The Company makes estimates based on technological developments, revenue trends and forecasting. During 2004, an inventory write-off of $0.6 million was charged to cost of sales.

Goodwill Impairment

The Company evaluates goodwill annually or whenever circumstances indicate that the carrying amount may not be recoverable. When the fair value of the Company is less than the fair value of the net assets, it becomes necessary to allocate the estimated fair value of the Company among the net assets including the recognized and unrecognized tangible and intangible net assets. The Company uses market capitalization and valuation models such as discounted cash flows to determine fair value and must exercise judgment and make assumptions. During 2004, the Company recorded a goodwill impairment of $9.7 million.

Amortization

The Company invests in capital equipment and acquired technology. These assets are amortized over their estimated useful lives. The Company does not capitalize development costs.

Quarterly Results of Operations

The following table sets forth certain unaudited consolidated statements of operation information for the eight most recent quarters of operations ending December 31, 2005. This unaudited information has been prepared on the same basis as our annual consolidated financial statements contained elsewhere in this annual report and includes all adjustments, consisting of only of normal recurring adjustments, necessary to present fairly the unaudited quarterly results. This information should be read in conjunction with our consolidated financial statements and related notes. The operating results for any quarter are not necessarily indicative of results for any future period.



Quarter Ended
2005 March 31 June 30 Sept. 30 Dec. 31
(in thousands of dollars, except per share amounts)

Revenues $ 741 $ 461 $ 501 $ 240
Cost of Sales 269 182 189 66
----- ----- ----- -----
Gross Margin 472 279 312 174

Operating Expenses:
Sales, marketing and customer
support 829 892 909 498
Product development 1,078 1,235 1,007 337
General and administrative 393 364 243 287
Amortization 248 242 235 239
Loss on disposal of capital
assets - 2 - 10
Restructuring costs - - 239 363
Interest income (48) (46) (30) (24)
----- ----- ----- -----
2,500 2,689 2,603 1,710

Net loss $ (2,028) $ (2,410) $ (2,291) $ (1,536)

Net loss per share $ (0.04) $ (0.04) $ (0.04) $ (0.03)



Quarter Ended
2004 March 31 June 30 Sept. 30 Dec. 31
(in thousands of dollars, except per share amounts)

Revenues $ 1,331 $ 782 $ 1,128 $ 492
Cost of Sales 509 306 433 779
----- ------ ----- -----
Gross Margin 822 476 695 (287)

Operating Expenses:
Sales, marketing and
customer support 756 754 842 582
Product development 946 919 784 670
General and administrative 373 322 494 466
Amortization 404 412 408 407
Loss on disposal of capital
assets - - - -
Goodwill impairment - 9,715 - -
Restructuring costs - - - (73)
Interest income (64) (65) (54) (52)
----- ------ ----- -----
2,415 12,057 2,474 2,000

Net loss $ (1,593)$ (11,581) $ (1,779) $ (2,287)

Net loss per share $ (0.03) $ (0.20) $ (0.03) $ (0.04)


Revenues decreased quarter over quarter in 2005 due to declining RASP sales as a result of the sunset date of December 31, 2005. Gross margin as a percentage of revenues remained consistent each quarter of 2005 except for Q4 where gross margin was 73% of revenues due to a large portion relating to Development revenues where the cost of sales is lower.

Total operating expenses averaged $2.6 million per quarter except Q4 2005, when accrued bonuses were reversed in all operating expenses categories in order to preserve cash and due to specific objectives not being met.

Net loss per share remained stable at $0.03 and $0.04 per share in 2005 due to efforts in reducing operating expenses as a result of the restructuring.

After removing the goodwill impairment of $9.7 million in Q2 of 2004 and removing the inventory write-off of $0.6 million from Cost of Sales in Q4, net loss per quarter for 2004 is consistent at $0.03 per share. Without the inventory write-off, gross margin in Q4 of 2004 would be 63%, which is in line with expectations.

Foreign Exchange

A significant portion of revenues continues to be billed in U.S. dollars. Expenses are incurred in local currencies of the countries in which Kasten Chase operates - Canada and the United States. The purchase of inventories is largely transacted in U.S. dollars. Foreign exchange gains or losses are included in General and Administrative expense. The Company does not engage in foreign currency speculation and does not use foreign exchange hedging.

Recent Accounting Developments

In 2005, the CICA approved amendments to new Section 3831 "Non-Monetary Transactions". This Section requires that all non-monetary transactions be measured at fair value, unless certain criteria are met. The amendments replace culmination of the earnings process as the test for applying fair value measurement with a test of commercial substance. Commercial substance involves satisfying one of two objectively determined tests based on assessments of cash flows expected with and without the exchange of non-monetary items. The new requirements apply to non-monetary transactions initiated in periods beginning on or after January 1, 2006. The Company does not expect adoption of this new Section to have a material impact on the Company's consolidated financial statements.

Risks and Uncertainties

Kasten Chase had a dependency on the sale of RASP Data Security™ products to the U.S. Government. In 2005, 49% of revenues were from sales to the U.S. Government. In 2004, 89% of revenues were from sales to the U.S. Government.

The demand for RASP Data Security products was uncertain and difficult to predict. The NSA's sunset date for RASP was December 31, 2005. This has adversely affect demand for RASP Data Security™ products sooner and more severely than anticipated. The NSA has not extended the sunset for RASP.

The Company has and continues to experience the risks and uncertainties typically experienced by a small information technology business developing new solutions for an emerging market. In particular, the Company's new commercial initiative, Assurency Secure Information Management Solutions, carries the risks generally associated with new technology ventures. These risks include:

- the nature, timing and extent of the development of the market for the Company's Solutions;

- the availability of financing for the Company;

- the level of interest of potential end users, customers, partners and investors in the Company and its products, services and technology;

- the efforts to gain end user, customer, partner and market acceptance of the Company's Solutions may not be successful;

- the efforts to establish key partnerships and distribution channels, particularly with storage vendors, may not be successful;

- the availability of funding for end user, customer and partner purchases;

- the process and timing of decisions affecting the Company to be made by third parties over which the Company has little or no control or influence such as delays in completing field trials, delays in processing proposals, bids, orders or contracts, delays in budget approvals and funding allocations, changes in planning, policy and priorities;

- the inability to attract and retain employees with key training, skills and experience;

- the potential loss of existing customers, partners, contractors and suppliers;

- the timing, cost and complexity of the commercial development of new products and services;

- Solutions development, validation, production and technology issues may cause delays in commercial releases, delays in certifications and/or cost overruns;

- the development of new and competitive technologies, products and services;

- the development and introduction of new technologies or storage security solutions by companies with more resources and established market presence;

- developments in the data storage industry, including mergers and acquisitions, affecting the relative importance of storage security initiatives; and,

- world events and changes in economic, market (information technology, storage and capital markets) and competitive conditions, industry standards, and government laws and regulations.

The development of the market for data storage security is occurring more slowly than expected. As a result, near term revenues are uncertain and difficult to predict.

There are at least three companies providing direct competition each private, focused only on secure networked storage, and well funded by venture capital. From a technical perspective, the Company is well positioned but may lack the financial resources to establish the market presence required for market leadership, especially in the U.S.

The Company may not, on a timely basis, be able to:

- generate revenues and/or reduce operating expenses to avoid depleting its cash;

- obtain additional cash financing to improve its financial position; or,

- complete strategic alliances to increase revenues, reduce operating losses, increase channels to market, add to core technology, or expand product and services offerings.

The Company must protect the proprietary technology underlying its products and services. There can be no assurance the steps historically taken by the Company in this regard will be adequate to deter misappropriation or independent third party development of its technology. Although the Company believes its products and services do not infringe proprietary rights of others, there can be no assurance third parties will not assert infringement claims or the Company will not be required to obtain licenses of third party technologies.

To the extent the Company makes sales denominated in currencies other than Canadian dollars, gains and losses on the conversion of such sales to Canadian dollars may, in the future, contribute to fluctuations in business and operating results. In addition, fluctuations in exchange rates could affect the demand for the Company's products.

Additional Information

Additional information about Kasten Chase, including the Annual Information Form and Information Circular, may be found on SEDAR at www.sedar.com.



KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Balance Sheets

---------------------------------------------------------------------
---------------------------------------------------------------------
(in thousands of dollars)
As at December 31 2005 2004
---------------------------------------------------------------------

Assets
Current assets:
Cash and cash equivalents (note 4) $ 1,557 $ 3,597
Short-term investments (note 4) - 5,475
Accounts receivable, net of allowance
for doubtful
accounts of $256 (2004 - $263) 144 333
Unbilled work in progress - 148
Inventory (note 5) 352 298
Prepaid expenses 190 204
---------------------------------------------------------------------
2,243 10,055

Capital assets (note 6) 496 794
Intangibles (note 7) 364 961
---------------------------------------------------------------------
$ 3,103 $ 11,810
---------------------------------------------------------------------
---------------------------------------------------------------------

Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable and accrued liabilities $ 591 $ 779
Deferred revenue 146 500
---------------------------------------------------------------------
737 1,279

Shareholders' equity
Capital stock (note 8) 75,258 75,258
Contributed surplus 205 105
Deficit (73,097) (64,832)
---------------------------------------------------------------------
2,366 10,531

---------------------------------------------------------------------
$ 3,103 $ 11,810
---------------------------------------------------------------------
---------------------------------------------------------------------

Nature of operations and going concern (note 1a)
Commitments (note 12)
Subsequent event (note 13)

See accompanying notes to consolidated financial statements


On behalf of the Board: John A. Rae John A. Morrison
Director Director


KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Statements of Operations and Deficit

---------------------------------------------------------------------
---------------------------------------------------------------------
(in thousands of dollars, except per share data)
For the years ended December 31 2005 2004
---------------------------------------------------------------------

Revenues $ 1,943 $ 3,733

Cost of sales 706 2,027
---------------------------------------------------------------------
Gross margin 1,237 1,706

Operating expenses:
Sales, marketing and customer support 3,128 2,934
Product development 3,657 3,319
General and administrative 1,287 1,655
Amortization 964 1,631
Goodwill impairment (note 2) - 9,715
Loss on disposal of assets 12 -
Restructuring costs (note 3) 602 (73)
---------------------------------------------------------------------
9,650 19,181

Loss before interest (8,413) (17,475)

Interest income 148 235
---------------------------------------------------------------------

Loss for the year (8,265) (17,240)

Deficit, beginning of year (64,832) (47,592)
---------------------------------------------------------------------
Deficit, end of year $ (73,097) $ (64,832)
---------------------------------------------------------------------
---------------------------------------------------------------------


Loss per share:
Basic $ (0.14) $ (0.30)
Diluted $ (0.14) $ (0.30)

Weighted average number of shares (in
thousands):
Basic 57,481 57,481
Diluted 57,481 57,481


See accompanying notes to consolidated financial statements


KASTEN CHASE APPLIED RESEARCH LIMITED

Consolidated Statements of Cash Flows

---------------------------------------------------------------------
---------------------------------------------------------------------
(in thousands of dollars)
For the years ended December 31 2005 2004
---------------------------------------------------------------------

Cash provided by (used for):
Operations:
Loss for the year $ (8,265) $ (17,240)
Add (deduct) items not affecting cash:
Amortization 964 1,631
Goodwill impairment (note 2) - 9,715
Foreign exchange (gain) loss (27) 59
Stock-based compensation 100 77
Loss on disposal of capital assets 12 -
Net changes in non-cash working capital
items:
Accounts receivable 189 530
Unbilled work in progress 148 524
Inventory (53) 748
Prepaid expenses 13 (30)
Accounts payable and accrued liabilities (179) (1,049)
Deferred revenue (357) (462)
---------------------------------------------------------------------
(7,455) (5,497)

Investing:
Proceeds from sale of capital assets 6 -
Redemption of short-term investments 5,475 6,406
Additions to capital assets (87) (280)
---------------------------------------------------------------------
5,394 6,126

Foreign exchange gain (loss) on cash held
in foreign currency 21 (86)

Increase (decrease) in cash equivalents (2,040) 543

Cash and cash equivalents, beginning of
year 3,597 3,054
---------------------------------------------------------------------
Cash and cash equivalents, end of year $ 1,557 $ 3,597
---------------------------------------------------------------------
---------------------------------------------------------------------


Short-term investments, end of year $ - $ 5,475
---------------------------------------------------------------------

Cash and cash equivalents and short-term
investments, end of year $ 1,557 $ 9,072

---------------------------------------------------------------------
Supplemental disclosure:
Interest received in cash $ 233 $ 330

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

See accompanying notes to consolidated financial statements


KASTEN CHASE APPLIED RESEARCH LIMITED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the years ended December 31, 2005 and 2004 (amounts in thousands of dollars, except shares and per share data)

Kasten Chase Applied Research Limited (Kasten Chase or the Company) is a high-assurance data security company. The Company has developed products that enable customers to communicate securely, protect stored data and access data securely. Kasten Chase's data security solutions address the needs of customers in the government and financial services sectors in North America.

1. Significant accounting policies:

These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in Canada, and include the following significant accounting policies:

(a) Nature of operations and going concern:

The Company's principal source of revenue from ongoing operations has been from the sale of RASP Data Security™ products which are sold pursuant to the U.S. National Security Agency's Remote Access Security Program (RASP). RASP had a sunset date of December 31, 2005 which has not been extended. The sunset date has caused a significant decline in RASP Data Security™ product revenues.

On March 27, 2006, the Company negotiated a credit facility for $1,500. The first tranche of $250 has been approved. Any balances borrowed against the facility are due on demand and secured by a general security agreement against the Company's assets. Interest is charged at the Company's bank's prime lending rate. See Note 13.

The Company's current estimate is it likely has sufficient cash and short-term investments to continue operations until the end of April 2006. If the above credit facility is fully utilized, the Company's current estimate is it likely has sufficient cash and short-term investments to continue operations until the end of June 2006. In addition to managing operating expenses and the use of cash, the Company is pursuing specific opportunities to generate revenues from its SecureData and CipherShare offerings. The Company is also pursing alternatives ranging from raising additional capital and seeking strategic investments to merger and acquisition activity.

These financial statements have been prepared on a going concern basis, which presume the realization of assets and discharge of liabilities in the normal course of business. The Company's ability to continue as a going concern is dependent upon achieving profitable operations and upon obtaining additional financing. While the Company is expending its best efforts in this regard, the outcome of these matters cannot be predicted at this time. These financial statements do not include any adjustments to the amounts and classification of assets and liabilities that might be necessary should the Company be unable to continue in business.

During the year, the Company incurred a loss of $8,265 and has an accumulated deficit of $73,097. Continued operations of the Company are dependent on the Company's ability to complete financing or generate profitable operations in the future. Management's plan in this regard is to secure additional funds through future financings, which may not be achievable.

(b) Basis of consolidation:

The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. The results of operations of acquisitions are included in these consolidated financial statements from the date of acquisition.

(c) Revenue recognition:

Revenue from the license and sale of products is recognized at the time of shipment if the installation and inspection process is straightforward, other obligations are insignificant and the costs associated with these activities are reasonably determinable. When installation or inspection are other than incidental to the sale, or obligations remaining after delivery are significant, revenue is recognized only when the goods have been installed and accepted by the customer and any other significant obligations have been fulfilled.

Revenues derived from longer term contracts to customize and develop software or products are recognized on a percentage-of-completion basis whereby revenue is recognized at the estimated realizable value of work completed to date. Unbilled work in progress represents revenue earned on projects in excess of amounts billed.

Amounts received in advance of revenue recognition are recorded as deferred revenue.

(d) Inventory:

Inventory is valued at the lower of cost and net realizable value and consists of raw materials, work-in-process and finished goods.

(e) Capital assets:

Capital assets are recorded at cost less related investment tax credits. Amortization is provided on a straight-line basis over the estimated useful lives of the assets beginning in the year they are put into production or acquired as follows:



----------------------------------------------------------------
Development equipment and software 20% and 33% per annum
Office equipment and computers 20% and 33% per annum
Leasehold improvements over the term of the lease
----------------------------------------------------------------


(f) Intangibles:

Acquired technology is recorded at cost less accumulated amortization and is amortized over its estimated useful life of 4 years.

(g) Impairment of long-lived assets:

The carrying amount of long-lived assets is reviewed on an annual basis, or more frequently if events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment is identified when the carrying amount of the asset exceeds the projected undiscounted future net cash flows expected from its use and disposal. An impairment loss is measured as the amount by which the carrying amount of the asset exceeds its fair value.

(h) Foreign currency translation:

The Company's foreign subsidiaries are considered to be integrated operations and their accounts are translated into Canadian dollars using the temporal method. The temporal method is also applied to monetary assets and liabilities of the Company, as well as revenue and expenses, which are denominated in foreign currencies. Under this method, monetary items are translated at the rate of exchange at the balance sheet dates, non-monetary items are translated at historical exchange rates and revenues and expenses are translated at the average exchange rate for the years. Amortization of non- monetary assets is translated at the same exchange rate as the assets to which they relate. Exchange gains or losses on translation are included in the determination of the loss for the year.

(i) Research and development costs:

Research costs, net of related investment tax credits, are expensed as incurred. Costs related to development of software, net of related investment tax credits, are expensed as incurred unless such costs meet the criteria for deferral and amortization under generally accepted accounting principles. The Company has not deferred any software development costs during 2005 or 2004.

Expenditures on development equipment, net of related investment tax credits, are recorded as capital assets.

(j) Stock-based compensation:

The Company has a stock option plan (the plan) for directors, officers and employees which is described in note 8(b).

All stock options granted to employees under the plan have an exercise price not less than the market price of the shares on the date the option is granted. The Company recognizes compensation expense for stock options granted in the consolidated statements of income using the fair value method of accounting for all options issued on or after January 1, 2003. Pro forma disclosures of net earnings and earnings per share, as if the fair value method of accounting for stock-based compensation for any options granted before January 1, 2003 but on or after January 1, 2002 are provided below. The pro forma effect of options granted prior to January 1, 2002 has not been included.

The estimated fair value of the options is amortized to income over the vesting period, on a straight-line basis, and was determined using the Black-Scholes option pricing model with the following weighted average assumptions:



---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
---------------------------------------------------------------------

Risk-free rate 3.5% 3.5%
Dividend yield 0.0% 0.0%
Volatility factor of expected market
price of the Company's shares 62.0% 75.0%
Expected option life (in years) 6.00 6.00
Weighted-average grant date fair values
of options granted $ 0.23 $ 0.49
---------------------------------------------------------------------
---------------------------------------------------------------------

For the year ended December 31, 2005, the Company expensed $100
(2004 - $77).

The pro forma disclosure relating to options granted in 2002 is as
follows:

---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
---------------------------------------------------------------------

Loss as reported $ (8,265) $ (17,240)
Deduct: Stock-based compensation
costs using the fair-value method (3) (456)
---------------------------------------------------------------------
Pro-forma loss $ (8,269) $ (17,696)

Loss per share:
Basic and diluted - as reported $ (0.14) $ (0.30)
Basic and diluted - pro forma $ (0.14) $ (0.31)


(k) Income taxes:

The Company uses the asset and liability method of accounting for income taxes. Under the asset and liability method, future tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Future tax assets and liabilities are measured using enacted or substantially enacted tax rates expected to be recovered or settled. The effect on future tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the date of enactment or substantive enactment.

(l) Loss per share:

Basic loss per share is computed using the weighted average number of common shares outstanding during the year. Diluted loss per share is computed using the weighted average number of common and potential common shares outstanding during the year. Potential common shares consist of the incremental common shares issuable upon the exercise of stock options using the treasury stock method.

(m) Use of estimates:

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of accounts receivable, unbilled work in progress, inventory, capital assets, intangibles, goodwill and deferred revenue and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the year. Actual results could differ from these estimates.

(n) Recent accounting pronouncements:

Non-monetary transactions

In 2005, the CICA approved amendments to new Section 3831 "Non-Monetary Transactions". This Section requires that all non-monetary transactions be measured at fair value, unless certain criteria are met. The amendments replace culmination of the earnings process as the test for applying fair value measurement with a test of commercial substance. Commercial substance involves satisfying one of two objectively determined tests based on assessments of cash flows expected with and without the exchange of non-monetary items. The new requirements apply to non-monetary transactions initiated in periods beginning on or after January 1, 2006. The Company does not expect adoption of this new Section to have a material impact on the Company's consolidated financial statements.

2. Goodwill Impairment:

During the second quarter of 2004, the Company performed a goodwill impairment test in accordance with the CICA Handbook section 3062. The Company is required to evaluate goodwill annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. This review was triggered as a result of the decline in the market capitalization of the Company during the second quarter of 2004. Using the weighted average share price for the quarter multiplied by the weighted average number of shares outstanding for the quarter as an estimate of fair value, the Company's fair value fell below the carrying value of its net assets. As a result, it was necessary to measure goodwill impairment by allocating the estimate of fair value among net assets in a manner similar to a business combination.

Impairment is measured by comparing the resulting fair value of goodwill to its carrying amount. This required determining the fair value of tangible net assets and both recognized and unrecognized intangible net assets, including internally developed intangible assets. The fair value of recognized and unrecognized tangible and intangible net assets (excluding goodwill) was determined to exceed the estimate of the Company's fair value. As a result of this analysis, the implied fair value of goodwill was found to be nil and the Company recognized an impairment charge of $9,715.

3. Restructuring costs:

During 2005, the Company reduced the number of full time employees by approximately 50% and incurred costs of $425. The Company also reduced the amount of leased space by approximately 60% and incurred costs of $177.

During the second quarter of 2003, the Company reduced the number of full time employees by approximately 20% and incurred costs of $1,018.



---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
---------------------------------------------------------------------

Restructuring liability at the beginning
of the year $ - $ 73
Accrued restructuring costs 602 -
Cash payments during the year (452) -
Adjustment - (73)
---------------------------------------------------------------------
Restructuring liability at the end of
the year $ 150 $ -
---------------------------------------------------------------------
---------------------------------------------------------------------


Of the balance remaining at December 31, 2005, $112 relates to employee termination costs and $38 relates to lease termination costs.

4. Cash and cash equivalents and short-term investments:

Cash of $109 (2004 - $470) consists of deposits with major financial institutions. Cash equivalents of $1,448 (2004 - $3,127) consist of money market instruments and short-term bonds with an original maturity of three months or less from the date of acquisition. Short-term investments of $ nil (2004 - $5,475) include money market instruments and bonds with a maturity of three months or more from the date of acquisition and are recorded at the lower of cost or market value.



5. Inventory:

---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
---------------------------------------------------------------------

Raw materials $ 7 $ 47
Work-in-progress - 219
Finished goods 345 32
---------------------------------------------------------------------
Total $ 352 $ 298
---------------------------------------------------------------------
---------------------------------------------------------------------

6. Capital assets:

Capital assets consist of the following:

---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
Accumu- Accumu-
lated Net lated Net
amorti- book amorti- book
Cost zation value Cost zation value
---------------------------------------------------------------------

Development equipment
and software $ 1,688 $ 1,449 $ 239 $ 1,632 $ 1,309 $ 323
Office equipment and
computers 2,012 1,947 65 2,164 1,967 197
Leasehold
improvements 984 792 192 984 710 274
---------------------------------------------------------------------
Total $ 4,684 $ 4,188 $ 496 $ 4,780 $ 3,986 $ 794
---------------------------------------------------------------------
---------------------------------------------------------------------

7. Intangibles:

---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
Accumu- Accumu-
lated Net lated Net
amorti- book amorti- book
Cost zation value Cost zation value
---------------------------------------------------------------------

Acquired technology $ 4,932 $ 4,568 $ 364 $ 4,932 $ 3,971 $ 961
---------------------------------------------------------------------
---------------------------------------------------------------------

8. Capital stock:

(a) The authorized capital consists of an unlimited number of common
shares.


---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
Number Amount Number Amount
---------------------------------------------------------------------

Common shares, issued
and outstanding 57,481,068 $ 75,258 57,481,068 $ 75,258

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


(b) Stock option plan:

The Company has established a stock option plan under which options to purchase 7,500,000 common shares of the Company may be granted to directors, officers and employees of the Company. The exercise price to acquire shares under the plan is a price not less than the market price of the shares on the date the option is granted. The vesting and exercise periods for options are at the discretion of the Company. The exercise period for options cannot exceed ten years.



---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
Weighted- Weighted-
average average
exercise exercise
Options price Options price
---------------------------------------------------------------------

Outstanding,
beginning of year 2,057,304 $ 2.28 2,400,673 $ 2.98
Granted 714,500 0.28 402,000 0.60
Exercised - - - -
Expired / forfeited (39,632) 4.96 (745,369) 3.66
---------------------------------------------------------------------
Outstanding, end of year 2,732,172 $ 1.71 2,057,304 $ 2.28
---------------------------------------------------------------------
---------------------------------------------------------------------

---------------------------------------------------------------------
---------------------------------------------------------------------
2005 Options outstanding Options exercisable

Weighted- Weighted- Weighted-
average average average
Range of exercise remaining exercise
exercise prices Number price life(years) Number price
---------------------------------------------------------------------

$ 0.28 to 1.01 1,973,748 $ 0.55 6.2 994,675 $ 0.72
2.20 to 3.45 291,999 3.24 3.6 291,999 3.24
3.50 to 4.00 333,500 3.57 4.8 333,500 3.57
5.75 to 5.75 35,000 5.75 4.1 35,000 5.75
12.85 97,925 12.85 3.8 97,925 12.85
---------------------------------------------------------------------
$ 0.28 to 12.85 2,732,172 $ 1.71 1,753,099 $ 2.63
---------------------------------------------------------------------
---------------------------------------------------------------------

---------------------------------------------------------------------
---------------------------------------------------------------------
2004 Options outstanding Options exercisable

Weighted- Weighted- Weighted-
average average average
Range of exercise remaining exercise
exercise prices Number price life(years) Number price
---------------------------------------------------------------------

$ 0.59 to 1.01 1,259,248 $ 0.71 5.8 841,772 $ 0.72
2.20 to 3.45 311,999 3.25 5.4 311,999 3.25
3.50 to 4.00 346,832 3.57 6.7 246,654 3.58
5.75 to 5.75 35,000 5.75 6.0 35,000 5.75
12.85 104,225 12.85 5.2 104,225 12.85
---------------------------------------------------------------------
$ 0.59 to 12.85 2,057,304 $ 2.28 1,539,650 $ 2.63
---------------------------------------------------------------------
---------------------------------------------------------------------


9. Income taxes:

The provision for income taxes differs from the amount computed by applying the statutory income tax rate to the loss before provision for income taxes. The sources and tax effects of the differences are as follows:



---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
---------------------------------------------------------------------

Basic rate applied to the loss before
provision for income taxes $ (2,986) $ (6,215)
Adjustments resulting from:
Effect of valuation allowance on
future tax assets 3,365 2,524
Effect of foreign tax rates
differing from Canadian tax rates (18) 32
Non-deductible goodwill - 3,509
Other (361) 150
---------------------------------------------------------------------
Income tax provision $ - $ -
---------------------------------------------------------------------
---------------------------------------------------------------------

Significant components of the Company's future tax assets are as
follows:

---------------------------------------------------------------------
---------------------------------------------------------------------
2005 2004
---------------------------------------------------------------------

Undeducted research and development
expenses $ 4,586 $ 4,031
Capital assets 1,432 1,145
Net operating losses 14,159 11,622
Other 183 197
---------------------------------------------------------------------
Future tax asset 20,360 16,995
Valuation allowance (20,360) (16,995)
---------------------------------------------------------------------
Total $ - $ -
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In assessing the realizability of future tax assets, management considers whether it is more likely than not that some portion or all of the tax benefits will not be realized. The ultimate realization of future tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers projected future taxable income, uncertainties related to the industry in which the Company operates, and tax planning strategies in making this assessment. Due to the uncertainties related to the industry in which the Company operates, the tax benefit of the Company's future tax assets have been completely offset by a valuation allowance. The Company has non-capital losses of approximately $31,000 for Canadian federal tax purposes and $38,000 for Ontario tax purposes expiring over the period 2006 to 2015. In addition, the Company has approximately $5,000 of net operating losses for United States tax purposes that expire over the period 2019 to 2025.

Tax credits

The Company is entitled to scientific research and experimental development ("SRED") tax credits granted by the Canadian federal government ("Federal") and the Ontario provincial government ("Provincial"). Federal SRED tax credits, which are non-refundable, are earned on qualified Canadian SRED expenditures and can only be used to offset Federal income taxes otherwise payable. Provincial SRED tax credits, which are refundable, are earned on qualified SRED salaries.

SRED and other tax credits are accounted for as a reduction of the related expenditures. The refundable portion of tax credits is recorded in the year in which the refund is received. The non-refundable portion of tax credits is recorded in the year in which the credit is used against federal taxes payable. During the year the Company recorded $161 of refundable credits relating to expenditures incurred in 2003. In addition, during the year, the Company filed a claim for $189 relating to 2004 expenditures which will be recorded when received.

10. Fair value of financial instruments and credit risk:

Financial instruments that potentially expose the Company to concentrations of credit risk consist primarily of cash equivalents, short-term investments, and accounts receivable.

The Company invests excess cash equivalents and short-term investments in high grade guaranteed investment certificates and fixed income securities with governmental agencies and large Canadian and US corporations. Short-term investments have maturities of less than one year. Due to the nature of these investments, their carrying value approximates fair value.

The reported values of financial instruments which consist of cash equivalents, short-term investments, accounts receivable and accounts payable and accrued liabilities, approximate their fair values due to the near term maturity of these instruments.

The Company performs periodic credit evaluations of the financial condition of its customers. Allowances are maintained for potential credit losses consistent with the credit risk of specific customers.

11. Segmented information:

The Company has reviewed its operations and determined that it operates in one business segment and only has one reporting unit. The Company designs, develops and manufactures data communications technology. The Company's products and services include secure communication software and devices, media encryptors, secure networked storage software and devices and secure workgroup software. Management reviews the Company's performance primarily by revenues.



a) Revenues from business sectors were as follows:

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2005 2004
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RASP Data Security $ 1,786 $ 3,541
Assurency Enterprise Security 157 192
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Total $ 1,943 $ 3,733
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b) The Company operates from Canada and also has a sales and
service operation in the United States. Revenues and assets by
geographic location of offices were as follows:

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2005 2004
Revenues Capital Revenues Capital
assets assets
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Canada $ 1,223 $ 490 $ 1,390 $ 786
United States 720 6 2,343 8
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Total $ 1,943 $ 496 $ 3,733 $ 794
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All of the intangibles were located in Canada in 2005 and 2004.

(c) Revenues attributed to regions based on location of customer
were as follows:

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2005 2004
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Canada $ 190 $ 437
United States 1,750 3,293
Europe 3 3
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Total $ 1,943 $ 3,733
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The Company's largest customer, the U.S. Federal government, accounted for approximately 49% of revenues in 2005 (2004 - 89%) and approximately 25% of accounts receivable at December 31, 2005 (2004 - 86%).

12. Commitments:

The Company is committed to the following future minimum lease payments for the rental of premises and other operating leases for the years ending December 31 as follows:



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2006 $ 293
2007 236
2008 44
2009 -
2010 -
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Total $ 573
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13. Subsequent Event:

On March 27, 2006, the Company negotiated a credit facility for $1,500. Any balances borrowed against the facility are due on demand and secured by a general security agreement against the Company's assets. Interest is charged at the Company's bank's prime lending rate.

The credit facility is also secured by personal guarantees and other collateral from certain directors of the Company. In consideration for these personal guarantees, the Company will issue warrants to the directors, entitling them to acquire a maximum of 2,875,000 common shares of the Company at an exercise price of $0.30 over a term of 18 months. Funds from the revolving credit facility will be drawn by the Company and the warrants will be issued in tranches on the approval of a majority of the Company's independent directors and a majority of the directors providing the guarantees and other collateral. The first tranche of $250 has been approved. The Company can redeem the warrants at any time at a purchase price of $0.21 per warrant. The fair value of the warrants will be expensed as the credit facility amounts are drawn.

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