10-K

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INDEX
INDEX TO FINANCIAL STATEMENTS

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the Fiscal year ended December 31, 2001
or

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                      to                                     

Commission file number 0-22844

SYLVAN LEARNING SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Maryland (State or other jurisdiction of incorporation or organization)	52-1492296 (IRS Employer Identification No.)
1001 Fleet Street, Baltimore, Maryland (Address of principal executive offices)	212002 (zip code)

(410) 843-8000
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Common Stock, Par Value $0.1
Preferred Stock Purchase Rights Name of each exchange on which registered
NASDAQ
None

Securities registered pursuant to Section 12(g) of the Act: None

        Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d), of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X]. No [    ].

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [    ]

        The aggregate market value of voting Common Stock held by non-affiliates of the registrant was approximately $925 million as of March 13, 2002.

        The registrant had 39,722,457 shares of Common Stock outstanding as of March 13, 2002.

DOCUMENTS INCORPORATED BY REFERENCE

        Certain information in Sylvan Learning Systems, Inc.'s definitive Proxy Statement for its 2002 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission pursuant to Regulation 14A no later than April 30, 2002, is incorporated by reference in Part III of this Form 10-K.

INDEX

PART I.
	Item 1.      Business
	Item 2.      Properties
	Item 3.      Legal Proceedings
	Item 4.      Submission of Matters to a Vote of Security Holders
PART II.
	Item 5.      Market for Registrant's Common Equity and Related Stockholder Matters
	Item 6.      Selected Consolidated Financial Data
	Item 7.      Management's Discussion and Analysis of Financial Condition and Results of Operations
	Item 7A.  Quantitative and Qualitative Disclosures About Market Risk
	Item 8.      Financial Statements and Supplementary Data
	Item 9.      Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
PART III.
	Items 10., 11., 12. and 13. are incorporated by reference from Sylvan Learning Systems, Inc.'s definitive Proxy Statement which will                       be filed with the Securities and Exchange Commission, pursuant to Regulation 14A, no later than April 30, 2002.
PART IV.
	Item 14.    Exhibits, Financial Statement Schedules and Reports on Form 8-K
SIGNATURES

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PART I.

Item 1.    Business

        Sylvan Learning Systems, Inc. ("the Company" or "Sylvan") is a leading international provider of educational services to families and schools. The Company seeks to maintain its leadership position in the core K-12 educational services market while significantly expanding its post secondary offerings and establishing a leadership role in the educational technology marketplace by focusing on the following business concentrations:

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K-12. Providing consumer and institutionally focused education services for students ranging from kindergarten through high school education levels. Services are provided through Sylvan Learning Centers and Sylvan Education Solutions. This business focuses on proven grade level advancement of students through direct student-instructor interaction.



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Post-Secondary. Providing educational services to students beyond the high school education level through a network of fully accredited international universities, center-based adult English language instruction and accredited teacher training university courses and degree programs. Services are tailored to address the fast growing international marketplace for advanced education as well as the shortage of teaching professionals in the United States. Services are provided through International Universities, Wall Street Institute and Canter.



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Education Technology. Investing in companies employing emerging technology solutions in the education marketplace. Building on brand recognition and an industry-leading position in education services, the Company seeks to create shareholder value by capitalizing on an opportunity to establish a leadership position in the application of Internet and wireless technologies to the marketplace through Sylvan Ventures.

        The Company provides lifelong educational services through five separate business segments. As of July 1, 2001, the Company realigned several of its business segments to emphasize the Company's focus on increasing its presence in the post-secondary education and online education markets. The new segments are K-12 Education Services (comprised of Sylvan Learning Centers and the Sylvan at School and Career Starters operations of the business formerly referred to as Sylvan Education Solutions), Online Higher Education (comprised of Canter and Associates and Sylvan Teacher Institute, both previously reported as a part of Sylvan Education Solutions), International Universities, English Language Instruction, and Sylvan Ventures. All segment information has been reclassified to conform to the new presentation.

        The K-12 Education Services segment includes the operations of Sylvan Learning Centers, which designs and delivers individualized tutorial programs to school-aged children through franchised and Company-owned learning centers; Schülerhilfe, a major provider of tutoring services in Germany; and Sylvan Education Solutions, which principally provides educational programs to students of public and non-public school districts through contracts funded by Title I and state-based programs. The Online Higher Education segment provides professional development and graduate degree programs to teachers through Canter and Associates and Sylvan Teacher Institute. The International Universities segment owns or maintains controlling interests in five private universities located in Spain, Switzerland, Mexico, Chile and France. The English Language Instruction segment consists of the operations of Wall Street Institute ("WSI"), a European-based franchiser and operator of learning centers that teach the English language in the post-secondary market. The Sylvan Ventures segment invests in and develops companies that are creating emerging technology solutions for the education marketplace, and includes the operations of eSylvan, Inc., a majority-owned subsidiary.

        Consistent with the stated goal of focusing management's efforts and the Company's resources on the core business of consumer educational services and in order to fund expansion of technology

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applications in educational and training services, the Company consummated the sales of three business units in fiscal 1999 and 2000. On December 31, 1999, The PACE Group ("PACE"), the Company's corporate training business, was sold in exchange for an equity investment in Frontline Group, Inc., the owner of a corporate training enterprise. On March 3, 2000, Prometric, the computer-based testing business, was sold for approximately $775 million in cash. On October 6, 2000, Aspect Language Schools, Inc. ("Aspect"), an English Language study/travel business, was sold for approximately $19.8 million in cash. Unless specifically noted, all discussion of financial results excludes the results of PACE, Prometric and Aspect except as disclosed as discontinued operations.

        Sylvan's services are delivered through an international network of Company-owned and franchised educational centers, in-school programs and agreements with university partners, as well as Sylvan controlled universities. In 2001, Company revenues were approximately $484.8 million, comprised of $184.6 million from the K-12 Education Services segment, $44.3 million from the Online Higher Education segment, $200.2 million from the International Universities segment and $55.7 million from the English Language Instruction segment. System wide revenues, which include franchised Learning Center revenues of $297.5 million and franchised WSI revenues of $133.0 million, totaled $915.3 million in 2001. Note 16 of the Company's 2001 audited financial statements contains additional disclosures regarding the Company's segments and geographic information.

K-12 Education Services

Sylvan Learning Centers

        Sylvan provides high quality educational services with consistent, quantifiable results. It has delivered its core educational service to more than 1.4 million students in grades K-12 over the past 20 years. The Sylvan Learning Centers ("SLC") division provides supplemental, remedial and enrichment instruction primarily in reading, writing, mathematics, study skills and test preparation, featuring an extensive series of standardized diagnostic assessments, individualized instruction, a student motivational system and continued involvement from both parents and the child's regular school teacher.

        Parents learn about Sylvan from the Company's media advertising, from a referral from another parent or from school personnel. The Learning Center's Sylvan-trained educators use assessment results to diagnose students' skill gaps and to design an individual learning program for each student. Sylvan Learning Center's curriculum is consistent throughout North America. Instruction is typically given three times per week for one hour per visit at U-shaped tables designed to ensure that teachers work with three to four students at a time. Instructional programs are research-based and built upon the philosophy of mastery learning. There are special incentives, such as tokens redeemable for novelties and toys, to motivate the student to achieve the program's objectives, to build self-confidence and to strengthen the student's enthusiasm for learning.

        A student's progress is monitored and parent conferences are scheduled after every 12 hours of a student's program. Throughout a student's course of study, the learning center assesses the student's progress using the same standardized diagnostic assessments. The results are shared with the parents in personal conferences, during which the student's continuation in a Sylvan program is discussed.

        Franchise Operations.    As of December 31, 2001, there were a total of 808 learning centers in 48 states, 8 Canadian provinces, Puerto Rico, Hong Kong and Guam operated by its franchisees. As of that date, there were 460 U.S. franchisees operating Sylvan Learning Centers. During 2001, a net of 48 franchised learning centers were opened. Additionally, during 2001, the Company acquired 5 franchisee-owned learning centers.

        The Company's typical franchise agreement (the "License Agreement") grants a license to operate a Sylvan Learning Center and to use Sylvan's trademarks within a specified territory. The Company

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currently offers a License Agreement with an initial term of ten years, subject to unlimited additional ten-year extensions at the franchisee's option under the same terms and conditions. The initial license fee and royalty rates vary depending upon the demographics of the territory. Franchisees must obtain the Company's approval for the location and design of the learning center and of all advertising, and must operate the learning center in accordance with the Company's methods, standards and specifications. The franchisee is required to purchase from Sylvan certain diagnostic and instructional materials, student record forms, parental information booklets and explanatory and promotional brochures developed by the Company. Sylvan specifies requirements for other items necessary for operation of a learning center, such as computers, instructional materials and furniture. Franchisees must also submit monthly financial data to the Company.

        The Company actively manages its franchise system. The Company requires franchisees and their employees to attend initial training in learning center operations and Sylvan's educational programs. The Company also offers franchisees continuing training each year. The Company employs field operations managers who act as "consultants" to provide assistance to franchisees in technology implementation, business development, marketing, education and operations. These employees also facilitate regular communications between franchisees and the Company.

        The Company believes there is significant potential for additional franchised learning centers both domestically and internationally. A number of territories with only one learning center could support one or more additional learning centers based upon the number of school-age children in the market area. The Company is actively encouraging existing franchisees in these territories to open additional learning centers. Additionally, management has identified at least 265 territories in North America, primarily in smaller markets, in which there are no learning centers. The Company is actively seeking franchisees for a number of these territories. Thirty-six new territories were sold in 2001.

        The Company has sold franchise rights for the operation of learning centers in Hong Kong, the United Kingdom, France and Spain. In pricing international franchise rights, the Company takes into account estimates of the number of centers that could be opened in an area. A master franchisee operates Sylvan Learning Centers in Spain and at December 31, 2001, had 123 centers in operation.

        Company-owned Learning Centers.    As of December 31, 2001, Sylvan owned and operated 90 learning centers: 9 in the greater Baltimore, MD area, 10 in the greater Philadelphia, PA area, 9 in the greater Washington, D.C. area, 8 in South Florida, 7 in Orlando, FL, 5 in Alabama, 5 in the greater Minneapolis, MN area, 7 in Dallas, TX, 8 in Houston, TX, 3 in Austin, TX, 5 in the greater Salt Lake City, UT area and 14 in the greater Los Angeles, CA area. The Company's operation of learning centers enables it to test new educational programs, marketing plans and learning center management procedures. Company-owned learning centers give the Company a local presence in key markets, which has been helpful in cross-marketing the Company's other educational services in these communities. The Company may consider selected acquisitions of additional learning centers now operated by franchisees.

        Schülerhilfe.    As of December 31, 2001, Schülerhilfe, a major provider of tutoring services in Germany, had approximately 234 company-owned centers and approximately 706 franchise locations in Germany, Italy and Austria. Schülerhilfe is engaged in providing tutoring service to primary and secondary students with an operational business model that is similar to Sylvan Learning Centers. Students typically attend twice per week and are instructed in small groups of four to six students per session. Schülerhilfe advertises using print, radio and television advertisements on local and national levels.

        Ivy West.    On May 19, 2000, the Company acquired Ivy West, an SAT/ACT preparation company based in California. Ivy West offers individual home-based instruction for students preparing to take the SAT I, SAT II, PSAT, or ACT. Ivy West also offers school partnerships to provide SAT preparation

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materials and instruction in a group or classroom environment. Sylvan Learning Centers also offer the Ivy Prep program in their centers using the traditional 3-to-1 student—teacher ratio, small group instruction and school partnership programs.

Sylvan Education Solutions

        Since 1993, Sylvan Education Solutions ("SES") has partnered with schools, school districts, education institutions and community organizations in providing learning programs that are outcomes-based and tailored to the individual needs of the student. Under contract to school systems and workforce development agencies, Sylvan Education Solutions provides direct instruction and after-school tutoring for K-12 students and work skills training for "hard-to-employ" individuals—at-risk and drop-out youth, welfare recipients, and underemployed workers. SES provides low-income families and students access to the same supplemental education and tutoring services offered by Sylvan Learning Centers. SES programs are provided at no cost to students. Funding sources for SES programs include federal Department of Education programs, such as Title I, state programs, such as PA Act 89, special education funds, local school funds and federal Department of Labor initiatives. In 2001, SES served over 59,000 students in its direct instruction programs. SES also provides specialized services to non-public schools, including speech and language instruction, special education instruction and early childhood programs.

Online Higher Education

Canter

        For more than 25 years, Canter has recognized that the key to student achievement is a well-trained teacher. To that end, Canter's mission is to enhance the quality of teaching and learning by empowering educators with new teaching strategies. Canter achieves this goal by offering products and services that present not only the most current educational theory, but also the practical applications educators need and want.

        Canter is the leading provider of teacher professional development training in the United States. Working in collaboration with its 16 college and university partners, Canter delivered more than 32,000 graduate courses and 9,200 online courses during 2001. Additionally, Canter had 10,800 teachers enrolled in its three master's degree programs at December 31, 2001.

        Canter's course topics and training include reading at the elementary and secondary level, elementary math, learning styles, instructional strategies, assessment, classroom management, reading and language development, character development and parental involvement. These courses are designed to satisfy certification requirements of teachers, as well as provide America's school districts with research-based, long-term technology embedded training that delivers measurable results.

        The master's degree programs developed by Canter in collaboration with its college and university partners focus on three key areas of study: elementary reading and literacy, integrating technology into the classroom and curriculum and instruction.

        Canter programs offer blended models that provide the best of video, online, print and live collaboration. Canter's proven model, focus and reputation set it apart in its ability to continue to thrive in the growing education marketplace.

Sylvan Teacher Institute

        Sylvan Teacher Institute provides services to K-12 schools designed to increase the number of highly qualified teachers. With massive teacher shortages and the soaring cost of recruiting and training highly qualified teachers, Sylvan Teacher Institute is positioned to provide solutions for school organizations and professionals desiring to transition their careers to teaching. Sylvan Teacher

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Institute's product line includes preparation courses for state required teacher certification tests, courses for substitutes and alternative routes to certification programs.

International Universities

        The International Universities segment is the leading network of private, post-secondary educational institutions outside the United States. Its offerings address the fast-growing international demand for career-oriented education. International Universities currently owns and operates five fully licensed universities.

University Descriptions

        International Universities has three full-service universities in Spain, Mexico and Chile and two highly specialized universities in France and Switzerland. It currently enrolls approximately 50,000 full-time students and offers more than 100 degree programs through 21 campuses. The universities primarily serve 18- to 24-year-old students and offer an education that emphasizes career-oriented fields of study with undergraduate and graduate degrees in a wide range of disciplines, including international business, hotel management, health sciences, information technology and engineering. The Company believes that the universities benefit from strong academic reputations and brand awareness and established operating histories. Each university also has flexible, non-tenured, teaching-focused faculty and is led by an experienced local management team.

        The following table presents information about the universities in the SIU network:

University	Principal Location	Date Founded	Date Acquired	Current Ownership		No. of Campuses	Enrolled Students(1)	Average Annual Tuition(2)		Regulatory Oversight
Universidad Europea de Madrid — CEES	Madrid, Spain	1995	1999	78	%	1	7,618	$	5,900	Spanish Ministry of Education
Universidad del Valle de Mexico	Mexico City, Mexico	1960	2000	80	%	13	32,777	$	3,400	Mexican Secretary of Education
Universidad de las Americas	Santiago, Chile	1988	2000	60	%	4	8,008	$	2,800	Chilean Ministry of Education
École Supérieure du Commerce Extérieur	Paris, France	1968	2001	99	%	1	1,045	$	4,700	French Ministry of Education
Swiss Hotel Association Hotel Management School "Les Roches"(3)	Bluche, Switzerland	1979	2000	100	%	2	1,337	$	11,300	Swiss Government (license), Swiss Hotel Association/ NEASC (accreditation)

(1)

Represents enrollment on the first day of classes of the primary enrollment period for each university.

(2)

Based on 2001 calendar year data in U.S. dollars rounded to the nearest hundred.

(3)

Includes a campus located in Marbella, Spain, which we acquired from a former franchisee in March 2002.

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        The universities provide a broad range of degrees and programs and are well regarded by students, employers and government authorities in their respective markets:

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Universidad Europea de Madrid—CEES ("UEM") offers 30 diploma or bachelor's degree programs and 20 master's and doctorate degree programs. The university includes a well-known school of health sciences and schools of architecture, economics, engineering, journalism and law. It is one of the largest private universities in Spain and in 2000 was ranked 17th out of 54 universities in Spain based on overall excellence by an independent research group in Spain.



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Universidad del Valle de Mexico ("UVM") offers 24 undergraduate and 6 graduate degree programs in a broad range of fields including accounting, architecture, business administration, education, engineering and law. The university is the third largest private university in Mexico in number of students and is the largest in number of campuses.



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Universidad de las Americas ("UDLA") offers 26 undergraduate degree programs focused on business administration, education, engineering, law and psychology. In 2001, this university had the highest number of new enrollments of any private university in Chile.



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École Supérieure du Commerce Extérieur ("ESCE") offers a four-year degree program in international commerce and management that features a combination of coursework and internships. This university was the first university in France to specialize in international trade. In 2000, ESCE was ranked 13^th out of 53 business schools in France based on overall excellence by the magazine Le Nouvel Economiste.



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Swiss Hotel Association Hotel Management School "Les Roches" ("Les Roches") offers globally recognized hospitality and hotel management programs. Les Roches' specialized programs require students to complete three internships prior to graduation. Les Roches was the first English-speaking hotel management school established in Switzerland and the first such school to be accredited by the New England Association of Schools and Colleges ("NEASC"). In March 2002, we acquired the second campus of this university in Marbella, Spain.

Degree Programs and Areas of Study

        International Universities offers more than 100 career-oriented undergraduate and graduate degree programs in a wide range of fields. The time typically required to complete a program varies by degree, with undergraduate degrees requiring on average four to five years and graduate degrees requiring on average two to three years following completion of an undergraduate degree. The Company's International Rector oversees the curriculum development and the deployment of programs in our network in cooperation with the deans of the universities. The Company also encourages its faculty to develop new educational programs and curricula. The programs are designed to satisfy three constituencies:

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Students. The Company believes that students choose from career-oriented schools based on the type and quality of the educational offering and career placement opportunities. The Company focuses on providing students with a solid academic foundation and the technical and practical skills necessary to pursue and excel in their careers.



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Employers. The relationship of each of the universities with the business community plays a significant role in the placement of our students and the development of curriculum. Each of the universities works with prominent members of the relevant industry to evaluate and improve existing programs in order to maintain their relevance in the workplace. These employers provide critical input on the latest advancements within each field and the implications of these changes on the curriculum.

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Regulating or licensing agencies. The degree programs of each of the universities have been approved in accordance with applicable law. For example, the Secretary of Education in Mexico has reviewed all of UVM's programs and given the university degree-granting authority for those programs. The Ministries of Education in Spain and France perform similar roles. The Company must generally work with the regulators of these universities to ensure that any new programs will be approved. In Chile, UDLA has been granted full autonomy by the Ministry of Education. As a result, the Company is free to create new degree programs in Chile without additional regulatory approval. Les Roches is licensed in Switzerland and is accredited by the New England Association of Schools and Colleges, one of six accrediting associations in the U.S, and must ensure that its curriculum continues to meet the standards of that association.

        The SIU network allows the Company to share high-quality curricula among the universities, broadening students' educational opportunities. For example, during 2001 UEM and Les Roches developed a new joint degree program in hospitality business management that is now being offered to students at UEM. Similarly, during the 2002-2003 academic term, UVM will offer at one of its campuses a sports management degree program developed at UEM. The Company intends to use highly specialized course materials developed at ESCE and Les Roches throughout the SIU network, potentially creating new degree programs at minimal cost.

Tuition and Fees

        Tuition varies at each of the universities depending on the curriculum and type of program. For the full-service universities, average annual tuition ranges from $3,000 to $6,200 for the 2001-2002 academic year. For the specialized universities, average tuition ranges from $5,000 to $11,100 for the 2001-2002 academic year. Tuition payment options vary by university and range from a lump sum payment at the beginning of the academic year to monthly installment payment plans. Historically, the Company has been able to increase tuition as educational costs and inflation have risen. In 2001, the Company implemented average tuition increases of approximately 8%. The Company intends to continue increasing tuition at each of the universities as market conditions warrant.

        Students are generally responsible for room and board fees, transportation expenses and costs related to textbook and supply purchases required for their educational programs. At some of the universities, the Company offers these services to the student body, which helps to generate incremental revenue.

        Students typically self-finance their education or seek non-university sponsored financing programs. Although none of the countries in which International Universities currently operates provides student loan programs similar to those in the U.S., the Company is actively working to develop a variety of financing alternatives for students.

English Language Instruction

        Through Wall Street Institute ("WSI"), Sylvan provides English language instruction using proprietary multi-media technologies to over 100,000 adult students annually with 17 courses ranging from beginning to advanced English, as well as courses for specific purposes, such as business English. As of December 31, 2001, the WSI organization included 421 English language centers in 21 countries primarily in Europe, Asia and the Americas. Located primarily in the business districts of urban areas, WSI centers are easily accessible to working adults. Enrollment at each center averages 350 to 400 students per year.

        English is the language of international business and the Company believes that a working knowledge of English has become increasingly important to many professionals throughout the world. Because English is becoming more prevalent around the world, the Company believes there is growing demand for instruction in English as a second language among both full-time university students and

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working adults. As more working adults and students seek English language instruction for employment or educational purposes, the Company believes that the English language instruction market will experience significant growth.

        WSI's goal is to enable its students to successfully learn English. WSI's method of English language instruction is based on six stages with a total of 17 levels ranging from beginning to advanced skills and includes courses for specific purposes, such as business English. WSI's courses use a combination of live, personalized instruction, small group classes and interactive computer-based instruction. Currently, the main product offering is English Online, a proprietary interactive computer-based instruction methodology that is personalized for each student's needs, timetable and goals. All of WSI's courses can be tailored by students to meet their scheduling needs as well as location preferences. Students can elect to take a course at a center, at home or at work. WSI's courses are taught by instructors that speak English as their first language and who have been trained and certified in our comprehensive program. Each student is given assistance and personalized attention and follow-up from a personal tutor. Each student also has the opportunity to socialize with other students and teachers at the social club at each center. WSI continually aims to update and innovate its English language courses. WSI is developing additional courses dedicated to teaching English for other specific purposes, such as tourism, law and medicine.

        WSI's per course tuition varies depending on the location of the center and type and amount of course work. On average, students take a three-level course, lasting a total of 8 to 11 months. The tuition for a course ranges from $700 in Colombia to $3,000 in China. Typically, payment is due at the beginning of each course. However, WSI does offer special student payment plans through financial institutions, which enable students to finance tuition in monthly installments.

        A substantial portion of WSI's expansion has been accomplished through franchising centers. Of WSI's 421 English language centers, 351 are franchised centers: 271 in Europe and Asia and 80 in the Americas. WSI also has 70 company-owned centers, most of which are located in Europe.

        Franchise Operations.    After WSI identifies an attractive area for growth, it typically seeks to open centers in that area by selling master franchising rights or developing the territory internally. The typical master franchising agreement grants a license to develop centers and obtain sub-franchisees in a specified exclusive country or region. WSI currently offers a master franchising agreement with an initial term ranging from ten to twenty-five years, subject to unlimited additional five to ten year extensions at the master franchisee's option on the same terms and conditions. The initial license fee ranges from $0.3 million to $1.5 million, depending on the size and population of the territory. Under this agreement, the master franchisee pays royalties of 4% of the revenue of its first center and any center in which the master franchisee has an equity interest. The master franchisee also pays 20% to 25% of all royalties and fees paid to it by all sub-franchisee centers within its territory. The royalties cover the use of WSI's brand name, multimedia teaching system, marketing and back-up support. WSI requires franchisees to use and pay for didactic materials.

        The typical sub-franchise agreement grants a license to operate a center and to use WSI's trademarks within a master franchisee's specified territory. The standard sub-franchise agreement extends for an initial term of ten years, subject to unlimited additional ten-year extensions at the sub-franchisee's option on the same terms and conditions. The initial license fee ranges from $70,000 to $100,000, depending on the territory. Under each agreement, the sub-franchisee pays the master franchisee royalties of 7% of revenue of each center.

        The Company actively manages its franchise system. The Company requires master franchisees, sub-franchisees and their employees to attend initial training in center operations and WSI's English language programs. Each master franchisee must obtain the Company's approval prior to opening its first center and any centers in which it has an equity interest and may not alter the standard form of sub-franchise agreement without the Company's approval. Master franchisees are also required to

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submit monthly financial data to the Company so that it can monitor their progress and address any potential issues. Master franchisees are responsible for monitoring sub-franchisees' compliance with the Company's methods and standards, including training requirements, correct administration of the multimedia teaching system, staffing and center appearance. If the Company determines that the training of a sub-franchisee's employees is inadequate, it may require the sub-franchisee employees to complete training at their own expense.

Sylvan Ventures

        Sylvan Ventures operates with the goal of investing in and developing companies to bring technology solutions to the education and training marketplace. On June 30, 2000, affiliates of Apollo Management L.P. and certain members of management joined the Company in the legal formation of Sylvan Ventures, LLC with total committed funds of $400 million. Of the $400 million commitment, the Company has committed $285 million, Apollo has committed $100 million, and management investors have committed $15 million.

        Sylvan Ventures intends to emerge as a market leader in the multi-billion dollar, highly fragmented e-learning market. Sylvan Ventures invests in select, strategic investments in all phases of the online educational lifecycle including K-12, higher education and professional development. By promoting activity between portfolio companies and supplementing the strengths of each enterprise with Sylvan's strong brand, established relationships, management team experience and substantial capital, Sylvan Ventures intends to create unique and significant operational synergies within and among the portfolio companies.

        As of December 31, 2001, Sylvan Ventures has investments in eSylvan, Inc., Walden E-Learning, Inc., Chancery Software Limited, iLearning, Inc., EdVerify, Inc., Mindsurf, Inc., HigherMarkets, Inc., Way2Bid, Inc. (formerly Kawama.com, Inc.), and Club Mom, Inc.

        For the year ended December 31, 2001, Sylvan Ventures reported significant losses resulting from recording its proportionate share of losses generated by its investees. These companies are in the early stages of development and significant losses are expected to be incurred through at least 2002.

        In accordance with the formation agreement, Sylvan Ventures is owned in the following percentages: Company 72%, Apollo 25% and management investors 3%. The Company has significant control of the operations of Sylvan Ventures as a result of being the majority shareholder and through representation on the Investment Committee, which reviews and approves individual Sylvan Ventures projects. The Sylvan Ventures' Board of Directors is comprised of the same slate of directors as the Company's Board of Directors. In the event of a profit triggering event, profits will be shared in the following percentages: Company 57%, Apollo 20%, management investors 3% and membership profit interests 20% (when fully allocated). As of December 31, 2001, only 15.3% of the membership profit interest has been granted. Profits are only allocated after all losses have been recaptured. Apollo has a preferred position in allocation of losses following the 2000 fiscal year. Losses will be allocated first to the Company and Management investors to the extent of the capital accounts, and then to Apollo. No losses can be allocated to the membership profit interests.

        The Company maintains a majority-ownership position in Sylvan Ventures and accounts for Sylvan Ventures as a consolidated subsidiary with a minority interest balance representing the minority owners' net investment.

Marketing

        K-12 Education Services.    The Company and its franchisees market SLC's services to parents of school-aged children at all grade levels and academic abilities. Far beyond tutoring, SLC's supplemental education utilizes a diagnostic and prescriptive approach to address the specific needs of each and

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every student. A portion of Sylvan's advertising includes commercials on morning news on the national networks as well as various cable delivered programs and Internet marketing. Sylvan's advertising positions it as the leader in supplemental education and emphasizes Sylvan's customized content, personalized attention and positive results: improved school performance and increased self-confidence. Franchisees form local cooperatives to collectively purchase local television and radio advertising and usually supplement their efforts with local newspaper and direct mail. The Company also has additional marketing support for specific programs, including Reading, Math, Algebra, Study Skills, SAT/ACT College Prep, and Writing.

        The Company markets its school-based educational services to local school districts and state education departments. This marketing effort has been expanded to seek contracts for both public and non-public schools, where both are administered by the local public school district. The Company markets its adult programs to state and local welfare agencies in need of remedial education and job training services.

        Online Higher Education.    The Company markets its Canter division primarily through cooperative programs with participating institutions and advertising aimed towards teachers.

        International Universities.    The Company markets its universities through professional broadcast and targeted marketing campaigns. These campaigns reach prospective students indirectly through media advertising campaigns as well as directly by mail or one-on-one meetings. During annual enrollment periods, the Company supplements its advertising with local, regional and sometimes national campaigns on television, radio, print and the Internet. Each university is responsible for implementing its own marketing campaign, although the Company provides a forum for the marketing departments of each of the universities to discuss and share best practices.

        English Language Instruction.    WSI employs a marketing staff that is primarily located in Barcelona, Spain. This staff is responsible for creating programs to build brand awareness and generate direct customer response to the centers. They develop advertising campaigns for various media as well as telemarketing, direct mail and referral programs. The staff works with the marketing staff of the master franchisee in each of the countries in which WSI operates. WSI and the franchisees typically market their services through the use of radio advertising programs and through locally placed advertising. Additionally, WSI centers are typically located in highly visible areas near central business areas and public transportation routes. WSI gauges the effectiveness of its promotions and marketing campaigns by monitoring in-bound leads, walk-ins and appointment presentations at each of its centers.

Competition

        The Company faces competition in each of its business segments. That competition focuses on price, educational quality and location in the franchise businesses. In the Education Solutions and International University businesses, the competition is primarily based on price, educational quality and reputation.

        K-12 Education Services.    The Company is aware of only four direct national corporate competitors in its U.S. based SLC business: Huntington Learning Centers, Inc., Kumon Educational Institutes, The Princeton Review and Kaplan Educational Centers. The Company believes these competitors operate fewer centers than Sylvan and that these firms concentrate their services within a smaller geographic area. In most areas served by SLC, competition also exists from individual tutors and local learning centers. State and local education agencies also fund tutoring by individuals, which compete with the Company's SLC business. Schülerhilfe's competition consists of one other provider of tutoring services in Germany as well as individual local tutors.

        Given the unique position of public education in the United States, the Company believes that educational reforms implemented directly by school officials will not face the same degree of public

12

resistance that the Company may face. The Company also competes with school reform efforts sponsored by private organizations and universities and with consultants hired by school districts to provide assistance in the identification of problems and implementation of solutions. The Company is aware of several entities that currently provide Title I and state-based programs on a contract basis for students attending parochial and private schools.

        Online Higher Education.    Canter competes with both public and private universities in the U.S. that provide graduate courses and master degree programs for teachers. The Company believes that it understands the needs of its customers based on Canter's 25 years of experience in the marketplace. In addition, the Company believes that it compares favorably to its competitors for some customers due to the convenience of its on-line and video delivery systems.

        International Universities.    The market for post-secondary education outside the U.S. is highly fragmented and marked by large numbers of local competitors. The target demographics are primarily 18- to 24-year-olds in each respective country in which the Company competes, except for Les Roches, which primarily targets non-Swiss citizens. The Company generally competes with both public and private universities on the basis of price, educational quality, reputation and location. Public universities tend to be less expensive, if not free, but more selective and less focused on career-oriented degree programs. The Company believes that it compares favorably with competitors because of its focus on quality, career-oriented curriculum and the efficiencies of its network. At present, the Company believes that no other Company has a similar network of international universities. There are a number of other private and public universities in each of the countries where the Company owns a university. Because the concept of private, for-profit universities is fairly new in many countries, it is difficult to predict how the market will evolve and how many competitors there will be in the future. The Company expects competition to increase as the market matures.

        English Language Instruction.    The English language instruction industry is highly fragmented, varying significantly among different geographic locations and types of consumers. The Company's ability to compete depends on its ability to improve existing or create new English language learning products to distinguish WSI from its competitors. Other providers of English language instruction include individual tutors, small language schools operated by individuals and public institutions, and franchisees or branches of large language instruction companies, some of which operate internationally. The smaller operations typically offer large group instruction and self-teaching materials for home study, while some larger competitors concentrate on the higher-priced, business-oriented segment of the English language instruction market by offering programs of intensive and individualized instruction. As the demand for English language skills rises due to the evolution of the information-based global economy, competing English language instruction providers are likely to try to strengthen their positions in the market by expanding their operations, pursuing strategic alliances and acquiring small competitors. This increasing competition may adversely affect the Company's ability to grow its English language instruction business and may also adversely affect its profitability. Additional competitive pressures exist specifically in Spain due to the saturation of the market for English language instruction providers in that country. This market saturation may result in certain under-performing centers closing.

Government Regulation

        Franchise.    Various state authorities as well as the Federal Trade Commission ("FTC") regulate the sales of franchises in the United States. The FTC requires that franchisers make extensive disclosures to prospective franchisees but does not require registration. A number of states require registration and prior approval of the franchise-offering document. In addition, many states have "franchise relationship laws" or "business opportunity laws" that limit the ability of a franchiser to terminate franchise agreements or to withhold consent to the renewal or transfer of these agreements.

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While the Company's franchising operations have not been materially adversely affected by such existing regulation, the Company cannot predict the effect of any future legislation or regulation.

        Title I.    Title I eligible school districts are responsible for implementing Title I and carrying out their educational programs. Title I regulations, as well as provisions of Title I itself, direct Title I eligible districts to satisfy obligations including involving parents in their children's education, evaluating and reporting on student progress, providing equitable services and other benefits to eligible non-public school students in the district and other programmatic and fiscal requirements. In contracting with school districts to provide Title I services, the Company has become, and will continue to be, subject to various Title I requirements and may become responsible to the school district for carrying out specific functions required by law. For example, Sylvan has responsibility for introducing program content adequate to achieve certain educational gains and maintaining the confidentiality of student records. The Company's failure to adhere to Title I requirements or to carry out regulatory responsibilities undertaken by contract may result in contract termination, financial liability or other sanctions.

        International University Regulation and Licensing.    In response to the growing demand for post-secondary education, governments in many countries have revised their regulations to encourage the establishment of private post-secondary universities. Each country in which International Universities currently operates has made this shift in regulatory policy. Typically, each applicable regulatory agency oversees universities, establishes requirements for creation of universities and sets the official qualifications and standards governing university departments and degree programs. In addition, these regulatory agencies establish prerequisites that students must satisfy in order to apply. These policies are designed to ensure that the universities have the resources and capability to provide the student body with a quality education.

        Wall Street Institute.    Because WSI does not offer any degree programs, it is generally not required to comply with any special educational regulation in the countries in which it operates. However, WSI typically registers as an educational institution in order to qualify for certain tax exemptions. Registration may subject WSI to additional regulation and possible restrictions on ownership or movement of funds in some countries. WSI is also subject to regulation by the applicable labor regulators in each country in which it operates.

Trademarks

        The Company has a federal trademark registration for the words "Sylvan Learning Center" and "eSylvan" and distinctive logos, along with various other trademarks and service marks and has applications pending for a number of other distinctive phrases. The Company also has obtained foreign registrations of a number of the same trademarks. The Company's License Agreement grants the franchisee the right to use the Company's trademarks in connection with operation of the franchisee's learning center. Additionally, the Company has a federal trademark registration for the words "Wall Street Institute" and distinctive logo (Statue of Liberty), as well as foreign trademark registrations and pending applications for the WSI trademark and logo.

Employees

        As of December 31, 2001, the Company had approximately 13,300 employees, 5,600 of whom were classified as full-time and 7,700 of whom were classified as part-time. Most of the Company's part-time employees are university employees and teachers in school-based programs, Company-owned learning centers and Schülerhilfe centers. The Company's employees at UEM and UVM are covered by labor agreements. The UEM agreement has been negotiated by a national union with a committee representing all of the private, for-profit universities in Spain. Substantially all of the faculty at UVM is represented by a union. The economic provisions of the labor agreement at UVM are scheduled to be

14

revised in 2003. The agreements govern salaries, benefits and working conditions for all union members at the universities. The Company considers its relationship with these unions and with all of its employees to be good.

Effect of Environmental Laws

        The Company believes it is in compliance with all environmental laws, in all material respects. Future compliance with environmental laws is not expected to have a material effect on the business.

Item 2.    Properties

        The Company leases many of its facilities, consisting principally of administrative office space and center site locations. The Company's administrative offices consist of four leased facilities in Baltimore, Maryland.

        The Company's segments lease various sites, primarily in North America and Europe. The K-12 Education Services segment leases space for 89 sites in the United States, 234 Schülerhilfe sites in Germany, and 9 regional offices; the International Universities segment leases 14 UVM sites, 1 UDLA site, 2 ESCE sites and 3 sites used for the UEM dentistry and podiatry clinics; and the English Language Instruction segment leases 50 sites around the world.

        The Company also owns academic buildings and dormitories on the UEM, Les Roches and UDLA campuses. Certain of the academic buildings and dormitories at UEM and UDLA are subject to mortgages.

Item 3.    Legal Proceedings

        The Company is a defendant in a legal proceeding currently pending in the United States Court of Appeals for the Eighth Circuit, Case No. 01-2775 on appeal from the United States District Court for the Northern District of Iowa. The case was originally filed on November 18, 1996 by ACT, Inc., an Iowa nonprofit corporation formerly known as American College Testing Program, Inc. ("ACT"). ACT's claim arose out of the Company's acquisition of rights to administer testing services for the National Association of Securities Dealers, Inc. ("NASD"). ACT asserted that the Company tortuously interfered with ACT's relations, contractual and quasi-contractual, with the NASD, that the Company caused ACT to suffer the loss of its advantageous economic prospects with the NASD and other ACT clients and that the Company has monopolized and attempted to monopolize the computer-based testing services market. ACT claimed unspecified amounts of compensatory, treble and punitive damages, as well as injunctive relief. If ACT were awarded significant compensatory or punitive damages, it could materially adversely affect the Company's results of operations and financial condition. In February 1998, the Court ruled that ACT may proceed only on three of its five antitrust theories and otherwise narrowed the scope of ACT's antitrust claims. In March 1998, the Court denied the Company's motion to dismiss ACT's state law claims. Formal discovery was completed in 1999. Following discovery, in response to the Company's motion to dismiss, the Court further narrowed the scope of the litigation by dismissing all of ACT's tort claims. Following the Court setting a trial date, the Company filed a motion in limine to strike all of ACT's alleged damages. The Court granted that motion on May 8, 2000. The Company then renewed the motion for summary judgment, and ACT filed a motion for reconsideration or, in the alternative, for an interlocutory appeal, as well as a motion to join Prometric, Inc. as an additional defendant. The Court indefinitely postponed the trial date to consider those motions. On March 21, 2001, the Court reaffirmed its earlier decision striking ACT's alleged damages but granted ACT's motion to certify that ruling for an interlocutory appeal to the United States Court of Appeals for the Eighth Circuit. The Court denied ACT's motion for reconsideration and also denied the Company's renewed motion for summary judgment because the Court would not preclude a trial on ACT's claim for injunctive relief. The Court denied all other

15

motions in limine without prejudice and granted ACT's motion to join Prometric, Inc. as an additional defendant. Prometric, Inc. is the Company's former subsidiary that now conducts the computer-based testing business formerly conducted by the Company. The Company has agreed to indemnify Prometric against loss in the case. The Eighth Circuit denied the interlocutory appeal in April of 2001. ACT then amended the complaint to withdraw the injunctive relief claim and the District Court then granted the Company's motion for summary judgment in June 2001. ACT appealed to the Eighth Circuit and oral argument was held in February 2002. The Company believes that all of ACT's claims are without merit but is unable to predict the outcome of the ACT litigation at this time.

        At this time the Company is not a party, either as plaintiff or defendant, to any other material litigation.

Item 4.    Submission of Matters to a Vote of Security Holders

        No matters were submitted to be voted on by security holders during the fourth quarter ended December 31, 2001.

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PART II.

Item 5.    Market for Registrants' Common Equity and Related Stockholder Matters

        The Company's Common Stock is traded on the NASDAQ National Market. The Company's trading symbol is SLVN. The high and low trade prices for 2001 and 2000 for the Company's Common Stock are set out in the following table. These prices are as reported by NASDAQ, and reflect inter-day price quotations, without retail mark-up, mark down or commission, and may not necessarily represent actual transactions.

2001	High		Low
1st Quarter	$	22.56	$	13.38
2nd Quarter	$	25.58	$	15.85
3rd Quarter	$	28.99	$	20.50
4th Quarter	$	27.52	$	17.92

2000	High		Low
1st Quarter	$	16.75	$	12.56
2nd Quarter	$	16.75	$	10.63
3rd Quarter	$	16.13	$	10.94
4th Quarter	$	16.31	$	12.63

        No dividends were declared on the Company's common stock during the years ended December 31, 2001 and 2000, and the Company does not anticipate paying dividends in the foreseeable future.

        The number of registered shareholders of record as of March 13, 2002 was 335.

        During the year ended December 31, 2001, the Company issued 12,630 shares of its common stock as part of acquisition transactions that were not registered under the Securities Act of 1933.

Item 6.    Selected Consolidated Financial Data

        The selected consolidated financial data for the years ended December 31, 2001, 2000, 1999, 1998, and 1997 have been derived from Sylvan's consolidated financial statements. The financial data should be read in conjunction with the consolidated financial statements and notes thereto.

        The Company consummated significant purchase business combinations in each of the five years in the period ended December 31, 2001. These business combinations affect the comparability of the amounts presented. Additionally, the accompanying financial data has been restated to reflect the net assets of the disposed operations of Aspect, Prometric and PACE as net assets and net liabilities of

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discontinued operations. The following data should be read in conjunction with Notes 3 and 4 to the consolidated financial statements.

		2001 (1)(2)(3)			2000 (4)(5)			1999 (6)(7)			1998 (8)(9)			1997
		(in thousands, except per share amounts)
Statements of Operations Data:
Revenues		$	484,804		$	314,739		$	276,333		$	178,802		$	118,101
Costs and expenses:
	Direct costs		413,809			269,061			220,007			134,132			96,464
	Sylvan Ventures operating costs		24,118			18,183			—			—			—
	General and administrative expense		22,003			20,306			26,855			15,530			18,085
	Transaction costs related to pooling-of-interests		—			—			—			3,245			—
	Restructuring and asset impairment charges		—			—			3,569			—			—
	Total costs and expenses		459,930			307,550			250,431			152,907			114,549
Operating income			24,874			7,189			25,902			25,895			3,552
Other non-operating income (expense)			(4,349	)		20,039			(12,248	)		3,988			32,802
Interest expense			(9,169	)		(6,968	)		(3,924	)		(319	)		(213	)
Sylvan Ventures investment income (losses)			22,136			(11,441	)		—			—			—
Equity in net loss of affiliates:
	Sylvan Ventures		(52,374	)		(21,222	)		—			—			—
	Other		(501	)		(981	)		(2,356	)		(3,500	)		(2,006	)
Minority interest:
	Sylvan Ventures		3,856			9,133			—			—			—
	Other		(7,599	)		(1,674	)		(319	)		—			—
Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting principle			(23,126	)		(5,925	)		7,055			26,064			34,135
Tax benefit (expense)			5,680			4,308			1,284			(6,624	)		(9,826	)
Income (loss) from continuing operations before cumulative effect of change in accounting principle		$	(17,446	)	$	(1,617	)	$	8,339		$	19,440		$	24,309
Income (loss) from continuing operations per share, basic		$	(0.46	)	$	(0.04	)	$	0.16		$	0.40		$	0.57
Income (loss) from continuing operations per share, diluted		$	(0.46	)	$	(0.04	)	$	0.16		$	0.38		$	0.54
Balance Sheet Data:
Cash and cash equivalents		$	102,194		$	116,490		$	18,995		$	29,267		$	6,613
Available-for-sale securities			60,091			202,077			10,890			6,108			82,951
Net working capital			119,995			165,431			284,311			24,584			113,572
Intangible assets and deferred contract costs (net)			300,620			283,441			194,645			116,667			25,602
Net assets of discontinued operations			—			—			280,287			278,150			134,062
Total assets			910,236			1,016,963			764,625			602,410			369,416
Long-term debt, including current portion and other long term liabilities			148,787			193,306			185,934			62,248			73,493
Stockholders' equity			545,855			553,263			474,093			488,833			340,460

(1)

On September 11, 2001 Sylvan Ventures recognized a gain of $24.7 million upon the sale of its 42% stake in Classwell Learning Group, Inc., which is included in Sylvan Ventures investment income (losses) above. Total proceeds of $31.8 million were received by Sylvan Ventures on October 5, 2001.

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(2)

On June 15, 2001, Caliber Learning Network, Inc. ("Caliber") filed for Chapter 11 bankruptcy protection. The Company recorded a loss on investment of $14.2 million, which is included in other non-operating income (expense) above. This charge consists of the reserve for notes receiveable and advances to Caliber of $7.5 million, as well as the accrual of a $6.7 million estimated liability relating to the Company's guarantee of certain non-cancelable Caliber lease obligations and other Caliber related liabilities incurred by the Company.

(3)

On October 30, 2001, the Company acquired for cash 98.8% of the common stock of École Supérieur du Commerce Extériuer ("ESCE"), a private, for-profit university in Paris, France. The purchase price totaled approximately $8.2 million. The Company's 2001 results of operations include the operations of ESCE for the period October 30, 2001 through December 31, 2001. During 2001, the Company also acquired 25 Wall Street Institute franchises for a combined purchase price of $9.7 million.

(4)

In 2000, the Company acquired for cash controlling interests in Gesthotel S.A., which owns and operates Les Roches; in Planeacion de Sistemas, S.A., which controls and operates UVM; and Desarrollo del Conocimiento S.A., a holding company that controls and operates UDLA. The purchase price for Les Roches totaled approximately $12.3 million. The purchase price was allocated to acquired assets totaling $32.4 million and assumed liabilities of $20.1 million. Additional variable amounts of consideration are also payable to the seller if specified earnings levels are achieved in 2001 and 2002. The purchase price for UVM totaled approximately $49.4 million. The purchase price was allocated to acquired assets totaling $73.0 million and assumed liabilities of $23.6 million. In connection with the acquisition of UVM, contingent consideration is also payable to the sellers if specified levels of earnings before interest and taxes are achieved in 2002. The purchase price for UDLA totaled approximately $26.0 million. Of the total purchase price, $13.0 million was due and paid in 2001 after finalization of UDLA's 2000 operating results. The purchase price was allocated to acquired assets totaling $43.3 million and assumed liabilities of $17.3 million. Additional amounts of contingent consideration are due the sellers based on operating results for the three years ended December 31, 2006. The Company's 2000 results of operations include the results of operations of Les Roches for the period June 30, 2000 through December 31, 2000; UVM for the period November 30, 2000 through December 31, 2000; and UDLA for the period December 12, 2000 through December 31, 2000.

Additionally, on May 18, 2000, the Company purchased certain assets and assumed certain liabilities of Ivy West. The purchase price totaled approximately $10.2 million. The Company's 2000 results of operations include the results of Ivy West for the period May 18, 2000 through December 31, 2000.

(5)

On March 3, 2000, the Company sold Prometric for approximately $775.0 million in cash and recorded an estimated gain on the sale of approximately $288.5 million, net of income taxes of approximately $136.8 million. On October 6, 2000, the Company sold Aspect for approximately $19.8 million in cash and recorded a gain on the sale of approximately $22.4 million including an income tax benefit of approximately $3.0 million. In 2000, the Company's consolidated statements of operations were restated to reflect the results of operations for Prometric and Aspect as discontinued operations. Therefore, the operations of these entities, along with the gain on the sale of these entities, are not presented on this table.

(6)

On April 1, 1999, the Company acquired a controlling interest in UEM for cash of $29.2 million. The acquisition was accounted for as a purchase, and Sylvan's 1999 results of operations include the results of operations of UEM for the period April 1, 1999 through December 31, 1999. Also during 1999, the Company acquired 23 WSI franchise businesses for a total purchase price of $65.8 million. This acquisition was accounted for using the purchase method of accounting.

(7)

During the quarter ended December 31, 1999, the Company recognized restructuring costs of $3.6 million related to continuing operations. Additionally, the Company recognized significant

19

non-recurring operating charges related to continuing operations during the fourth quarter of 1999, which totaled $10.0 million, of which $7.0 million is included in direct costs and $3.0 million is included in general and administrative expenses above. These charges were principally related to asset impairment charges, which resulted from management's focus on simplification of the business model and a return to the core business strengths. Losses recorded on disposal of investments in the fourth quarter of 1999 also resulted in $13.4 million of non-recurring charges during the period. The cumulative effect of these significant, unusual charges was to reduce income from continuing operations before income taxes and cumulative effect of change in accounting principle by $26.9 million during the fourth quarter of 1999.

(8)

Includes $3.2 million of expenses related to a pooling-of-interest acquisition such as legal, accounting and advisory fees.

(9)

On January 1, 1998, the Company acquired Canter for an initial purchase price of $25.0 million. Additional consideration of $48.8 million has been paid upon Canter's achievement of certain targets. The acquisition was accounted for as a purchase, and Sylvan's results of operations from January 1, 1998 include the operations of Canter.

Effective October 28, 1998, the Company acquired Schülerhilfe for an initial purchase price of $19.1 million in cash. Additional consideration of $10.4 million was recorded subsequent to the initial purchase upon the achievement of revenue and collection targets in 1999. The results of operations of Schülerhilfe subsequent to October 28, 1998 are included in Sylvan's results of operations.

Item 7.    Management's Discussion and Analysis of Financial Condition and Results of Operations

        The statements contained herein include forward-looking statements. Forward-looking statements include information about possible or assumed results of operations, business strategies, financing plans, competitive position and potential growth opportunities. Forward-looking statements include all statements that are not historical facts and are generally accompanied by words such as "may," "will," "intend," "anticipate," "believe," "estimate," "expect," "should" or similar expressions. These statements also relate to the Company's contingent payment obligations relating to acquisitions, future capital requirements, potential acquisitions and the Company's future development plans and are based on current expectations. Forward-looking statements involve various risks, uncertainties and assumptions. The Company's actual results may differ materially from those expressed in these forward-looking statements.

        Future events and actual results could differ materially from those set forth in the forward-looking statements as a result of many factors. These factors may include, without limitation: the Company's ability to continue to make acquisitions and to successfully integrate and operate acquired businesses; changes in student enrollment; the development and expansion of our franchise system and the effect of new technology applications in the educational services industry; failure to maintain or renew required regulatory approval, accreditation or state authorizations; the Company's ability to effectively manage business growth; possible increased competition from other educational service providers; the effect on the business and results of operations of fluctuations in the value of foreign currencies; and the many risks associated with the operation of an increasingly global business, including complex management, foreign currency, legal, tax and economic risks and the risk of changes in the business climate in the markets where the Company operates. These forward-looking statements are based on estimates, projections, beliefs and assumptions of management and speak only as of the date made and are not guarantees of future performance.

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Overview

        The Company has continued to grow during 2001 through focusing on expanding opportunities in the educational services industry. The Company increased its activity in the post secondary market with the integration and expansion of universities acquired in 2000 and 2001. The International Universities segment continues to operate the largest global network of international universities with full local accreditation through its network of five universities. Growth in Online Higher Education occurred through increased Canter enrollments and the expansion of its integration with Walden E-Learning, Inc. The Company's K-12 Education Services segment also displayed continued strong growth with the expansion of the Learning Centers network and the addition of contracts and services within Education Solutions. The Company also continued to focus on opportunities created by technology applications in the education and instruction marketplaces through the investments and operations of Sylvan Ventures.

Critical Accounting Policies and Estimates

        The Company's accounting policies are more fully described in Note 1 of Notes to Consolidated Financial Statements. As disclosed in Note 1 of Notes to Consolidated Financial Statements, the preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The Company believes the following key accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements and are critical to its business operations and the understanding of its results of operations.

        Revenue Recognition.    Revenue from the sale of educational products is generally recognized when shipped. Revenue from educational services are recognized in the period services are provided. As the Company continues to integrate educational product and service businesses, the resulting business structure may impact the revenue recognition of product sales to affiliated educational service providers.

        Educational services provided by the Company include results-oriented English language instruction modules that are based on desired proficiency levels. The related revenue is recognized ratably over the estimated period required to complete the modules, which ranges from 8 months to 11 months, depending on the location that the services are provided. The Company estimates the period of instruction based on an analysis of actual historical activity by location. If the historical data the Company uses to calculate these estimates does not properly reflect future usage, revenue recognized by the Company may be negatively impacted. Additionally, if usage trends change over time, the Company may have significant fluctuations in recognized revenues in the future.

        A portion of the Company's revenue is derived from fixed-price contracts with school districts, which are accounted for under the percentage-of-completion method. Income is recognized based on the percentage of contract completion determined by the total expenses incurred to date as a percentage of total estimated expenses to complete the contract. If the Company does not accurately estimate the resources required, does not manage its contracts properly within the planned periods of time, or does not satisfy its obligations under the contracts, future margins may be negatively impacted or losses on existing contracts may need to be recognized.

        Goodwill and Other Intangible Assets.    During each of the years presented, the Company acquired certain businesses accounted for using the purchase method of accounting. A portion of the purchase prices for these businesses was allocated to identifiable tangible and intangible assets and assumed

21

liabilities based on estimated fair values at the dates of acquisitions. Any excess purchase price was allocated to goodwill. This goodwill is being amortized using the straight-line method over estimated useful lives ranging from 15 to 35 years.

        The intangible assets identified by the Company to which a portion of the purchase prices was allocated include acquired student rosters, non-competition agreements and curriculum. The assumptions used to calculate the fair value of these identified intangible assets included estimates of future operating results and cash flows, as well as discount rates based on specifically identified risks for each acquisition and assumptions about the weighted average cost of capital for each acquisition. The assigned useful lives, which range from 1 to 7 years, is based upon estimated matriculation rates and other factors.

        If the Company used different assumptions and estimates in the calculation of the fair value of identified intangible assets and the estimation of the related useful lives, the amounts allocated to these assets, as well as the related amortization expense, could have been significantly different than the amounts recorded.

        In assessing the recoverability of the Company's goodwill and other intangible assets, the Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets not previously recorded. In June 2001, the Financial Accounting Standards Board issued Statement No. 142, Goodwill and Other Intangible Assets, which will require the Company to analyze its goodwill for impairment during the first six months of the 2002 fiscal year, and then on an annual basis thereafter. During the 2001 fiscal year, the Company did not record any impairment losses related to goodwill and other intangible assets.

        Investment in Affiliated Companies and Other Investments.    The Company holds minority interests in companies having operations or technology in areas within its strategic focus, some of which are in non-publicly traded companies whose value is difficult to determine. The Company records an investment impairment charge when it believes an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment's current carrying value, thereby possibly requiring an impairment charge in the future.

        Income Taxes.    The Company earns a significant portion of its income from subsidiaries located in countries outside of the United States. At December 31, 2001, undistributed earnings of foreign subsidiaries totaled approximately $340.0 million. Deferred tax liabilities have not been recognized for these undistributed earnings because it is management's intention to reinvest such undistributed earnings outside of the United States. APB Opinion No. 23, Accounting for Income Taxes—Special Areas, requires that a company evaluate its circumstances to determine whether or not there is sufficient evidence to support the assertion that it has or will reinvest undistributed foreign earnings indefinitely.

        The Company's assertion that earnings from its foreign operations will be permanently reinvested is supported by projected working capital and long-term capital needs in each subsidiary location in which the earnings are generated, as well as similar considerations for domestic operations. Additionally, the Company believes that it has the ability to permanently reinvest foreign earnings based on a review of projected cash flows from domestic operations, projected working capital and liquidity for both short-term and long-term domestic needs, and the expected availability of debt or equity markets to provide funds for those domestic needs.

        If circumstances change and it becomes apparent that some or all of the undistributed earnings of the Company's foreign subsidiaries will be remitted in the foreseeable future, the Company will be

22

required to recognize deferred tax liabilities on those amounts. As of December 31, 2001, if all undistributed earnings had been remitted to the United States, the amount of incremental U.S. federal income tax liabilities, net of foreign tax credits, would have been approximately $117.4 million of which $83.4 million would be a charge to discontinued operations.

        The Company has generated significant deferred tax assets, primarily as a result of its equity in the net losses of affiliated companies. The Company records a valuation allowance to reduce its deferred tax assets to the amount that it believes is more likely than not to be realized. The primary factor used by the Company to determine the amount of valuation allowance needed to offset deferred tax assets related to these losses is that when realized, these capital losses may be carried back to offset the Company's substantial prior year capital gains, subject to certain limitations. The Company also has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the amount of valuation allowance needed. If the Company were to determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. Likewise, should the Company determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax assets would increase income in the period such determination was made.

        Accounts and Notes Receivable.    The Company's accounts receivable consist primarily of installment payments due from parents and students for tuition at learning centers and universities; related fees that are payable over the course of payment plans of up to nine months; and amounts due from franchisees for franchise fees, franchise royalties and didactic material purchases. Notes receivable consist primarily of loans to franchisees, which are generally collateralized. The Company routinely makes estimates of the collectability of its accounts and notes receivable. A considerable amount of judgment is required in assessing the ultimate realization of these receivables, including the credit-worthiness of each customer and franchisee. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers and franchisees to make required payments. If the financial condition of the Company's customers and franchisees were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Results of Operations

        Sylvan generates revenues from four of its business segments: K-12 Education Services, which primarily earns franchise royalties, franchise sales fees, Company-owned learning center revenues and contract-based revenues from providing supplemental remedial education services to public and non-public schools; Online Higher Education, which primarily earns revenues from providing teacher training products and services; International Universities, which earns tuition and related fees paid by the students of UEM, Les Roches, UVM, UDLA and ESCE; and English Language Instruction, which primarily earns franchise royalties, Company-owned center revenue and franchise sales fees. Sylvan Ventures has not generated material revenues since its inception in 2000, but costs have been incurred to build consolidated businesses and to oversee its investments.

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        The following table sets forth the percentage relationships of operating revenues and direct costs for each segment, as well as certain income statement line items expressed as a percentage of total revenues for the years ended December 31:

			2001		2000		1999
Revenues:
	K-12 Education Services		38	%	53	%	57	%
	Online Higher Education		9	%	12	%	13	%
	International Universities		41	%	19	%	11	%
	English Language Instruction		12	%	16	%	19	%
		Total revenues	100	%	100	%	100	%
Direct costs:
	K-12 Education Services		31	%	43	%	46	%
	Online Higher Education		7	%	9	%	8	%
	International Universities		36	%	18	%	11	%
	English Language Instruction		11	%	15	%	15	%
		Total direct costs	85	%	85	%	80	%
General and administrative expenses			5	%	7	%	10	%
Sylvan Ventures operating costs			5	%	6	%	0	%
Costs related to pooling of interests and restructuring costs			0	%	0	%	1	%
Operating income			5	%	2	%	9	%
Other non-operating income (loss)			(1	%)	7	%	(4	%)
Interest expense			(2	%)	(2	%)	(1	%)
Sylvan Ventures investment income (losses)			5	%	(4	%)	0	%
Equity in loss of affiliates			(11	%)	(7	%)	(1	%)
Minority interest			(1	%)	2	%	0	%
Income (loss) from continuing operations before taxes			(5	%)	(2	%)	3	%
Tax benefit			1	%	1	%	0	%
Income (loss) from continuing operations			(4	%)	(1	%)	3	%

Comparison of results for the year ended December 31, 2001 to results for the year ended December 31, 2000.

        Revenues.    Total revenues from continuing operations increased by $170.1 million, or 54% to $484.8 million for the year ended December 31, 2001 ("2001 fiscal year") from $314.7 million for the year ended December 31, 2000 ("2000 fiscal year"). Included in total revenues for the 2001 fiscal year were $150.9 million of revenues from Les Roches, UVM and UDLA, which were acquired in the third and fourth quarters of 2000. Total revenues increased 12% excluding the increase due to the Les Roches, UVM and UDLA acquisitions. This revenue increase was primarily driven by growth in the Online Higher Education segment and acquisitions of learning centers in the K-12 Education Services segment and English Language Instruction segment.

K-12 Education Services revenue increased by $17.2 million, or 10%, to $184.6 million for the 2001 fiscal year compared to the 2000 fiscal year. Franchise royalties increased by $2.4 million, or 12% as a result of the net increase of 43 franchised centers opened in 2001 and a 9% increase in same center revenue. Revenues for Ivy West, an SAT preparation company that was acquired in May 2000, increased by $4.0 million as the 2001 fiscal year includes a full year of revenues. Product sales and other franchise service revenues increased $0.6 million for the 2001 fiscal year as compared to the 2000 fiscal year. Revenues from Company-owned learning centers increased $7.5 million, or 16% to

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$55.2 million during the 2001 fiscal year. Same center revenues increased 7% or $3.3 million, with the remaining revenue increase of $4.2 million generated from 8 new Company-owned centers opened or acquired from franchise owners in the 2001 fiscal year. International revenues, primarily Schülerhilfe, increased by $1.1 million, or 8%, to $15.4 million in the 2001 fiscal year. Contract-based revenue increased by $1.7 million, or 2%, to $70.0 million in the 2001 fiscal year compared to the 2000 fiscal year due to new contracts started after the 2000 fiscal year. Operating revenue for K-12 Education Services represents 38% of total revenues of the Company for the year ended December 31, 2001.

Online Higher Education revenue increased by $7.5 million, or 20%, to $44.3 million for the 2001 fiscal year compared to the 2000 fiscal year. Canter product license and service revenue increased $7.5 million, or 22%, to $42.2 million in the 2001 fiscal year from $34.7 million in the 2000 fiscal year. The Canter revenue increase is due to the increased demand for the distance learning masters programs offered by Canter's university customers. Sylvan Teacher Institute revenue remained constant at $2.1 million for both the 2001 and the 2000 fiscal year. Operating revenue for Online Higher Education represents 9% of total revenues of the Company for the year ended December 31, 2001.

International Universities revenue increased by $139.3 million, or 229%, to $200.2 million for the 2001 fiscal year compared to the 2000 fiscal year. Of this increase, $135.1 million was due to the full year effect of acquisitions of controlling interests of Les Roches, UVM and UDLA, which occurred in the third and fourth quarters of 2000 and the acquisition of the controlling interest in ESCE, which occurred in the fourth quarter of 2001. Revenue at UEM increased $4.2 million, or 10%, to $48.4 million for the 2001 fiscal year compared to the 2000 fiscal year primarily due to increased enrollment, new program offerings and tuition increases. Operating revenue for International Universities represents 41% of total revenues of the Company for the year ended December 31, 2001.

English Language Instruction revenue increased by $6.0 million, or 12%, to $55.7 million for the 2001 fiscal year compared to the 2000 fiscal year. The increase was primarily attributable to increases in WSI educational services and franchise services revenue, generated by WSI center acquisitions in Italy, Portugal, Argentina and Brazil. These increases were partially offset by lower franchise sales and maturation of the market in Spain. Operating revenue for English Language Instruction represents 12% of total revenues of the Company for the year ended December 31, 2001.

        Direct Costs.    Total direct costs, excluding Sylvan Ventures, increased by $144.7 million, or 54%, to $413.8 million for the 2001 fiscal year from $269.1 million for the 2000 fiscal year. Included in direct costs in the 2001 fiscal year were $126.6 million of costs of Les Roches, UVM and UDLA, which were acquired in the third and fourth quarters of 2000. Total direct costs increased $31.3 million, or 12%, excluding the costs related to Les Roches, UVM and UDLA. Direct costs as a percentage of total revenues remained constant at 85% in both the 2001 and the 2000 fiscal year.

K-12 Education Services expenses increased by $12.3 million to $149.1 million, or 81% of K-12 Education Services revenue for the 2001 fiscal year, compared to $136.8 million, or 82% of K-12 Education Services revenue for the 2000 fiscal year. The increase for the 2001 fiscal year was primarily related to expenses incurred by Company-owned learning centers due to the acquisition of franchised learning centers and costs associated with higher revenues at existing Company-owned centers. Cost increases also related to franchise services support costs as a result of growth in franchised centers over the prior year, costs related to Sylvan Ivy Prep, and increased costs related to international development. International expenses increased $2.1 million, consisting of increased Schülerhilfe costs of $1.2 million and an increase of $0.9 million related to international development in the United Kingdom and France. Contract-based expenses decreased by $0.7 million to $59.3 million, compared to $60.0 million for the 2000 fiscal year.

Online Higher Education expenses increased by $6.1 million to $35.2 million, or 79% of Online Higher Education revenue for the 2001 fiscal year, compared to $29.1 million, or 79% of Online

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Higher Education revenue for the 2000 fiscal year. Expenses as a percentage of revenue for the 2001 fiscal year remained constant compared to the 2000 fiscal year.

International Universities expenses increased by $118.1 million to $174.4 million, or 87% of International Universities revenue for the 2001 fiscal year, compared to $56.3 million, or 92% of International Universities revenue for the 2000 fiscal year. Expenses increased $114.2 million due to the full year effect of acquisitions of controlling interests of Les Roches, UVM and UDLA, which occurred in the third and fourth quarters of 2000 and the acquisition of the controlling interest in ESCE, which occurred in the fourth quarter of 2001. The decrease in expenses as a percentage of revenue for the 2001 fiscal year was primarily due to improved operating margin performance at UEM, higher margins at Les Roches and UDLA, strong operating performance at UVM and management's efforts to control divisional overhead costs while expanding the university network.

English Language Instruction expenses increased by $8.2 million to $55.1 million, or 99% of English Language Instruction revenue for the 2001 fiscal year, compared to $46.9 million, or 94% of English Language Instruction revenue in the 2000 fiscal year. This increase in expenses as a percentage of revenue was primarily a result of reduced operating margin efficiency in Brazil and competitive pressures in the saturated Spain market.

        Other Expenses.    General and administrative expenses increased by $1.7 million in the 2001 fiscal year compared to the 2000 fiscal year. During the 2000 fiscal year, the Company continued to provide certain general and administrative services to Prometric and Aspect after the sale of these companies for a short transition period. The increase in general and administrative expenses was due to the decrease in the reimbursement of these administrative costs in 2001 and the additional costs of overseeing the international expansion of the Company. General and administrative expenses as a percentage of revenues decreased to 5% in the 2001 fiscal year from 6% in the 2000 fiscal year due to cost controls and the strong revenue expansion in the 2001 fiscal year.

        Sylvan Ventures operating costs increased by $5.9 million to $24.1 million for fiscal year 2001, compared to $18.2 million for fiscal year 2000. Operating costs of eSylvan, a subsidiary of Sylvan Ventures, remained constant at $13.1 versus $13.0 for fiscal years 2001 and 2000, respectively. The nature of the eSylvan operating expenses changed as a decrease in content and product development costs in fiscal year 2000 were offset by operating costs and media advertising at the end of fiscal year 2001. Sylvan Ventures management expenses increased to $11.0 million in fiscal year 2001 compared to $5.2 million for fiscal year 2000. This increase was primarily due to a full year of management operations in fiscal year 2001. Additionally, Sylvan Ventures incurred additional costs in 2001 related to the research and development of potential future investments.

        Sylvan Ventures' equity in net losses of affiliates increased by $31.2 million to $52.4 million for the 2001 fiscal year, compared to $21.2 million for the 2000 fiscal year. This increase was the result of a full year of operations from a greater number of portfolio companies in fiscal year 2001 as compared to fiscal year 2000. These losses relate to Sylvan Ventures' share of operating losses generated by the early stage enterprises in the investment portfolio and the amortization of the difference between the initial carrying amount of equity method investments and the underlying equity in net assets of these investments at the time of purchase. Sylvan Ventures' investment income of $22.1 million consisted of the $24.7 million gain on the sale of its Classwell investment, partially offset by impairment charges related to portfolio investments.

        The loss on investment was prompted by Caliber Learning Network, Inc.'s ("Caliber") filing for Chapter 11 bankruptcy protection on June 15, 2001. The Sylvan Ventures investment in Caliber of $2.9 million was reduced to $0 upon recording its allocable share of losses related to Caliber prior to the bankruptcy proceedings, which is included in Sylvan Ventures' equity in net loss of affiliates. Additionally, the Company recorded a loss on investment of $14.2 million in the 2001 fiscal year. This charge consists of bad debt expense for notes receivable and advances to Caliber of $7.5 million, as

26

well as the accrual of a $6.7 million estimated liability relating to the Company's guarantee of certain non-cancelable Caliber lease obligations and other Caliber related liabilities incurred by the Company. Due to the uncertainties surrounding the bankruptcy proceedings and the ultimate settlement of Caliber's lease and other liabilities, it is possible that the Company's loss estimate may change prior to finalization.

        Other non-operating items decreased by $17.8 million for the 2001 fiscal year compared to the 2000 fiscal year. This net decrease was primarily attributable to a decrease in interest income of $12.3 million, an increase in interest expense of $2.2 million and an increase in minority interest allocations of $5.9 million, partially offset by a $2.2 million decrease in foreign currency exchange loss. The increased minority interest allocations were generated from strong operating performance of the universities in which the International Universities segment maintains a controlling interest. The decrease in the exchange loss was due to a loss of $3.1 million incurred in the 2000 fiscal year on the settlement of a forward exchange contract acquired to protect against fluctuations in local currency prior to the UVM acquisition.

        The Company's effective income tax rate prior to Sylvan Ventures was 34% for both the 2001 and 2000 fiscal years. This reported effective income tax rate differs from the U.S. federal statutory tax rate due to the impact of state income taxes, minority interests and foreign income taxed at lower rates.

        Income (Loss) from Continuing Operations.    Income (loss) from continuing operations before cumulative effect of change in accounting principle decreased by $15.8 million, to a loss of $17.4 million for the 2001 fiscal year. The decrease was primarily a result of the loss on the investment in and advances to Caliber of $14.2 million, a decrease in net interest income and other income of $12.0 million and additional Sylvan Ventures equity basis losses of $31.2 million, as well as increased minority interest ownership allocation of $11.2 million, partially offset by the Sylvan Ventures investment income increase of $33.6 million and improved operating income of $17.6 million.

Comparison of results for the year ended December 31, 2000 to results for the year ended December 31, 1999.

        Revenues.    Total revenues from continuing operations increased by $38.4 million, or 14%, to $314.7 million for the year ended December 31, 2000 ("2000 fiscal year") from $276.3 million for the year ended December 31, 1999 ("1999 fiscal year"). This revenue increase was primarily driven by expansion of the International Universities segment through university acquisitions along with revenue growth in the K-12 Education Services segment. These revenue increases were partially offset by the impact of the Company's announced strategy of foregoing franchise sales in lieu of retaining ownership of franchise territories in high potential markets.

K-12 Education Services revenue increased by $10.9 million, or 7%, to $167.3 million for the 2000 fiscal year compared to the 1999 fiscal year. Franchise royalties increased by $3.2 million, or 18%, as a result of the net increase of 55 franchised centers opened in 2000 and a 12% increase in same center revenue. Franchise sales fees decreased by $5.6 million, primarily due to an international area development agreement to develop France sold for $5.0 million in September 1999. Ivy West, an SAT preparation company based in California, was acquired in May 2000, which resulted in additional revenues of $3.0 million. Product sales and other franchise service revenues increased $2.6 million for the 2000 fiscal year as compared to the 1999 fiscal year. Revenues from Company-owned learning centers increased $5.6 million, or 13%, to $47.7 million during the 2000 fiscal year. Same center revenues increased 5%, or $2.1 million, with the remaining revenue increase of $3.5 million generated from 3 new Company-owned centers opened or acquired from franchise owners in the 2000 fiscal year. International revenues, primarily Schülerhilfe, decreased by $0.5 million to $13.9 million primarily due to unfavorable foreign exchange variances for the 2000 fiscal year compared to the 1999 fiscal year. Contract-based revenue increased by $2.6 million, or 4%, to $68.4 million for the 2000 fiscal year compared to the 1999 fiscal year. Operating revenue for K-12 Education Services represents 53% of total revenues from continuing operations of the Company for the year ended December 31, 2000.

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Online Higher Education revenue increased by $1.3 million, or 4%, to $36.8 million for the 2000 fiscal year compared to the 1999 fiscal year. Canter product license and service revenue increased $1.3 million to $36.8 million in the 2000 fiscal year from $35.5 million in the 1999 fiscal year. Canter revenues grew $4.8 million, in the 2000 fiscal year, through programs designed to meet the strong demand for teacher training. This increase in 2000 revenues was partially offset in the comparison to 1999 revenues by a $3.5 million international license fee recorded in 1999. Operating revenue for Online Higher Education represents 12% of total revenues from continuing operations of the Company for the year ended December 31, 2000.

International Universities revenue increased by $29.3 million, or 93%, to $60.9 million for the 2000 fiscal year compared to the 1999 fiscal year. UEM revenues increased $12.6 million in 2000 principally because the 1999 fiscal year included only nine months of operations. Additionally, the acquisitions of controlling interests of Les Roches on June 30, 2000, UVM on November 30, 2000 and UDLA on December 12, 2000 contributed $6.3 million, $9.5 million and $0.9 million in revenue, respectively. Operating revenue for International Universities represents 19% of total revenues from continuing operations of the Company for the year ended December 31, 2000.

English Language Instruction revenue decreased by $3.1 million, or 6%, to $49.7 million for the 2000 fiscal year compared to the 1999 fiscal year. The primary reason for the revenue decrease is that sales of territory fees decreased by $4.7 million to $2.5 million for the 2000 fiscal year from $7.2 million for the 1999 fiscal year. This decline in territory fees resulted from the aforementioned change in the Company's expansion strategy to one of retaining ownership of franchise territories in high potential markets. The remaining $1.6 million increase in revenue is attributable to expansion in Brazil and Italy. These increases were partially offset by lower franchise sales, maturation of the market in Spain and unfavorable foreign exchange differences for the 2000 fiscal year compared to the 1999 fiscal year. Operating revenue for English Language Instruction represents 16% of total revenues from continuing operations of the Company for the year ended December 31, 2000.

        Direct Costs.    Total direct costs of revenues from continuing operations, excluding Sylvan Ventures, increased by $49.1 million, or 22%, to $269.1 million for the 2000 fiscal year from $220.0 million for the 1999 fiscal year, as a result of business expansion. Direct costs as a percentage of total revenues increased to 85% in the 2000 fiscal year from 80% in the 1999 fiscal year. The increase in direct costs as a percentage of total revenues from continuing operations is primarily due to the expenses related to the international expansion of the International Universities and English Language Instruction segments.

K-12 Education Services expenses increased by $9.1 million to $136.8 million, or 82% of K-12 Education Services revenue for the 2000 fiscal year, compared to $127.7 million, or 81% of K-12 Education Services revenue for the 1999 fiscal year. The increase for the 2000 fiscal year is primarily related to expenses incurred by Company-owned learning centers due to the acquisition of franchised learning centers and costs associated with higher revenues at existing Company-owned learning centers. Cost increases also related to franchise services support costs as a result of growth in franchised centers over the prior year, costs related to Sylvan Ivy Prep, and increased costs related to international development. These cost increases were partially offset by a $3.4 million decrease in non-recurring costs incurred in the 1999 fiscal year related to the technology driven impairment of certain educational programs, and the refocusing of management efforts on core business objectives during 1999. Contract-based expenses decreased by $1.5 million to $60.0 million, compared to $61.5 million in the 1999 fiscal year.

Online Higher Education expenses increased by $6.7 million to $29.1 million, or 79% of Online Higher Education revenue for the 2000 fiscal year, compared to $22.4 million, or 63% of Online Higher Education revenue for the 1999 fiscal year. The increase in expenses as a percentage of revenue

28

for the 2000 fiscal year is primarily due to $3.5 million of high-margin revenue in the 1999 fiscal year related to the sale of a territory license to provide Canter's master's degree program in Mexico.

International Universities expenses increased by $27.4 million to $56.3 million, or 92% of International Universities revenue for the 2000 fiscal year, compared to $28.8 million or 91% of International Universities revenue for the 1999 fiscal year. This increase in expenses is primarily due to the full year 2000 impact of UEM, which was acquired in April 1999, as well as acquisition of the controlling interests in Les Roches, UVM, and UDLA during the 2000 fiscal year. Additionally, headquarters personnel costs for International Universities also increased to support the expansion of the university network during the 2000 fiscal year.

English Language Instruction expenses increased by $5.8 million to $46.9 million, or 94% of English Language Instruction revenue for the 2000 fiscal year, compared to $41.1 million, or 78% of English Language Instruction revenue in the 1999 fiscal year. The increase in expenses as a percentage of revenue was primarily a result of the business decision to retain ownership of territories in high potential markets, thereby reducing the amount of high margin territory sales. Additionally, cost increases in staffing administrative efforts were required to internally support the international expansion program.

        Other Expenses.    General and administrative expenses decreased by $6.5 million in the 2000 fiscal year compared to the 1999 fiscal year. This decrease in expense was due to overall cost reductions as a result of discontinued business units, as well as $3.0 million of non-recurring expenses in the 1999 fiscal year related to business start-up costs and simplification of the Sylvan business model. Excluding these non-recurring expenses, general and administrative expenses as a percentage of revenues decreased to 6% in the 2000 fiscal year from 9% in the 1999 fiscal year.

        Sylvan Ventures operating costs were $18.2 million for the 2000 fiscal year. eSylvan, a wholly-owned subsidiary of the Company, contributed $13.0 million of expenses related to the development of the Company's Internet based tutoring operations. Sylvan Ventures incurred management expenses of $5.2 million related to organizational start-up costs and the research, evaluation and management of the investment portfolio companies.

        Sylvan Ventures investment losses of $11.4 million related to the sale of the Zapme! investment and various impairment charges related to portfolio investments. Sylvan Ventures' equity in net losses of affiliates of $21.2 million relates to Sylvan Ventures' share of operating losses generated by the early stage enterprises in the investment portfolio and the amortization of the initial difference between the carrying amount of equity method investments and the underlying equity in net assets of these investments at the time of the purchase. Sylvan Ventures minority interests' share of investment losses totaled $9.1 million for fiscal 2000. Beginning in 2001, any investment losses incurred by Sylvan Ventures are allocable principally to the Company.

        Other non-operating items increased by $15.6 million in the 2000 fiscal year compared to the 1999 fiscal year. This net increase was primarily attributable to a $20.9 million increase in interest income from investing the proceeds of the March 2000 sale of Prometric, partially offset by a $3.0 million increase in interest expense related to increased borrowings outstanding during the period, and a $2.0 increase in foreign currency exchange losses. The primary reason for the exchange loss was a $3.1 million loss that was incurred on the settlement of a forward exchange contract acquired to protect against fluctuations in local currency related to the UVM acquisition that was pending in the 2000 fiscal year.

        Fiscal 1999 results from continuing operations included $3.6 million in restructuring costs resulting from strategic changes in the Company's core educational services business. These restructuring charges were primarily the result of employee termination costs, school closings and facility exit costs resulting

29

from management's plan to exit certain activities outside the core business of providing educational instruction.

        In conjunction with the Company's 1999 formal restructuring plan, management also examined existing corporate investments to determine realizable investment value. Non-operating losses totaling $13.4 million were incurred in 1999 as a result of decreases in investment values resulting from changing market conditions for the educational services industry, including an aggregate loss of $11.4 million related to the sale of the investment in JLC Learning Corporation as disclosed in Note 6 to the audited consolidated financial statements.

        The Company's effective income tax rate for continuing operations prior to Sylvan Ventures was 34% for the 2000 fiscal year. This reported effective income tax rate differs from the U.S. federal statutory tax rate due to the impact of state income taxes and the impact of minority interests.

        The Company's effective tax rate for continuing operations for the 1999 fiscal year was significantly impacted by utilized tax credits, foreign tax benefits and state income taxes, partially offset by permanent differences that arose due to the significant amount of restructuring and non-recurring charges in 1999. Because of these factors, comparison of the 2000 fiscal year and the 1999 fiscal year effective tax rates is not meaningful.

        Income (loss) from Continuing Operations.    Income (loss) from continuing operations before cumulative effect of change in accounting principle decreased by $10.0 million, to a loss of $1.6 million for the 2000 fiscal year. The decrease is primarily a result of costs and investment losses totaling $25.2 million related to Sylvan Ventures. Prior to the fiscal 2000 impact of Sylvan Ventures and after the removal of 1999 restructuring and non-recurring items, pre-tax income from continuing operations increased in the 2000 fiscal year by $1.8 million, to $35.8 million, due primarily to the increase in interest income related to the investment of the proceeds of the sale of discontinued operations, partially offset by the impact of the Company's change in international strategy to retaining ownership of franchise territories in high potential markets.

Future Assessment of Recoverability and Impairment of Goodwill

        In connection with various acquisitions, the Company has recorded goodwill. At December 31, 2001, unamortized goodwill was $288.1 million, which represented 32% of total assets and 53% of stockholders' equity. Goodwill arises when an acquirer pays more for a business than the fair value of the tangible and separately measurable intangible net assets. In connection with the Company's fiscal 2000 acquisitions of Les Roches, UVM and UDLA, additional goodwill may be recorded for variable amounts of contingent consideration that are payable to the sellers if certain criteria are met. The contingent consideration will be recorded as additional goodwill when the contingencies are resolved and the additional consideration is payable. An additional $0.5 million of consideration is payable to the sellers of UVM in 2003 if 2002 earnings exceed certain specified amounts. Variable amounts of contingent consideration are payable to the seller's of Les Roches if specified levels of earnings are achieved in 2001 and 2002. Variable amounts of contingent consideration are payable to the sellers of UDLA in 2006 and 2007 if specified levels of earnings are achieved in 2004, 2005 and 2006.

        In June 2001, the Financial Accounting Standards Board issued Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Under Statement No. 141, the pooling-of-interests method of accounting has been eliminated for all business combinations except for qualifying business combinations that were initiated prior to July 1, 2001. Statement No. 141 also includes new criteria to recognize intangible assets separately from goodwill, and is effective for any business combination accounted for by the purchase method that is completed after June 30, 2001. Under Statement No. 142, goodwill will no longer be amortized but will be subject to annual impairment tests for fiscal years beginning after December 15, 2001. Other intangible assets will

30

continue to be amortized over their useful lives. The Company will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002.

        In accordance with Statement No. 142, management will periodically review the Company's carrying value and recoverability of unamortized goodwill. If the facts and circumstances suggest that goodwill may be impaired, the carrying value of such goodwill will be adjusted, which will result in an immediate charge against income during the period of the adjustment. Once adjusted, there can be no assurance that there will not be further adjustments for impairment discovered in future periods.

Liquidity and Capital Resources

        During 2001, cash used in operations was $45.4 million compared to cash provided by operations of $7.9 million in the 2000 fiscal year. The reported net loss of $17.4 million included significant non-cash elements such as equity in loss of affiliates, primarily due to Sylvan Ventures ($52.9 million), depreciation and amortization charges ($38.0 million), net gain on sale of investments ($7.9 million) and minority interest ($3.7 million). Working capital related decreases in liquidity of $113.7 million during the year consisted primarily of income tax payments resulting from the sale of Prometric in the first quarter of 2000, which were not payable until 2001.

        Cash generated from investing activities was $0.5 million in the 2001 fiscal year, a decrease of $304.8 million from the cash generated from investing activities of $305.3 million in the 2000 fiscal year. The 2001 investment activity was primarily the result of net proceeds from the sale of available-for-sale securities ($142.7 million) offset by cash paid related to acquisitions ($60.3 million), purchases of property, plant and equipment ($55.8 million), increases in investments ($19.1 million) and expenditures for deferred contract costs ($3.6 million). The significant investing proceeds received in the 2000 fiscal year related primarily to the sale of the Prometric division ($730.1 million), partially offset by net purchases of available-for-sale securities ($191.8 million), cash paid related to acquisitions ($110.3 million), increases in investments related primarily to Sylvan Ventures ($69.5 million) and purchases of property, plant and equipment ($33.8 million). At December 31, 2001, the Company had accrued obligations payable in cash of $3.7 million related to contingent consideration for certain acquisitions. The amount due will be paid in 2002.

        Cash provided by financing activities was $30.7 million in the 2001 fiscal year. The 2001 financing activity related primarily to capital contributions from the minority interest members of Sylvan Ventures ($23.2 million) and proceeds from the exercise of options ($16.9 million), offset by net repayment of debt ($11.1 million). Cash used by financing activities of $212.0 million in the 2000 fiscal year related primarily to the repurchase of common shares pursuant to two Company tender offers ($212.0 million) and net repayment of the Company's existing credit agreements ($26.2 million), partially offset by the capital contributions from the minority interest members of Sylvan Ventures ($24.9 million).

        The Company anticipates that cash flow from operations, available cash and existing credit facilities, will be sufficient to meet its operating requirements, including the expected expansion of its existing business, the funding of International University acquisitions and contingent consideration, and the funding of the Company's proportionate share of Sylvan Ventures investments and operating costs. In connection with the Company's ownership of Sylvan Ventures, commitments have been made to provide certain additional investment funding totaling $20 million. The Company continues to examine opportunities in the educational services industry for potential synergistic acquisitions.

31

Contingent Matters

        The following tables reflect the Company's contractual obligations and other commercial commitments as of December 31, 2001 (amounts in thousands):

		Payments Due by Period
Contractual Obligations		Total		Less than 1 year		1-3 years		4-5 years		After 5 years
Long-Term Debt		$	130,923	$	6,449	$	11,115	$	10,224	$	103,135
Operating Leases			185,744		31,541		56,502		43,358		54,343
Other Long-Term Obligations			4,079		3,657		422		—		—
	Total Contractual Cash Obligations	$	320,746	$	41,647	$	68,039	$	53,582	$	157,478

		Amount of Commitment Expiration Per Period
Other Commercial Commitments		Total Amounts Committed		Less than 1 year		1-3 years		4-5 years		Over 5 years
Lines of Credit		$	100,000	$	—	$	100,000	$	—	$	—
Guarantees			10,678		10,094		584		—		—
Standby Letters of Credit			858		—		858		—		—
	Total Commercial Commitments	$	111,536	$	10,094	$	101,442	$	—	$	—

        In connection with the Company's acquisition of Les Roches, various amounts of contingent consideration are payable to the seller if specified levels of earnings are achieved in 2001 and 2002. In connection with the Company's acquisition of UDLA, variable amounts of contingent consideration are also payable to the seller in 2006 and 2007 if specified levels of earnings are achieved in 2004, 2005 and 2006. In connection with the Company's acquisition of UVM, additional purchase consideration of $0.5 million is due in 2003 if 2002 earnings exceed certain specified amounts. The Company will record the contingent consideration when the contingencies are resolved and the additional consideration is payable.

        The Company has entered into agreements with franchisees of Sylvan Learning Centers and Wall Street Institute that allow the franchisee to put the centers back to the Company in the future at a predetermined multiple of operating results upon the achievement of specified operating thresholds. When the Company can assess the likelihood of a put being exercised and the amount of the related commitment to purchase the center, the amount of the obligation will be disclosed.

        The Company has guaranteed that services will be provided under the terms of franchisee agreements with customers who have financed their tuition with a certain financial institution. If the franchisees do not provide all of the services that are financed under this program, the Company must either provide the services through one of its company-owned centers, arrange for the services to be provided by a comparable third party or refund to the customer the amount that was paid for the services. As of December 31, 2001, the amount that was financed under this program was $9.9 million.

        The Company has guaranteed various loans of franchisees with certain banks. These loans primarily represent the financing of programs and other instructional materials. Of the $1.7 million of available credit under these loans, the outstanding balance was $0.8 million at December 31, 2001.

Related Party Transactions

Transactions between UVM and Certain Officers and Minority Shareholders

        UVM has entered into lease agreements for its university campuses with certain officers and minority owners of the Company's Mexican university subsidiary. The leases have an initial term of ten

32

years with an additional two-year extension available at the Company's option. Fixed monthly rents are adjusted annually for inflation. For the year ended December 31, 2001, the Company incurred approximately $4.1 million of rent under these leases. The lease agreements enable the Company to operate the university at the already established campuses. The value of the contracts was determined by arms-length negotiation between the parties and based upon the then prevailing market rates, and was corroborated by an independent real estate appraisal.

        These officers and minority shareholders also provide staffing services to UVM for one of its campuses under a contract with an open-ended term, allowing either party to cancel with a one-year written notification to the other party. UVM incurred approximately $0.7 million of expenses for the 2001 fiscal year in connection with this contract. The utilization of such services saves the Company the carrying costs of additional personnel and related overhead. In addition, these services are provided to the Company at cost, thus increasing its flexibility and competitiveness.

        UVM subcontracts educational programs provided to government employees to a company partially owned by certain of its officers and minority shareholders. UVM pays 50% of the revenue, net of related expenses, associated with each government contract to this company, which amounted to $0.5 million for the 2001 fiscal year. This is an arms-length, three-party agreement, in which one of the parties is a government agency. The agreement enables the Company to provide educational services "outside its walls" or physical limits to government agencies, thus increasing the Company's operating capacity.

        UVM contracts certain construction and architectural services from a company owned by certain of UVM's minority shareholders. These contracts amounted to $0.7 million for the 2001 fiscal year. This architectural company has provided its services to UVM in years prior to the acquisition of a UVM controlling interest by the Company. Prices and projects are subject to budgetary submission and control, and to board approval.

Transactions between Les Roches and Certain Officers

        Les Roches entered into lease agreements for certain dormitories and other facilities with certain former owners of Les Roches. Pursuant to these agreements, the Company incurred rent expense of approximately $0.5 million for the 2001 fiscal year and $0.3 million from July 26, 2000, the date of acquisition of Les Roches, through December 31, 2000. In January 2002, the Company entered into an agreement with the officers to purchase these properties for approximately $2.7 million.

        Les Roches purchases marketing services from an entity controlled by an officer of the university. Pursuant to the terms of the agreement, the Company incurred marketing expenses of $0.6 million for the 2001 fiscal year and $0.2 million from July 26, 2000, the date of acquisition of Les Roches, to December 31, 2000. Similar lease agreements and marketing service agreements were in place prior to the acquisition of Les Roches by the Company. The company negotiated at arms-length for the terms of these new contracts, which were priced at the fair market prices then prevailing, corroborated by independent third parties.

Euro Conversion

        On January 1, 1999, certain countries of the European Union established fixed conversion rates between their existing currencies and one common currency, the Euro. The Euro is now traded on currency exchanges and may be used in business transactions. In January 2002, new Euro-denominated currencies were issued and the existing currencies were withdrawn from circulation. The Company has adapted computer and other business systems and equipment to address the competitive impact of cross-border transparency. At present, management does not believe the Euro conversion will have a material impact on the Company's financial condition or results of operations.

33

Effects of Inflation

        Inflation has not had a material effect on Sylvan's revenues and income from continuing operations in the past three years. Inflation is not expected to have a material effect in the foreseeable future.

Seasonality in Results of Operations

        The Company experiences seasonality in results of operations primarily as a result of changes in the level of student enrollments and the timing of semester cycles, particularly in the International Universities segment. Timing of semester breaks at the International Universities results in the most favorable operating performance being achieved in the second and fourth quarters of the year. Other factors that impact the seasonality of operating results include: timing of contracts funded under Title I, timing of summer vacations, timing of franchise license fees and the timing of Sylvan Ventures' development costs. Revenues and profits in any period will not necessarily be indicative of results in subsequent periods.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

        Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from the changes in the price of financial instruments. The Company is exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, equity prices and investment values. The Company occasionally uses derivative financial instruments to protect against adverse currency movements related to significant foreign acquisitions. Exposure to market risks related to operating activities is managed through the Company's regular operating and financing activities.

Foreign Currency Risk

        The Company derives approximately 56% of its revenues from customers outside the United States. This business is transacted through a network of international subsidiaries, generally in the local currency that is considered the functional currency of that foreign subsidiary. Expenses are also incurred in the foreign currencies to match revenues earned and minimize the Company's exchange rate exposure to operating margins. A hypothetical 10% adverse change in average annual foreign currency exchange rates would have increased net loss and decrease cash flows for the 2001 fiscal year by $3.8 million. The Company generally views its investment in the majority of its foreign subsidiaries as long-term. The effects of a change in foreign currency exchange rates on the Company's net investment in foreign subsidiaries are reflected in other comprehensive income (loss). A 10% depreciation in functional currencies relative to the U.S. dollar would have resulted in a decrease in the Company's net investment in foreign subsidiaries of approximately $28.3 million at December 31, 2001.

Interest Rate Risk

        The Company holds its cash and cash equivalents in high quality, short-term, fixed income securities. Consequently, the fair value of the Company's cash and cash equivalents would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due to the short-term nature of the Company's portfolio. The Company's long-term revolving credit facility bears interest at variable rates, and the fair value of this instrument is not significantly affected by changes in market interest rates. The Company's convertible debentures bear interest at 5%, which currently approximates the market rate, and therefore the fair value approximates the recorded value of this liability. A 100 basis point decrease in interest rates would have reduced net interest income for the 2001 fiscal year by $1.4 million.

34

Equity Price Risk

        The fair value of the Company's convertible debentures is sensitive to fluctuations in the price of the Company's common stock into which the debentures are convertible. Changes in equity prices would result in changes in the fair value of the Company's convertible debentures due to the difference between the current market price of the debentures and the market price at the date of issuance of the debentures. A 10% increase in the year end 2001 market price of the convertible debentures would result in an increase of approximately $14.0 million in the net fair value of the debentures.

        The Company is exposed to equity price risks on equity securities included in the portfolio of investments entered into for the promotion of business and strategic objectives. The Company typically does not attempt to reduce or eliminate its market exposure on these securities. A 10% adverse change in equity prices would not materially impact the fair value of the Company's marketable securities or other comprehensive income (loss).

Investment Risk

        The Company's investment portfolio contains debt securities that mature within one year. A hypothetical 10% adverse change in the fair value of the debt securities would not materially adversely effect earnings or cash flows because of the Company's ability to hold the debt securities until maturity.

        In addition to the debt securities, the Company has an investment portfolio that consists of direct investment positions in education technology companies through Sylvan Ventures, as well as short-term investments in available-for-sale debt and equity securities. The Company's investment portfolio is exposed to risks arising from changes in these investment values.

        The Company's investment portfolio includes a number of holdings of non-publicly traded companies in the educational services industry. The Company accounts for these investments using either the cost method (cost less impairment, if any) or the equity method of accounting. Equity method investments are specifically excluded from the scope of this disclosure. Non-public investments where the Company owns less than a 20% interest are subject to fluctuations in market value, but their current illiquidity reduces the exposure to pure market risk while resulting in risk that the Company may not be able to liquidate these investments in a timely manner for their estimated fair value.

        All the potential impacts noted above are based on sensitivity analysis performed on the Company's financial position at December 31, 2001. Actual results may differ materially.

Item 8.    Financial Statements

        The financial statements of the Company are included on pages 39 through 69 of the report as indicated on page 38.

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

        There were no changes in accountants, disagreements, or other events requiring reporting under this Item.

35

PART III.

Item 10.    Directors and Executive Officers of Sylvan Learning Systems, Inc.

        Information required is set forth under the caption "Election of Sylvan Directors" in the Proxy Statement relating to the 2002 Annual Meeting of Shareholders, which will be filed on or before April 30, 2002.

        Information required pertaining to compliance with Section 16 (a) of the Securities and Exchange Act of 1934 is set forth under the caption "Election of Sylvan Directors" in the Proxy Statement relating to the 2002 Annual Meeting of Shareholders, which is incorporated by reference.

Item 11.    Executive Compensation

        Information required is set forth under the caption "Compensation of Executive Officers and Directors" in the Proxy Statement relating to the 2002 Annual Meeting of Shareholders, which is incorporated by reference.

Item 12.    Security Ownership of Certain Beneficial Owners and Management

        Information required is set forth under the caption "Stock Ownership of Certain Beneficial Owners, Directors and Management" in the Proxy Statement relating to the 2002 Annual Meeting of Shareholders, which is incorporated by reference.

Item 13.    Certain Relationships and Related Transactions

        Information required is set forth under the caption "Certain Relationships and Related Transactions" in the Proxy Statement relating to the 2002 Annual Meeting of Shareholders, which is incorporated by reference.

36

PART IV.

Item 14.    Exhibits, Financial Statement Schedules and Reports on Form 8-K

(a)

The following documents are filed as a part of this report:

1.    Financial Statements

The

response to this portion of Item 14 is submitted as a separate section of this Report.

2.    Financial Statement Schedules

All

schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are inapplicable or immaterial and therefore have been omitted.



(b)

Reports on Form 8-K:



The

Company did not file any reports on Form 8-K during the three-month period ended December 31, 2001.

3.    Exhibits

(a)

Exhibits:

Exhibit Number	Description
23.01	Consent of Ernst & Young LLP with respect to consolidated financial statements of Sylvan Learning Systems, Inc., HigherMarkets, Inc. and Mindsurf, Inc.
23.02	Consent of Arthur Andersen LLP with respect to consolidated financial statements of iLearning, Inc
23.03	Consent of Pricewaterhouse Coopers, LLP with respect to financial statements of Chancery Software, Inc.
99.1	Chancery Software Limited Audited Financial Statements
99.2	HigherMarkets, Inc. Audited Financial Statements
99.3	iLearning, Inc. Audited Financial Statements
99.4	Mindsurf, Inc. Audited Financial Statements

37

SIGNATURES

        Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on March 28, 2002.

SYLVAN LEARNING SYSTEMS, INC. (REGISTRANT)
By:	/s/  DOUGLAS L. BECKER Douglas L. Becker Chairman of the Board

        Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated and on March 28, 2002.

Signature	Capacity
/s/  DOUGLAS L. BECKER Douglas L. Becker	Director, Chairman of the Board and Chief Executive Officer
/s/  PETER COHEN Peter Cohen	President and Chief Operating Officer
/s/  SEAN R. CREAMER Sean R. Creamer	Senior Vice President and Chief Financial Officer
/s/  JOHN MILLER John Miller	Director
/s/  R. CHRISTOPHER HOEHN-SARIC R. Christopher Hoehn-Saric	Director
/s/  JAMES H. MCGUIRE James H. McGuire	Director
/s/  LAURENCE M. BERG Laurence M. Berg	Director

38

/s/  R. WILLIAM POLLOCK R. William Pollock	Director
/s/  RICHARD RILEY Richard Riley	Director
/s/  JUDITH D. MOORE Judith D. Moore	Director

39

INDEX TO FINANCIAL STATEMENTS

The Company:

40

REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Sylvan Learning Systems, Inc.

        We have audited the accompanying consolidated balance sheets of Sylvan Learning Systems, Inc. and subsidiaries as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2001. 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. The financial statements of iLearning, Inc., (a corporation in which the Company has a 27% interest) and the financial statements of Chancery Software Limited, (a corporation in which the Company has a 42% interest), have been audited by other auditors whose reports have been furnished to us; insofar as our opinion on the consolidated financial statements relates to data included for iLearning, Inc. and Chancery Software Limited, it is based solely on their reports. In the consolidated financial statements, the Company's combined investment in iLearning, Inc. and Chancery Software Limited is stated at $7,235,000 and $19,791,000, respectively, at December 31, 2001 and 2000, and the Company's combined equity in the net losses of iLearning, Inc. and Chancery Software Limited is stated at $6,844,000 and $2,070,000, for the years then ended.

        We conducted our audits in accordance with auditing standards generally accepted in the 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 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 reports of other auditors provide a reasonable basis for our opinion.

        In our opinion, based on our audits and the reports of other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sylvan Learning Systems, Inc. and subsidiaries at December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.

        As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for start-up costs in 1999.

/s/ Ernst & Young LLP

Baltimore, Maryland
February 20, 2002

41

SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollar and share amounts in thousands, except per share data)

		December 31, 2001			December 31, 2000
Assets
Current assets:
	Cash and cash equivalents	$	102,194		$	116,490
	Available-for-sale securities		60,091			202,077
Receivables:
	Accounts receivable		70,925			68,468
	Costs and estimated earnings in excess of billings on uncompleted contracts		1,586			2,613
	Notes receivable from tuition financing		7,545			7,489
	Other notes receivable		18,185			13,317
	Other receivables		7,058			15,549
			105,299			107,436
Allowance for doubtful accounts			(11,415	)		(5,554	)
			93,884			101,882
Inventory			7,344			5,832
Deferred income taxes			3,810			3,936
Prepaid expenses and other current assets			21,391			20,955
	Total current assets		288,714			451,172
Notes receivable from tuition financing, less current portion			8,636			8,313
Other notes receivable, less current portion			11,601			2,378
Property and equipment:
	Land		14,552			16,176
	Buildings		88,190			78,193
	Construction in-progress		8,897			3,688
	Furniture, computer equipment and software		115,140			96,592
	Leasehold improvements		34,876			18,501
			261,655			213,150
Accumulated depreciation			(60,147	)		(39,594	)
			201,508			173,556
Intangible assets:
	Goodwill		317,591			296,422
	Other		8,400			2,611
			325,991			299,033
Accumulated amortization			(33,314	)		(21,078	)
			292,677			277,955
Investments in and advances to affiliates			40,387			57,999
Other investments			27,326			25,935
Deferred income taxes			13,823			—
Deferred costs, net of accumulated amortization of $3,322 and $1,833 at December 31, 2001 and 2000, respectively			7,943			5,486
Other assets			17,621			14,169
	Total assets	$	910,236		$	1,016,963

42

		December 31, 2001			December 31, 2000
Liabilities and stockholders' equity
Current liabilities:
	Accounts payable	$	15,696		$	19,571
	Accrued expenses		48,462			40,452
	Income taxes payable		31,723			119,511
	Current portion of long-term debt		6,449			12,856
	Due to shareholders of acquired companies		3,657			40,195
	Deferred revenue		54,578			42,483
	Other current liabilities		8,154			10,673
	Total current liabilities		168,719			285,741
Long-term debt, less current portion			124,474			131,425
Deferred income taxes			—			4,824
Other long-term liabilities			14,207			8,830
	Total liabilities		307,400			430,820
Minority interest			56,981			32,880
Stockholders' equity:
Preferred stock, par value $.01 per share—authorized 10,000 shares, no shares issued and outstanding as of December 31, 2001 and 2000			—			—
Common stock, par value $.01 per share—authorized 90,000 shares, issued and outstanding shares of 38,742 as of December 31, 2001 and 37,278 as of December 31, 2000			387			373
Additional paid-in capital			229,386			205,343
Retained earnings			342,786			360,232
Accumulated other comprehensive loss			(26,704	)		(12,685	)
	Total stockholders' equity		545,855			553,263
	Total liabilities and stockholders' equity	$	910,236		$	1,016,963

See accompanying notes to financial statements.

43

SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollar and share amounts in thousands, except per share data)

		Year Ended December 31,
		2001			2000			1999
Revenues		$	484,804		$	314,739		$	276,333
Cost and expenses
Direct costs			413,809			269,061			220,007
Sylvan Ventures operating costs			24,118			18,183			—
General and administrative expense			22,003			20,306			26,855
Restructuring charges			—			—			3,569
	Total expenses		459,930			307,550			250,431
Operating income			24,874			7,189			25,902
Other income (expense)
Investment and other income			9,882			20,039			1,122
Interest expense			(9,169	)		(6,968	)		(3,924	)
Sylvan Ventures investment income (losses)			22,136			(11,441	)		—
Loss on investment			(14,231	)		—			(13,370	)
Equity in net loss of affiliates:
	Sylvan Ventures		(52,374	)		(21,222	)		—
	Other		(501	)		(981	)		(2,356	)
			(52,875	)		(22,203	)		(2,356	)
Minority interest in consolidated subsidiaries:
	Sylvan Ventures		3,856			9,133			—
	Other		(7,599	)		(1,674	)		(319	)
			(3,743	)		7,459			(319	)
Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting principle			(23,126	)		(5,925	)		7,055
Income tax benefit			5,680			4,308			1,284
Income (loss) from continuing operations before cumulative effect of change in accounting principle			(17,446	)		(1,617	)		8,339
Income (loss) from discontinued operations, net of income tax expense of $163 and $12,398, respectively			—			(3,968	)		4,964
Gain (loss) on disposal of discontinued operations, net of income tax expense of $133,753 and $1,100, respectively			—			310,807			(26,968	)
Income (loss) before cumulative effect of change in accounting principle			(17,446	)		305,222			(13,665	)
Cumulative effect of change in accounting principle, net of income tax benefit of $682			—			—			(1,323	)
Net income (loss)		$	(17,446	)	$	305,222		$	(14,988	)
Earnings (loss) per common share, basic:
	Income (loss) from continuing operations before cumulative effect of change in accounting principle	$	(0.46	)	$	(0.04	)	$	0.16
	Net income (loss)	$	(0.46	)	$	7.02		$	(0.29	)
Earnings (loss) per common share, diluted:
	Income (loss) from continuing operations before cumulative effect of change in accounting principle	$	(0.46	)	$	(0.04	)	$	0.16
	Net income (loss)	$	(0.46	)	$	7.02		$	(0.28	)

See accompanying notes to financial statements.

44

SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(Dollar and share amounts in thousands, except per share data)

		Common Stock			Additional Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income (Loss)			Total Stockholders' Equity
Balance at January 1, 1999		$	510		$	410,694		$	75,852		$	1,777		$	488,833
Options and warrants exercised for purchase of 311 shares of common stock, including income tax benefit of $1,456			3			4,391									4,394
Stock options granted to non-employees						348									348
Repurchase of 1,730 shares of common stock for cash			(17	)		(36,195	)								(36,212	)
Issuance of 41 shares of common stock in connection with the Employee Stock Purchase Plan						961									961
Issuance of 1,329 shares in connection with business combinations			13			34,368			(102	)					34,279
Comprehensive income (loss):
	Net loss for 1999								(14,988	)					(14,988	)
	Foreign currency translation adjustment											(6,639	)		(6,639	)
	Unrealized gain on available-for-sale securities											3,117			3,117
	Total comprehensive loss														(18,510	)
Balance at December 31, 1999			509			414,567			60,762			(1,745	)		474,093
Repurchase of 13,823 shares of common stock for cash			(139	)		(211,850	)								(211,989	)
Options exercised for purchase of 91 shares of common stock, including income tax benefit of $322			1			801									802
Issuance of 62 shares of common stock in connection with the Employee Stock Purchase Plan			1			785									786
Effect of change in year-end of subsidiary									(5,752	)					(5,752	)
Other			1			1,040									1,041
Comprehensive income (loss):
	Net income for 2000								305,222						305,222
	Foreign currency translation adjustment											(8,140	)		(8,140	)
	Unrealized loss on available-for-sale securities											(793	)		(793	)
	Reclassification adjustment, net of tax											(2,007	)		(2,007	)
	Total comprehensive income														294,282
Balance at December 31, 2000			373			205,343			360,232			(12,685	)		553,263
Options exercised for purchase of 1,444 shares of common stock, including income tax benefit of $6,152			14			23,064									23,078
Issuance of 29 shares of common stock in connection with the Employee Stock Purchase Plan						404									404
Other						575									575
Comprehensive income (loss):
	Net loss for 2001								(17,446	)					(17,446	)
	Foreign currency translation adjustment											(13,394	)		(13,394	)
	Unrealized loss on available-for-sale securities											(414	)		(414	)
	Minimum pension liability adjustment											(211	)		(211	)
	Total comprehensive loss														(31,465	)
Balance at December 31, 2001		$	387		$	229,386		$	342,786		$	(26,704	)	$	545,855

See accompanying notes to financial statements.

45

SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollar and share amounts in thousands, except per share data)

			Year Ended December 31,
			2001			2000			1999
Operating activities
Net income (loss)			$	(17,446	)	$	305,222		$	(14,988	)
Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities:
	Depreciation			24,474			16,700			25,999
	Amortization			13,494			13,742			20,788
	Gain from discontinued operations			—			(310,807	)		26,891
	Loss (gain) on investments			(7,905	)		11,441			13,370
	Other non-cash items			253			2,063			2,586
	Minority interest in income of consolidated subsidiaries			3,743			(7,459	)		319
	Cumulative effect of change in accounting principle			—			—			1,323
	Equity in net loss of affiliates			52,875			22,203			2,140
	Deferred income taxes			(1,213	)		(4,640	)		(317	)
	Changes in operating assets and liabilities:
		Receivables		(10,409	)		(21,304	)		(35,109	)
		Inventory, prepaid expenses and other current assets		(1,764	)		8,185			(4,018	)
		Accounts payable and accrued expenses		423			4,384			33,672
		Income taxes payable		(100,821	)		(25,769	)		(3,643	)
		Deferred revenue and other current liabilities		(1,108	)		(6,033	)		1,907
Net cash provided by (used in) operating activities				(45,404	)		7,928			70,920
Investing activities
Purchase of available-for-sale securities				(151,030	)		(418,828	)		—
Proceeds from sale or maturity of available-for-sale securities				293,697			227,026			3,082
Investment in and advances to affiliates and other investments				(19,148	)		(69,524	)		(10,510	)
Purchase of property and equipment, net				(55,785	)		(33,813	)		(61,211	)
Proceeds from sale of discontinued operations				—			730,106			—
Proceeds from sale of investment in JLC Learning Corporation				—			—			15,211
Acquisitions of international universities, including direct costs of acquisition, net of cash acquired				(6,268	)		(64,173	)		(26,000	)
Payment of contingent consideration for prior period acquisitions				(38,044	)		(19,323	)		(16,689	)
Cash paid for other businesses, net of cash acquired				(16,165	)		(26,833	)		(48,989	)
Expenditures for deferred contract costs				(3,582	)		(3,711	)		(10,367	)
Increase in other assets				(3,139	)		(15,665	)		(3,854	)
Net cash provided by (used in) investing activities				536			305,262			(159,327	)
Financing activities
Proceeds from exercise of options and warrants				16,926			480			2,938
Repurchases of common stock				—			(211,989	)		(36,212	)
Proceeds from issuance of common stock				—			785			961
Proceeds from issuance of long-term debt				191,450			233,437			207,748
Payments on long-term debt				(202,520	)		(259,670	)		(97,295	)
Cash received from minority interest members in Sylvan Ventures				23,190			24,931			—
Increase (decrease) in long-term liabilities				1,607			—			(1,268	)
Net cash provided by (used in) financing activities				30,653			(212,026	)		76,872
Effect of subsidiary year-end change on cash and cash equivalents				—			(2,565	)		—
Effects of exchange rate changes on cash				(81	)		(1,104	)		(2,640	)
Net change in cash and cash equivalents				(14,296	)		97,495			(14,175	)
Cash and cash equivalents at beginning of year				116,490			18,995			33,170
Cash and cash equivalents at end of year			$	102,194		$	116,490		$	18,995

See accompanying notes to financial statements.

46

SYLVAN LEARNING SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollar and share amounts in thousands, except per share data)

Note 1—Description of Business and Basis of Presentation

        Sylvan Learning Systems, Inc. and subsidiaries ("the Company" or "Sylvan") is an international provider of educational services. The Company conducts operations in five separate business segments. As of July 1, 2001, the Company realigned several of its business segments to emphasize the Company's focus on increasing its presence in the post-secondary education and online education markets. The new segments are K-12 Education Services (comprised of Sylvan Learning Centers and the Sylvan at School and Career Starters operations of the business formerly referred to as Sylvan Education Solutions), Online Higher Education (comprised of Canter and Associates and Sylvan Teacher Institute, both previously reported as a part of Sylvan Education Solutions), International Universities, English Language Instruction, and Sylvan Ventures.

        The K-12 Education Services segment includes the operations of Sylvan Learning Centers, which designs and delivers individualized tutorial programs to school-aged children through franchised and Company-owned learning centers; Schülerhilfe, a major provider of tutoring services in Germany; and Sylvan Education Solutions, which principally provides educational programs to students of public and non-public school districts through contracts funded by Title I and state-based programs. The Online Higher Education segment develops and licenses professional development programs to universities through Canter and Associates. The International Universities segment owns or maintains controlling interests in five private universities located in Spain, Switzerland, Mexico, Chile and France. The English Language Instruction segment consists of the operations of Wall Street Institute ("WSI"), a European-based franchiser and operator of learning centers that teach the English language in a post-secondary market. The Sylvan Ventures segment invests in and develops companies that are creating emerging technology solutions for the education marketplace, and includes the operations of eSylvan, Inc. a majority-owned subsidiary.

        The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States that require the Company's management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ from those estimates.

        Certain amounts previously reported have been reclassified to conform with the 2001 presentation.

Principles of Consolidation

        The various interests that the Company acquires in its affiliated companies are accounted for under three methods: consolidation, equity method, or cost method. The Company determines the method of accounting for its affiliated companies on a case-by-case basis based upon its ownership percentage in each affiliated company, as well as its degree of influence over each affiliated company.

        Consolidation.    Affiliated companies in which the Company owns, directly or indirectly, or otherwise controls more than 50% of the outstanding voting interests are accounted for under the consolidation method of accounting. Two subsidiaries of the Company consolidate not-for-profit, non-stock universities that are controlled through majority voting interests in the Board of Directors. The Company also has a substantial economic interest in the net assets of these not-for-profit universities. Under the consolidation method, an affiliated company's results of operations are reflected within the Company's consolidated statements of operations. Earnings or losses attributable to other stockholders of a consolidated affiliated company are classified as "minority interest in consolidated

47

subsidiaries" in the Company's consolidated statements of operations. Minority interest adjusts the Company's consolidated net results of operations to reflect only its share of the earnings or losses of an affiliated company. Transactions between the Company and its consolidated affiliated companies are eliminated in consolidation.

        Equity Method.    Affiliated companies, in which the Company owns 50% or less of the outstanding voting interests, but over which the Company exercises significant influence, are accounted for under the equity method of accounting. Significant influence with respect to an affiliated company depends on an evaluation of several factors including, among other things, representation on the associated company's board of directors, ownership percentage and voting rights associated with the Company's holdings in the securities of the affiliated company. Investments accounted for under the equity method are reflected in the consolidated balance sheet as "investments in and advances to affiliates". Under the equity method of accounting, affiliated companies' results of operations are not reflected within the Company's consolidated operating results. However, the Company's share of the earnings or losses of these affiliated companies is classified as "equity in net income (loss) of affiliates" in the Company's consolidated statements of operations. The Company initially records its share of the earnings or losses of an affiliated company based upon its proportionate ownership of voting common stock. If the affiliated company is incurring losses, and previous losses have reduced the common stock investment account to zero, or if the Company holds no common stock, the Company continues to recognize equity method losses based on the ownership level of the particular affiliated company security or loan/advance held by the Company to which the equity method losses are being applied. The Company continues to report losses up to the investment carrying value, including any additional financial support made or committed to by the Company.

        The amount by which the Company's carrying value exceeds its share of the underlying net assets of the affiliated companies accounted for under the equity method of accounting, if any, is amortized on a straight-line basis over the estimated useful life of three years. This amortization adjusts the Company's share of the "equity in net loss of affiliates" in the Company's consolidated statements of operations.

        Cost Method.    Affiliated companies not accounted for under either the consolidation or the equity method of accounting are accounted for under the cost method of accounting. Under this method, the Company's share of earnings or losses of these companies is not included in the Company's consolidated statements of operations. However, a series of operating losses of an affiliated company or other factors may indicate that a decrease in value of the investments has occurred which is other than temporary. These impairment losses are recognized in the consolidated statements of operations and are included in "investment losses."

        The Company records its ownership interest in equity securities of its affiliated companies accounted for under the cost method at cost, unless the securities have readily determinable fair values based on quoted market prices, in which case these interests are reported at fair value.

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Note 2—Accounting Policies

Cash Equivalents

        The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents.

Investments

        Available-for-sale securities are carried at fair value, with any unrealized gains and losses, net of tax, reported in other comprehensive income (loss). The amortized cost of debt securities in this category is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included in investment income. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in investment and other income. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in investment and other income.

Inventory

        Inventory, consisting primarily of computer software and educational, instructional, and marketing materials and supplies, is stated at the lower of cost (first-in, first-out) or market value.

Property and Equipment

        Property and equipment is stated at cost. Included in property and equipment are the direct costs of developing or obtaining software for internal use. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which are as follows:

Buildings	29-50 years
Furniture, computer equipment and software	2-7 years
Leasehold improvements	2-12 years

Intangible Assets

        Goodwill consists of the cost in excess of fair value of the identifiable net assets of entities acquired in purchase transactions. The Company amortizes goodwill on a straight-line basis over the estimated future periods to be benefited, which range from 15 to 35 years. At December 31, 2001 and 2000, accumulated amortization of goodwill was $31,083 and $19,370, respectively. In 2002, the Company will adopt the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, and will no longer amortize goodwill. See Impact of Recently Issued Accounting Standards for further discussion.

        Other intangibles include student rosters, covenants not-to-compete, curricula and accreditations acquired in purchase business combinations. Amortization is computed over estimated useful lives ranging from one to seven years.

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Deferred Costs

        Deferred costs include direct costs incurred for services to universities licensing distance learning masters programs. These costs are capitalized when incurred and expensed when the related revenue is recognized.

        Deferred costs also include the cost of internally developing proprietary products and materials. These costs are capitalized and amortized over the estimated useful life of the products and materials, which approximates five years.

Impairment of Long-Lived Assets

        Long-lived assets, including intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or group of assets may not be fully recoverable. These events or changes in circumstances may include a significant deterioration of operating results, changes in business plans, or changes in anticipated future cash flows. If an impairment indicator is present, the Company evaluates recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets. Assets are grouped at the lowest level for which there is identifiable cash flows that are largely independent of the cash flows generated by other asset groups. If the assets are impaired, the impairment recognized is measured by the amount by which the carrying amount exceeds the fair value of the assets. Fair value is generally determined by estimates of discounted cash flows. The discount rate used in any estimate of discounted cash flows would be the rate required for a similar investment of like risk.

        Assets to be disposed of are reported at the lower of carrying value or fair values, less estimated costs of disposal.

Revenue Recognition

        Revenue related to single-center and area franchise sales is recognized when all material services or conditions relating to the sales have been substantially performed or satisfied by the Company and collectibility of the fee is reasonably assured. For single-center franchise sales, the criteria for substantial performance include: (1) receipt of an executed franchise license agreement, (2) receipt of full payment of the franchise fee, (3) completion of requisite training by the franchisee or center director, and (4) completion of site selection assistance and site approval. Area franchise sales generally transfer to the licensee the right to develop and operate centers in a specified territory, primarily in a foreign country, and the Company's future obligations are insignificant. Area franchise fees are recognized upon the signing of the license agreement and the determination that all material services or conditions relating to the sale have been satisfied and a non-refundable fee has been paid. Franchise sales fees not meeting the recognition criteria are recorded as deferred revenue if not refundable, or deposits from franchisees if refundable.

        Fixed price contracts with school districts receiving funds under the federal Title I program and state-based programs are accounted for using the percentage-of-completion method. Income is recognized based on the percentage of contract completion determined by the total expenses incurred to date as a percentage of total estimated expenses at the completion of the contract. Total contract

50

income is estimated as contract revenue less total estimated costs considering the most recent cost information. Revenues from cost-plus-fee contracts are recognized on the basis of costs incurred during the period plus the fee earned.

        Franchise royalties are reported as revenue as the royalties are earned and become receivable, unless collection is not reasonably assured. Revenues from educational services are recognized in the period the services are provided. Revenue from the sale of educational products is generally recognized when shipped.

        Tuition revenue is recognized ratably over the period of instruction, and is reported net of scholarships and other discounts. Dormitory revenues are recognized over the occupancy period. Tuition paid in advance or unpaid tuition included in accounts receivable and unearned is included in deferred revenue.

Direct Costs

        Direct costs represent divisional costs of operations, including selling and administrative expenses that are directly attributable to specific operating units.

Advertising

        The Company expenses advertising costs as incurred. Advertising expense for the years ended December 31, 2001, 2000 and 1999 was $34,820, $25,841 and $23,663 respectively.

Stock Options Granted to Employees and Non-Employees

        The Company records compensation expense for all stock-based compensation plans using the intrinsic-value-based method and provides pro forma disclosures of net income (loss) and net earnings (loss) per common share as if the fair value method had been applied in measuring compensation expense. The Company records compensation expense for all stock options granted to non-employees in an amount equal to their estimated fair value at the earlier of the performance commitment date or the date at which performance is complete, determined using the Black-Scholes option valuation model. The compensation expense is recognized ratably over the vesting period.

Foreign Currency Translation

        The financial statements of foreign subsidiaries with a functional currency other than the U.S. dollar have been translated into U.S. dollars using the current rate method. Assets and liabilities have been translated using the exchange rates at year-end. Income and expense amounts have been translated using the average exchange rates for the year. Translation gains or losses resulting from the changes in exchange rates have been reported as a component of accumulated other comprehensive income (loss) included in stockholder's equity, net of tax.

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Note 2—Accounting Policies (Continued)

Other Comprehensive Income

        The Company displays changes to the accumulated balance of other comprehensive income (loss) in accumulated other comprehensive income (loss) in the statement of stockholders' equity. The components were as follows at December 31:

	2001			2000
Foreign currency translation adjustment	$	(26,396	)	$	(13,002	)
Unrealized gain (loss) on available for-sale-securities, net of tax		(97	)		317
Minimum pension liability adjustment		(211	)		—
Accumulated other comprehensive loss	$	(26,704	)	$	(12,685	)

Income Taxes

        The Company accounts for income taxes using the liability method. Under the liability method, deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities (i.e. temporary differences) and are measured at prevailing enacted tax rates that will be in effect when these differences are settled or realized.

Start-Up Costs

        On January 1, 1999, the Company adopted the provisions of AICPA Statement of Position No. 98-5, Reporting the Costs of Start-up Activities ("SOP 98-5"), which requires start-up costs capitalized prior to January 1, 1999 to be written-off and any future start-up costs to be expensed as incurred. The Company previously capitalized pre-contract costs directly associated with specific anticipated contracts as well as certain development costs for new educational programs that were estimated to be recoverable. The cumulative effect of adopting SOP 98-5 in 1999 decreased net income for the year ended December 31, 1999 by $1,323 (net of $682 in income taxes). The amount of the cumulative effect related to the discontinued operations was $567 (net of $291 in income taxes).

Impact of Recently Issued Accounting Standards

        In June 2001, the Financial Accounting Standards Board issued Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets. Under Statement No. 141, the pooling-of-interests method of accounting has been eliminated for all business combinations except for qualifying business combinations that were initiated prior to July 1, 2001. Statement No. 141 also includes new criteria to recognize intangible assets separately from goodwill, and is effective for any business combination accounted for by the purchase method that is completed after June 30, 2001. Under Statement No. 142, goodwill will no longer be amortized but will be subject to annual impairment tests for fiscal years beginning after December 15, 2001. Other intangible assets will continue to be amortized over their useful lives. The Company will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. The Company will perform the first of the required impairment tests of goodwill as of January 1, 2002 and has not yet determined what the effect of these tests will be on the earnings and financial position of the

52

Company. The Company has estimated that the impact of the non-amortization provisions of Statement No. 142 will be a decrease in amortization expense of approximately $17,400 in 2002, including approximately $5,100 related to the amortization of Sylvan Ventures equity method investments.

        In August 2001, the Financial Accounting Standards Board issued Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Statement No. 144 supersedes Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and provides a single accounting model for long-lived assets to be disposed of. The Company will apply the new rules on accounting for the impairment or disposal of long-lived assets beginning in the first quarter of 2002. Statement No. 144 retains the requirements of Statement No. 121 to recognize an impairment loss only if the carrying amount of a long-lived asset is not recoverable from its undiscounted future cash flows and to measure the impairment loss as the difference between the carrying amount and the fair value of the asset. The Company does not believe that the adoption of the new standard will have a material impact on its consolidated financial position or results of operations.

Note 3—Discontinued Operations

Aspect

        On October 6, 2000, the Company sold its English Language immersion business, Aspect ("Aspect") for $19,794 in cash. The gain on the disposition recognized in 2000 was $22,353, which includes an income tax benefit of $3,047. The Company has estimated the domestic and foreign income taxes resulting from the sale based on the expected allocation of proceeds to subsidiaries that are a party to the transaction and the tax laws of the jurisdictions in which theses subsidiaries operate, assuming that undistributed gains outside the United States will be reinvested outside the United States.

        Effective January 1, 2000, the Company changed the year-end of Aspect from September 30 to December 31 to produce a consistent reporting period for the consolidated entity. As a result of this change in year-end, Aspect's net results of operations for the three month period ended December 31, 1999 are reflected as an adjustment to retained earnings on the consolidated balance sheet as of January 1, 2000. The impact of this change resulted in a decrease in retained earnings of approximately $5,752. The results of Aspect's operations, which are included in discontinued operations, for the period October 1, 1999 to December 31, 1999 are summarized as follows:

Revenues	$	10,709
Direct costs		(16,350	)
Operating loss		(5,641	)
Other expense		(111	)
Net loss	$	(5,752	)

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Sylvan Prometric

        On March 3, 2000, the Company sold its computer-based testing division, Sylvan Prometric ("Prometric") for approximately $775,000 in cash. The gain on the disposition recognized in 2000 was approximately $288,454, net of income taxes of $136,800. The final proceeds from the sale may change based on contractual provisions that provide for certain adjustments to the sale price, including an adjustment for changes in working capital of Prometric between November 30, 1999 and March 3, 2000. The Company and the buyer have not completed the process required to provide for a final settlement of the sale proceeds. However, management believes that any future adjustments will be immaterial to financial position and results of operations. The Company has estimated the domestic and foreign income taxes resulting from the sale based on the expected allocation of proceeds to subsidiaries that are a party to the transaction and the tax laws of the jurisdictions in which these subsidiaries operate, assuming that undistributed gains outside the United States will be reinvested outside the United States.

The PACE Group

        On September 30, 1999, the Company adopted a formal plan to dispose of PACE, its corporate training business. The sale transaction closed on December 31, 1999, and the Company received 10 shares of preferred stock and 2,503 shares of common stock of Frontline Group, Inc., a private investment holding company. The Company's investment in the stock was recorded at its estimated fair value at December 31, 1999 of $7,000, based on an independent appraisal, and a resulting loss on disposition was recorded in 1999 of approximately $27,000, including income tax expense of approximately $1,100.

Summarized Financial Information of Discontinued Operations

        Summarized operating information of the Company's discontinued operations for the years ended December 31 are as follows:

	2000			1999
Revenues	$	75,898		$	293,877
Income (loss) before income taxes		(3,805	)		17,362
Income tax expense		(163	)		(12,398	)
Net income (loss)	($	3,968	)	$	4,964

        Included in income from discontinued operations for the years ended December 31, 2000 and 1999 is an allocation of corporate interest expense of $784, and $2,411, respectively, based upon a percentage of the net equity investment in discontinued operations to the net equity of the Company including the discontinued operations. The accompanying consolidated statements of operations have been restated to reflect the results of operations for these entities as discontinued operations.

        At December 31, 2001, undistributed gains on the sale of non-domestic discontinued operations totaled approximately $238,400. Deferred tax liabilities have not been recognized for these undistributed gains because it is management's intention to reinvest such undistributed gains outside of

54

the United States. If all undistributed gains were remitted to the United States, the amount of incremental United States federal income taxes, net of foreign tax credits, would be approximately $83,400.

Note 4—Acquisitions

        During each of the years presented, the Company acquired certain businesses accounted for using the purchase method of accounting. A portion of the purchase prices for these businesses was allocated to identifiable tangible and intangible assets and assumed liabilities based on estimated fair values at the dates of acquisition. Any excess purchase price was allocated to goodwill. Certain acquisitions require the payment of contingent amounts of purchase consideration if specified operating results are achieved in periods subsequent to the acquisition date. Upon the resolution of these contingent payments, the Company records as goodwill any additional consideration owed to the sellers. The Company amortizes goodwill on a straight-line basis over estimated useful lives ranging from 15 to 35 years. In 2002 the Company will adopt the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, and as such will no longer amortize goodwill. See Note 2 for further discussion. The results of operations of the acquired businesses are included in the accompanying financial statements commencing on the date of acquisition.

2001 Acquisitions

ESCE

        On October 30, 2001, the Company acquired for cash 98.8% of the common stock of École Supérieur du Commerce Extériuer ("ESCE"), a private, for-profit university in Paris, France enrolling over 1,000 students. The purchase price totaled approximately $8,153, including acquisition costs of $484. The purchase price was allocated to acquired assets totaling $13,753 and assumed liabilities of $5,600.

Wall Street Institute Franchises

        During 2001, the Company acquired 25 Wall Street Institute franchises for a combined net cash purchase price of $9,739, including acquisition costs of $346. The acquisitions were accounted for using the purchase method of accounting and goodwill of $10,107 was recorded.

2000 Acquisitions

Les Roches

        In July 2000, the Company acquired for cash all of the outstanding common stock of Gesthotel S.A., which owns and operates the Swiss Hotel Association Hotel Management School Les Roches ("Les Roches"), located in Bluche, Switzerland. Additionally, the Company acquired the real estate on which the school resides from the former shareholders of Gesthotel S.A. Les Roches currently enrolls more than 1,100 full-time students in one undergraduate and one graduate program. Les Roches specializes in, and is globally recognized for, its hospitality and hotel management program.

55

        The purchase price for the outstanding common stock totaled approximately $6,975, including acquisition costs of $946. Additionally, the Company paid $5,305 to the former shareholders for the real estate. The purchase price was allocated to acquired assets totaling $32,414 and assumed liabilities of $20,134. In connection with the acquisition of Les Roches, variable amounts of contingent consideration are also payable to the sellers if specified levels of earnings are achieved in 2001 and 2002. At December 31, 2001, the Company determined that the additional consideration due the sellers based on 2001 operating results was $40.

Universidad del Valle de Mexico (UVM)

        On November 24, 2000, the Company acquired for cash 80% of the outstanding common stock of Planeacion de Sistemas, S.A., which controls and operates the Universidad del Valle de Mexico ("UVM"), a private, not-for-profit university principally located in Mexico City, Mexico. UVM currently enrolls more than 32,000 full-time students in 30 undergraduate and graduate degree programs, and has nine campuses located in and around Mexico City and four others throughout Mexico. The initial purchase price totaled approximately $49,394, including acquisition costs of $4,494. The purchase price was allocated to acquired assets totaling $73,029 and assumed liabilities of $23,635. In connection with the acquisition of UVM, contingent consideration is also payable to the sellers if specified levels of earnings before interest and taxes ("EBIT") are achieved in 2002.

Universidad de Las Americas (UDLA)

        On December 12, 2000, the Company acquired for cash 60% of the outstanding common stock of Desarrollo del Conocimiento S.A. ("Decon"), a holding company that controls and operates the Universidad de Las Americas ("UDLA"), a private, not-for-profit university in Santiago, Chile. UDLA has four campuses and currently enrolls more than 8,000 full-time students in 26 undergraduate degree programs. Decon has the right to appoint the directors of UDLA and through its subsidiaries has entered into contracts that provide for the provision of essential services and the use of facilities in exchange for fees and rent that are substantially equal to UDLA's income.

        The purchase price totaled approximately $25,991, including acquisition costs of $1,681. Of the total purchase price, $13,000 was due and paid in 2001 after finalization of UDLA's 2000 operating results. The purchase price was allocated to acquired assets totaling $43,327 and assumed liabilities of $17,336.

        Additional amounts of contingent consideration are due the sellers based on operating results for the three years ended December 31, 2006. No later than March 31, 2006, the Company is obligated to the sellers for an amount equal to 60% of six times (i) average EBIT for 2004 and 2005, less (ii) 2000 EBIT, reduced by (iii) 42% of certain specified debt. No later than March 31, 2007, the Company is obligated to the sellers for an amount equal to 20% of four times (i) average EBIT for 2005 and 2006, less (ii) 2000 EBIT, reduced by (iii) 20% of certain specified debt. The Company has pledged its shares of Decon to satisfy its payment obligations to the sellers. The Company cannot dispose, lien or encumber the shares without the prior approval of the sellers.

        Upon the payment of any amounts due on March 31, 2007, the Company will receive additional shares of Decon representing 20% of the outstanding shares. Subsequent to the March 31, 2007

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payment, the sellers have the right to require the Company to purchase their remaining 20% interest in Decon for a variable purchase price based on average EBIT for certain specified periods.

Ivy West

        Effective May 18, 2000, the Company purchased certain assets and assumed certain liabilities of Ivy West, which offers SAT test preparation services. The purchase price totaled approximately $10,200 including estimated net cash payments of $7,900, a promissory note of $1,400, common stock valued at $250, common stock of a subsidiary of the Company valued at approximately $250 and the assumption of $400 of liabilities. The acquisition was accounted for using the purchase method of accounting and goodwill of $9,300 was recorded.

1999 Acquisitions

Universidad Europea de Madrid (UEM)

        On April 1, 1999 the Company acquired for cash 54% of the outstanding common stock of Prouniversidad S.A., which owns and operates the Universidad Europea de Madrid ("UEM"), a private, for-profit university in Madrid, Spain. UEM enrolls more than 7,000 full-time students in 50 degree programs at the undergraduate and graduate levels. The purchase price was approximately $29,208, including acquisition costs of $2,577.

        During August 2001, the Company acquired an additional 23.75% ownership interest in Prouniversidad S.A. for cash of approximately $18,500. The purchase of the additional interest was accounted for as a step acquisition.

Wall Street Institute Franchises

        During 1999, the Company acquired 23 Wall Street Institute franchises for a combined cash purchase price of approximately $65,800, including cash payments of $36,000 and $18,700 in 1999 and 2000, respectively, a $2,600 promissory note, and the assumption of approximately $8,500 of liabilities. The acquisitions were accounted for using the purchase method of accounting and goodwill of $55,700 was recorded. In 2000, certain sellers of these businesses earned $12,000 of additional consideration based on contingent payment provisions of the purchase agreements.

Unaudited Pro Forma Results of Operations

        The following unaudited consolidated pro forma results of operations of the Company give effect to the acquisitions of

        UEM, Les Roches, UVM and UDLA as though they had each occurred on January 1, 1999. The 2001 acquisitions of ESCE and certain Wall Street Institute franchises would not have materially

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affected reported results of operations in 2001, 2000 or 1999 had these acquisitions occurred on January 1, 1999.

	2000			1999
Revenues	$	417,021		$	388,286
Income (loss) from continuing operations before cumulative effect of change in accounting principle		(1,992	)		9,830
Net income (loss)		304,847			(13,497	)
Earnings (loss) per common share, diluted:
Continuing operations before cumulative effect of change in accounting principle	$	(0.05	)	$	0.18
Net income (loss)	$	7.01		$	(0.25	)

Supplemental Cash Flow Information Related to Acquired Businesses

        The following is a summary of changes to assets (other than cash) and liabilities as a result of the acquisitions described above:

	Year ended December 31
	2001			2000			1999
Working capital, other than cash	$	2,731		$	(18,613	)	$	(27,784	)
Property and equipment		24			58,386			82,233
Goodwill		17,098			72,010			54,045
Other intangible assets		1,011			2,561			10
Long-term debt		(4,855	)		(21,466	)		(30,842	)
Other liabilities		—			(2,289	)		(6,759	)
Minority interest		(2	)		(3,576	)		(8,228	)
Equity		—			(250	)		—
Purchase price, net of cash received	$	16,007		$	86,763		$	62,675

Note 5—Available-For-Sale Securities

        The following is a summary of available-for-sale securities at December 31:

	2001		2000
Equity securities	$	70	$	99
Debt securities		59,493		201,649
Cash reserve fund and other		528		329
	$	60,091	$	202,077

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Note 5—Available-For-Sale Securities (Continued)

        At December 31, 2001, equity securities represent common stock investments in a public company with a cost of $285 and a quoted market price of $70. The adjustment to unrealized holding loss of $215 is a component of accumulated other comprehensive income (loss), included in stockholders' equity. The cost of the Company's other investments approximates fair value. Aggregate maturities of debt securities are as follows: $37,785 within 1 year, $20,856 within 2-5 years and $852 thereafter. The investments are classified as current as the Company views its available-for-sale securities as available for use in its current operations.

Note 6—Investments

Formation of Sylvan Ventures

        The Sylvan Ventures segment was established during the first quarter of 2000 to invest in and develop companies with emerging technology solutions for the education marketplace ("portfolio companies"). On June 30, 2000, affiliates of Apollo Management L.P. ("Apollo") and certain members of Sylvan's management ("management investors") joined the Company to form Sylvan Ventures, LLC, with total committed funds of $400,000. Of the $400,000 commitment, the Company has committed $285,000, including investments in portfolio companies valued at $65,000 upon formation; Apollo has committed $100,000; and the management investors have committed $15,000. Upon formation, Sylvan Ventures issued common membership interests to Sylvan and the management investors and preferred membership interests to Apollo. Additionally, Sylvan Ventures authorized the granting of plan membership profit interests to members of management that entitle the recipients to receive an aggregate allocation of up to 20% of any cumulative net profits. As of December 31, 2001, plan membership profit interests have been granted to management for an aggregate allocation of approximately 15.3% of the cumulative net profits upon the occurrence of any profits interest event.

        In 2000, the membership agreement provided for the allocation of net losses to the common and preferred members on a pro rata basis, subject to certain limitations. Beginning January 1, 2001, net losses are being allocated on a pro rata basis only to the common membership interest holders until their capital account balances have been reduced to zero, at which time any losses will be allocated to Apollo until its capital account balance has been reduced to zero. Thereafter, any losses will be allocated on a pro rata basis to all membership interest holders. Any annual profits earned after January 1, 2001 will first be allocated to Apollo until it has recovered its 2000 allocated losses and then pro rata to the common membership interest holders to recover previously allocated losses. After all previously allocated losses have been recovered through profit allocations, any additional net profits will be allocated on a pro rata basis to all interest holders, including the plan membership profit interest holders. The preferred members also maintain a preferred position relating to cash distribution provisions of the membership agreement.

Consolidated Investments

        eSylvan, Inc. ("eSylvan") is a development stage organization formed to distribute the Company's learning center tutoring product to students at home via computer. Sylvan Ventures owns 85% of the common stock of eSylvan. eSylvan has not generated significant revenue through December 31, 2001, and its operating expenses have been included in the 2001 and 2000 consolidated statements of operations as a component of Sylvan Ventures' operating costs. During 2001, eSylvan issued common

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stock representing a 15% ownership interest to franchisees of Sylvan Learning Centers to more fully leverage the relationship between center-based and online tutoring. Sylvan Ventures has committed additional funding of $1,500 as of December 31, 2001 for eSylvan development and operating costs for a portion of 2002.

Investment in Affiliates (Equity Method Investments):

        The Company's investment in and advances to affiliates consist of investments in and loans to companies in the initial or early stages of development. These companies are frequently illiquid or experiencing cash flow deficits from operations. Further, investments are generally unsecured and subordinated to the claims of other creditors. Accordingly, the Company's investments in and advances to affiliates are subject to a high degree of investment and credit risk. The Company's accounting policies with respect to its investments are described in Note 1. The Company has made estimates of the recoverability of loans and advances to its affiliates, and due to the inherent uncertainty of the operations of these affiliates, it is possible that these estimates may change in the near term.

        Investments in and advances to affiliates consist principally of investments in common stock and preferred stock, as follows as of December 31:

		2001		Voting Interest		2000		Voting Interest
Walden E-Learning, Inc.		$	31,909	16	%	$	—	—
Chancery Software Limited			6,774	42	%		14,224	42	%
iLearning, Inc.			461	27	%		5,568	29	%
EdVerify, Inc.			679	42	%		—	—
Mindsurf, Inc.			—	45	%		1,109	47	%
HigherMarkets, Inc.			—	31	%		6,694	31	%
Classwell Learning Group, Inc.			—	—			13,045	42	%
Caliber Learning Network, Inc.			—	—			15,123	36	%
Other			564	—			2,236	—
	Total	$	40,387			$	57,999

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        Each period in the table below includes summarized financial data of those affiliates in which Sylvan Ventures had an interest at the end of the respective period and includes results of operations data of the affiliate for the entire year.

	2001			2000			1999
Current assets	$	23,176		$	44,420		$	31,765
Other assets		17,988			67,191			21,519
Current liabilities		19,916			37,902			12,570
Long-term liabilities and other		17,004			7,149			10,250
Redeemable convertible preferred stock		66,878			77,643			15,153
Net sales		48,445			36,086			26,033
Gross profit		29,181			23,105			15,885
Net loss		(103,900	)		(66,761	)		(22,242	)

        Walden E-Learning, Inc. ("Walden") is a leading online university offering Ph.D. and other graduate-level degree programs in education, management, and the social and behavioral sciences. Sylvan Ventures initially had the right to acquire a 41% stake in Walden, pending the final payment of the purchase price. The Company at December 31, 2001 had voting rights for 16% of the outstanding common stock. Subsequent to year-end, Sylvan Ventures exercised an option to acquire an additional 10% interest in Walden for $8,000.

        Chancery Software Limited is a provider of an enterprise student information system for schools that includes tracking of grading, attendance, and other school and student communications.

        iLearning, Inc. is a leading provider of innovative training and educational solutions for businesses and organizations.

        EdVerify, Inc. is a business-to-business digital service provider that specializes in verifying the higher education enrollment and degree attainment of job candidates and credit requestors.

        Mindsurf, Inc. is a start-up organization aimed at improving communication between teachers, students, and parents by providing students with computing and communication resources though low cost, wireless handheld devices.

        HigherMarkets, Inc. is developing an e-procurement solution for universities and other educational institutions.

        Sylvan Ventures' equity in net losses related to the investments in affiliates for 2001 and 2000 was $52,374 and $21,222 respectively. At December 31, 2001, the difference between the carrying amount of equity method investments and the amount of underlying equity in net assets of these investments was $25,988. This amount was being amortized for each investment primarily over a three-year period as a component of the Company's allocable share of income or loss. For the years ended December 31, 2001 and 2000, equity in net loss of affiliates includes amortization of $8,938 and $3,793, respectively. Under the provisions of Statement No. 142 (see Note 2), this goodwill related to equity method investments will no longer be amortized effective January 1, 2002.

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Other Investments (Cost Method Investments):

        Other investments consist of non-marketable investments in common and preferred stocks of private companies in which the Company does not exercise significant influence. These investments are carried at cost unless a decline in estimated fair value is determined to be permanent. Other investments consisted of the following at December 31:

		2001		2000
ClubMom.com. Inc.		$	7,326	$	7,000
Chauncey Group International, Ltd.			8,000		8,000
Frontline Group, Inc.			7,000		7,000
Other			5,000		3,935
	Total	$	27,326	$	25,935

Realized Investment Income and Losses

        The Company recognized a net realized investment gain of $7,905 in 2001, a realized investment loss of $11,441 in 2000, and a realized investment loss of $13,370 in 1999. The most significant transactions giving rise to these gains and losses are described below.

        On September 11, 2001 Sylvan Ventures recognized an investment gain of $24,724 upon the sale of its 42% stake in Classwell Learning Group, Inc. for total cash proceeds of $31,807.

        On June 15, 2001, Caliber Learning Network, Inc. ("Caliber") filed for Chapter 11 bankruptcy protection. The Sylvan Ventures investment in Caliber of $2,931 was reduced to $0 upon recording its allocable share of losses related to Caliber prior to the bankruptcy proceedings, which is included in equity in net loss of affiliates. Additionally, the Company recorded a loss on investment of $14,231. This loss consists of bad debt expense for notes receivable from and advances to Caliber of $7,497, as well as the accrual of a $6,734 estimated liability relating to the Company's guarantee of certain non-cancelable Caliber lease obligations and other Caliber related liabilities incurred by the Company. Due to the uncertainties surrounding the bankruptcy proceedings and the ultimate settlement of Caliber's lease and other liabilities, it is possible that the Company's loss estimate may change prior to finalization.

        In 2000, Sylvan Ventures incurred a $3,051 realized loss upon the disposal of its $4,912 investment in the common stock of ZapMe! for cash proceeds of $1,861. Sylvan Ventures also recorded realized investment losses of $8,390 in 2000 based on an assessment that two investments were permanently impaired due to a significant deterioration in operating results and concerns regarding the ability of these companies to successfully implement their business plan.

        During 1999, the Company recorded investment losses of $13,370, principally related to the redemption of the Company's $26,600 investment in JLC Learning Corporation ("JLC") for proceeds of $15,200 in cash and purchase credits for JLC products. In 1999, the Company determined that the remaining amount of the purchase credit would not be realized as a result of the inability to use the credit to purchase products consistent with its customers' needs. The Company wrote-off the remaining

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product credit and the 1999 realized loss on investments include an aggregate loss of $11,400 related to the sale of the JLC investment.

Note 7—Long-Term Debt

        Long-term debt consists of the following at December 31:

		2001		2000
Convertible debentures		$	100,000	$	100,000
Mortgage notes payable for university facilities bearing interest at variable rates ranging from 6.20% to 7.84%			18,444		24,146
Notes payable secured by fixed assets, bearing interest at 4.65%			9,980		11,143
Long-term credit lines bearing interest at rates ranging from 4.75% to 7.87%			214		7,028
Capital lease agreements bearing interest at rates ranging from 4.75% to 17.50%			601		401
Various notes payable bearing interest at fixed rates ranging from 3.00% to 8.00%			1,684		1,563
			130,923		144,281
Less: current portion of long-term debt			6,449		12,856
	Total long-term debt	$	124,474	$	131,425

        On June 30, 2000, the Company issued $100,000 of ten-year convertible subordinated debentures to Apollo Management Group. The debentures bear interest at a fixed rate of 5.00%, payable semi-annually, and are convertible at any time into the Company's common stock at $15.735 per share. The debentures are redeemable by the Company, subsequent to June 30, 2003, providing certain conditions are achieved including the average share price exceeding 150% of the conversion price. The debentures mature on June 30, 2010.

        The Company has a revolving credit facility (the "Facility") with a group of five banks, which allows the Company to borrow up to an aggregate of $100,000 at variable rates. Outstanding borrowings under the Facility are unconditionally guaranteed by a pledge of the capital stock of the Company's domestic subsidiaries. The Facility expires on December 23, 2003 and there were no borrowings outstanding at December 31, 2001 and 2000. Debt covenants of the Facility require the Company to maintain certain debt-to-earnings and interest coverage ratios. Other provisions require maintenance of minimum net worth levels and restrict advances, investments, loans, capital expenditures and dividends. At December 31, 2001 the Company was in compliance with the covenants under the Facility.

        The Company's long-term debt is secured by assets with a carrying value of $81,286 at December 31, 2001. Aggregate maturities of Company's borrowings are as follows: 2002—$6,449; 2003—$5,948; 2004—$5,167; 2005—$9,244; 2006—$980 and thereafter $103,135.

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Note 8—Due to Shareholders of Acquired Companies

        Due to shareholders of acquired companies consists of the following amounts payable in cash at December 31:

	2001		2000
Amounts payable to former shareholders of Drake Prometric	$	3,050	$	3,050
Amounts payable to former shareholders of Les Roches		1,029		435
Amounts payable to former shareholders of Canter		—		13,145
Amounts payable to former shareholders of WSI franchises		—		12,000
Amounts payable to former shareholders of UDLA		—		12,000
		4,079		40,630
Less: Long-term portion (included in other long-term liabilities)		422		435
Total current portion	$	3,657	$	40,195

Note 9—Leases and Related Party Transactions

        The Company conducts significant operations from leased facilities. These facilities include the Company's corporate headquarters and other office locations, warehouse space, and Company-owned learning centers. The terms of substantially all of these leases are five years or less, with the exception of the Company's corporate headquarters facility, which has a lease term ending in August 2009, and generally contain renewal options. The Company also leases certain equipment under non-cancelable operating leases, the majority of which are for terms of 36 months or less. Future minimum lease payments at December 31, 2001, by year and in the aggregate, under all non-cancelable operating leases are as follows:

Years ending December 31:
2002	$	31,541
2003		29,944
2004		26,558
2005		23,637
2006		19,721
Thereafter		54,343
	$	185,744

        The Company has entered into sublease agreements with the purchaser of Prometric for leased space approximating 81,000 square feet, for an annual fee of $2,600, adjusted annually for increases in gross operating rent and related expenses. The subleases extend from March 3, 2000 through lease expiration in December 2007.

        The Company has entered into lease agreements for its university campuses in Mexico with certain officers and minority owners of the Company's Mexican university subsidiary. The leases have an initial term of ten years with an additional two-year extension available at the Company's option. Fixed monthly rents are adjusted annually for inflation. For the year ended December 31, 2001, the Company recognized approximately $4,090 of rent expense under these leases.

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        The Company has also entered into lease agreements for certain dormitories and other facilities in Switzerland with certain former owners of Les Roches. Pursuant to these agreements, the Company recognized rent expense of approximately $470 and $320 for the years ended December 31, 2001 and 2000, respectively. In December 2001, the Company accelerated an option agreement with the officers to purchase these properties for approximately $2,700.

        Rent expense, net of sub-lease income, included in income from continuing operations for all cancelable and non-cancelable leases was approximately $28,998, $18,383 and $14,310 for the years ended December 31, 2001, 2000 and 1999, respectively.

Note 10—Commitments and Contingencies

Loss Contingencies

        On November 18, 1996, ACT, Inc. filed suit against the Company alleging that the Company violated federal antitrust laws and committed various state law torts in connection with the operations of its computer-based testing operations and in obtaining a testing services contract from the National Association of Securities Dealers ("NASD"). The trial court has granted the Company's motion for summary judgment and ACT, Inc. has filed its appeal of the decision to the U.S. Court of Appeals for the Eighth Circuit and oral arguments have been held. Management is unable to predict the ultimate outcome of the appeal, but believes that the ultimate resolution of the matter will not have a material effect on the Company's consolidated financial position.

        The Company is subject to other legal actions arising in the ordinary course of its business. In management's opinion, the Company has adequate legal defenses and/or insurance coverage with respect to the eventuality of such actions and does not believe any settlement would materially affect the Company's financial position.

Guarantees

        The Company has guaranteed that services will be provided under the terms of franchisee agreements with customers who have financed their tuition with a certain financial institution. If the franchisees do not provide all of the services that are financed under this program, the Company must either provide the services through one of its company-owned centers, arrange for the services to be provided by a comparable third party, or refund to the customer the amount that was paid for the services. As of December 31, 2001, the amount that was financed under this program was approximately $9,900.

        The Company has guaranteed the loans of franchisees with certain banks. These loans primarily represent the financing of programs and other instructional materials. Of the $1,700 of available credit under these loans, the outstanding balance was approximately $800 at December 31, 2001.

Contingent Payments and Business Combinations

        In the normal course of business, the Company is party to option agreements with franchisees that allow, under specified circumstances, the repurchase of operating franchises at predetermined multiples of operating results. These options may be at the Company's or the franchisee's discretion based upon

65

the individual agreement and specific operating criteria. None of these option agreements would be individually material and operating results of the Company would not be materially impacted for the current period if the options were exercised.

        The Company is self-insured for health care, workers compensation, and other insurable risks up to predetermined amounts above which third party insurance applies. The Company is contingently liable to insurance carriers under certain of these policies and has provided a letter of credit in favor of the insurance carriers for approximately $900.

Note 11—Fair Value of Financial Instruments

        The fair value of the Company's financial instruments consist primarily of cash and cash equivalents, accounts and notes receivable, available-for-sale investments, accounts payable, due to shareholders of acquired companies, and short and long-term debt. Except for convertible debentures with a carrying value of $100,000, the fair value of these financial instruments approximate their carrying amounts reported in the consolidated balance sheets. The Company's convertible debentures have a fair value of approximately $140,000 at December 31, 2001, calculated based on the quoted value of the Company's common stock and the number of shares issuable upon conversion.

        It is not practical to estimate the fair value of the Company's cost method investments because of the lack of quoted market prices of the underlying securities and the inability to determine fair value without incurring excessive costs.

Note 12—Employee Benefit Plans

Stock Options Plans

        The Board of Directors may grant options under five stock option plans to selected employees, officers and directors of the Company to purchase shares of the Company's common stock at a price not less than the fair market value of the stock at the date of the grant. The 1998 Stock Incentive Plan ("1998 Plan") is the only plan with significant stock option awards available for grant. The 1998 Plan allows for the grant of up to 3,750 shares of common stock in the form of incentive and non-qualified stock options, stock appreciation rights, stock awards, phantom stock awards, convertible securities and performance awards that expire six or ten years after the date of grant. Options outstanding under all five of the Company's stock option plans have been granted at prices which are equal to or exceed the market value of the stock on the date of grant and vest ratably over periods not exceeding six years.

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        The following table summarizes the stock option activity of the Company for the years ended December 31:

	2001				2000				1999
	Options		Weighted Average Exercise Price		Options		Weighted Average Exercise Price		Options		Weighted Average Exercise Price
Outstanding at beginning of year	9,939		$	17.52	10,380		$	18.13	9,067		$	18.24
Granted	997			18.14	679			14.31	1,737			17.07
Exercised	(1,492	)		12.01	(91	)		5.42	(243	)		9.93
Forfeited	(1,265	)		22.18	(1,029	)		22.27	(181	)		24.62
Outstanding at end of year	8,179		$	17.85	9,939		$	17.52	10,380		$	18.13
Exercisable at end of year	5,088		$	16.47	5,675		$	15.88	4,402		$	14.17

        The following table summarizes information about stock options outstanding at December 31, 2001:

	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number of Shares	Weighted Average Exercise Prices		Weighted Average Remaining Contractual Life	Number of Shares	Weighted Average Exercise Prices
$3.48–  $6.08	738	$	4.77	1.6	721	$	4.80
$6.78–$13.11	1,294		11.52	6.6	666		10.41
$13.55–$19.77	2,995		15.04	5.7	2,008		14.30
$21.15–$32.38	3,152		26.18	6.1	1,693		26.39

Defined Contribution Retirement Plan

        The Company sponsors a defined contribution retirement plan under section 401(k) of the Internal Revenue Code. The provisions of this plan allow for voluntary employee contributions up to 15% of their salary, subject to certain annual limitations. The Company may at its discretion make matching contributions, which are allocated to eligible participants. All employees are eligible after meeting certain service requirements. The Company made discretionary contributions to this plan of $742, $1,218 and $461 during the years ended December 31, 2001, 2000 and 1999, respectively.

Employee Stock Purchase Plan

        The Company sponsors an employee stock purchase plan that allows eligible employees to purchase shares of common stock at a 15% discount to the lower of the fair market value on the first day or the last day of the annual offering period. Employees may authorize the Company to withhold up to 10% of their compensation during any offering period, subject to certain limitations. During 2001, 2000, and 1999, shares totaling 29, 62 and 41 were issued under the plan at an average price of $13.93, $12.61 and $23.23, respectively.

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Shares Reserved For Future Issuance

        As of December 31, 2001, the Company has reserved 16,500 shares of common stock for future issuance upon the exercise of all outstanding stock options and the conversion of debentures.

Management Ownership Interests in Subsidiaries

        Executives of the Company have been granted options to purchase common stock in the Company's subsidiary operating its International University segment. At December 31, 2001, the options represent 20% of the total outstanding shares and are exercisable at an exercise price equal to or greater than the estimated fair value of the common stock at the grant date. The options vest over periods of up to five years.

        In June 2000, executives of the Company were granted membership profits interest in Sylvan Ventures upon formation in the amount of 15% of total outstanding units. These membership profit interests entitle the holders to a share of profits upon the occurrence of a profit event and shall be converted into common stock of the corporate successor in the event of a qualified initial public offering of Sylvan Ventures.

Pro Forma Information

        Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation ("Statement No. 123"), defines a fair-value-based method of accounting for an employee stock option. However, it allows an entity to continue to measure compensation cost for those instruments using the intrinsic value method of accounting prescribed by APB Opinion No. 25. As permitted by Statement No. 123, the Company elected to retain the intrinsic value method of accounting for stock options, and disclose supplementally pro forma net income as if the fair value method had been used.

        For the years ended December 31, 2001, 2000 and 1999, pro forma net income and earnings per share information required by Statement No. 123 has been determined as if the Company had accounted for its stock options using the fair value method. The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for 2001, 2000 and 1999: risk-free interest rate of 4.5%, 5.5% and 5.5% respectively, dividend yield of 0%, volatility factors of the expected market price of the Company's common stock of .464, .460 and .443, respectively, and an expected life of granted options from four to six years depending upon the vesting period.

        The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options. The weighted average estimated fair values of stock options granted during fiscal years 2001, 2000, and 1999 were $8.26, $6.12 and $7.37, respectively.

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        For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting periods. The Company's pro forma information for the years ended December 31 is as follows:

		2001			2000			1999
Pro forma income (loss) from continuing operations before cumulative effect of change in accounting principle		$	(24,414	)	$	(8,760	)	$	3,513
Pro forma net income (loss)		$	(24,414	)	$	298,079		$	(21,897	)
Pro forma earnings (loss) per share, basic:
	Income (loss) from continuing operations before cumulative effect of change in accounting principle	$	(0.64	)	$	(0.20	)	$	0.07
	Net income (loss)	$	(0.64	)	$	6.85		$	(0.42	)
Pro forma earnings (loss) per share, diluted:
	Income (loss) from continuing operations before cumulative effect of change in accounting principle	$	(0.64	)	$	(0.20	)	$	0.07
	Net income (loss)	$	(0.64	)	$	6.85		$	(0.42	)

Note 13—Investment and Other Income

        The Company's investment and other income consists of the following as of December 31:

	2001		2000			1999
Interest and other income	$	9,758	$	22,068		$	1,170
Gain (loss) on foreign exchange		124		(2,029	)		(48	)
	$	9,882	$	20,039		$	1,122

        Gain (loss) on foreign exchange in 2000 includes a $3,149 loss related to the settlement of a foreign exchange contract in August 2000.

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Note 14—Income Taxes

        Significant components of the income tax benefit on earnings from continuing operations for the years ended December 31 are as follows:

		2001			2000			1999
Current:
	Federal	$	715		$	(4,018	)	$	(180	)
	Foreign		13,587			6,591			2,114
	State		(1,882	)		(2,242	)		(1,801	)
			12,420			331			133
Deferred:
	Federal		(12,483	)		(3,129	)		(2,087	)
	Foreign		(3,265	)		(202	)		176
	State		(2,352	)		(1,308	)		494
			(18,100	)		(4,639	)		(1,417	)
Total benefit		$	(5,680	)	$	(4,308	)	$	(1,284	)

        For the years ended December 31, 2001, 2000 and 1999, foreign income from continuing operations before income taxes was $32,572, $20,997 and $14,028, respectively.

70

        Significant components of the Company's deferred tax assets and liabilities arising from continuing operations as of December 31 are as follows:

		2001			2000
Deferred tax assets:
	Net operating loss carryforwards	$	13,085		$	5,658
	Deferred revenue		2,865			1,729
	Allowance for doubtful accounts		2,801			1,355
	Deferred compensation		1,033			591
	Equity in net losses of affiliates		30,568			18,017
	Charitable contributions carryforward		100			—
	Non-deductible reserves		1,190			2,191
	Tax credit carryforward		2,900			500
	Other		349			146
Total deferred tax assets			54,891			30,187
Deferred tax liabilities:
	Deferred contract costs		1,957			1,389
	Prepaid expenses		601			871
	Depreciation		7,727			6,933
	Amortization of intangible assets		2,861			3,093
	Deferred income		14,043			12,840
	Unbilled receivables		636			1,113
	Other		202			979
Total deferred tax liabilities			28,027			27,218
Net future income tax benefits (liabilities)			26,864			2,969
Valuation allowance for net deferred tax assets			(9,231	)		(3,857	)
Net deferred tax asset (liability)		$	17,633		$	(888	)

        At December 31, 2001, undistributed earnings from continuing operations of non-U.S. subsidiaries totaled approximately $100,000. Deferred tax liabilities have not been recognized for these undistributed earnings because it is management's intention to reinvest such undistributed earnings outside of the U.S. If all undistributed earnings were remitted to the U.S., the amount of incremental U.S. federal income taxes, net of foreign tax credits, would be approximately $34,000.

        The net operating loss carryforwards at December 31, 2001 are related to subsidiaries of the Company, and are available only to offset future taxable income of those subsidiaries. These net operating loss carryforwards will begin to expire in 2005. The tax credit carryfowards consist of foreign tax credits at December 31, 2001 that expire in 2006. The increase in the valuation allowance from 2000 to 2001 resulted from an increase in net operating losses of a majority-owned subsidiary of Sylvan Ventures that can not be deducted by the Company.

71

        The reconciliation of the reported income tax expense to the amount that would result by applying the U.S. federal statutory tax rate of 35% to income from continuing operations before income taxes and cumulative effect of change in accounting principle for the years ended December 31 is as follows:

	2001			2000			1999
Tax expense at U.S. statutory rate	$	(8,094	)	$	(2,073	)	$	2,469
Expense (benefit) attributable to minority interest		1,132			(3,542	)		154
Permanent differences		2,208			(155	)		494
State income tax expense, net of federal tax effect		(3,296	)		(949	)		(1,196	)
Tax effect of foreign income taxed at lower rate		(3,290	)		(1,676	)		(3,233	)
Change in valuation allowance		5,374			3,857			—
Other		286			230			28
Total tax benefit	$	(5,680	)	$	(4,308	)	$	(1,284	)

72

Note 15—Earnings (Loss) Per Share

        The following table summarizes the computations of basic and diluted earnings per share for the years ended December 31:

		2001			2000			1999
Numerator used in basic and diluted earnings (loss) per common share:
	Income (loss) from continuing operations, before cumulative effect of change in accounting principle	$	(17,446	)	$	(1,617	)	$	8,339
	Income (loss) from discontinued operations, net of tax		—			(3,968	)		4,964
	Gain (loss) on disposal of discontinued operations, net of tax		—			310,807			(26,968	)
	Cumulative effect of change in accounting principle, net of tax		—			—			(1,323	)
	Net income (loss)	$	(17,446	)	$	305,222		$	(14,988	)
Denominator for basic earnings (loss) per share—weighted-average common shares outstanding			38,135			43,501			51,553
Net effect of dilutive stock options based on treasury stock method			—			—			1,604
Denominator for diluted earnings (loss) per share—weighted average common shares outstanding and assumed conversions			38,135			43,501			53,157
Earnings (loss) per common share, basic:
	Income (loss) from continuing operations, before cumulative effect of change in accounting principle	$	(0.46	)	$	(0.04	)	$	0.16
	Income (loss) from discontinued operations, net of tax		—			(0.08	)		0.10
	Gain (loss) on disposal of discontinued operations, net of tax		—			7.14			(0.52	)
	Cumulative effect of change in accounting principle, net of tax		—			—			(0.03	)
	Earnings (loss) per common share, basic	$	(0.46	)	$	7.02		$	(0.29	)
Earnings (loss) per common share, diluted:
	Income (loss) from continuing operations, before cumulative effect of change in accounting principle	$	(0.46	)	$	(0.04	)	$	0.16
	Income (loss) from discontinued operations, net of tax		—			(0.08	)		0.09
	Gain (loss) on disposal of discontinued operations, net of tax		—			7.14			(0.51	)
	Cumulative effect of change in accounting principle, net of tax		—			—			(0.02	)
	Earnings (loss) per common share, diluted	$	(0.46	)	$	7.02		$	(0.28	)

        Stock options and the convertible outstanding debentures (see Note 7) were not dilutive for the years ended December 31, 2001 and 2000 as the Company reported a net loss from continuing operations.

Note 16—Business and Geographic Segment Information

        The Company is organized on the basis of educational services provided. The Company's segments are business units that offer distinct services. The segments are managed separately as they have different customer bases and delivery channels. As discussed in Note 1, as of July 1, 2001, the Company

73

realigned several of its business segments. All segment information has been reclassified to conform to the new presentation. Reportable segments are as follows:

K-12 Education Services provides personalized instructional services to students of all ages and skill levels through its network of franchised and Company-owned learning centers, and provides educational programs to students of public and non-public school districts through contracts funded by Federal Title I and State-based programs.

Online Higher Education develops and licenses professional development and graduate degree programs to universities.

International Universities provides post-secondary instruction and degree programs through its network of fully accredited or licensed universities located in Spain, Switzerland, Mexico, Chile and France. The segment commenced operations in the second quarter of 1999 with the acquisition of a controlling interest in UEM. During 2000, the Company acquired controlling interests in Les Roches, UVM and UDLA, and in 2001 acquired a controlling interest in ESCE.

English Language Instruction provides English language instruction through a combination of computer-based and live instruction through its network of franchised and Company-owned learning centers.

Sylvan Ventures began operations in the first quarter of 2000. Sylvan Ventures invests in and incubates companies developing emerging technology solutions for the education and training marketplace.

        The Company evaluates performance and allocates resources based on operating income before corporate general and administrative expenses and income taxes. There are no significant intercompany sales or transfers. Segment profit is net operating profit (loss) for the operating segments. Segment profit for Sylvan Ventures is calculated as the sum of net development costs, net investment income (loss) and equity in net loss of affiliates.

74

        The following table sets forth information on the Company's reportable segments for the years ending December 31:

2001	K-12 Education Services		Online Higher Education		International Universities		English Language Instruction		Sylvan Ventures
Revenues	$	184,538	$	44,328	$	200,201	$	55,737	$	—
Segment profit (loss)		35,423		9,104		25,846		622		(54,356	)
Segment assets		106,184		101,517		290,475		156,143		70,430
Long-lived assets		10,620		7,155		145,640		14,040		2,525
Depreciation and amortization		7,069		5,402		12,402		7,248		2,234

2000	K-12 Education Services		Online Higher Education		International Universities		English Language Instruction		Sylvan Ventures
Revenues	$	167,306	$	36,814	$	60,873	$	49,746	$	—
Segment profit (loss)		30,485		7,752		4,623		2,818		(50,846	)
Segment assets		112,395		93,256		239,166		135,857		82,006
Long-lived assets		12,278		3,432		127,098		11,328		3,728
Depreciation and amortization		6,414		4,788		4,981		5,678		690

1999	K-12 Education Services		Online Higher Education		International Universities		English Language Instruction		Sylvan Ventures
Revenues	$	156,405	$	35,522	$	31,558	$	52,848	$	—
Restructuring charges		2,707		—		447		—		—
Segment profit		26,023		13,116		2,291		11,742		—
Segment assets		108,648		67,722		69,042		121,408		—
Long-lived assets		13,732		1,891		80,862		7,491		—
Depreciation and amortization		6,146		2,984		3,095		4,296		—

75

        The following tables reconcile the reported information on segment profit and assets to income (loss) before income taxes and cumulative effect of change in accounting principle and total assets reported in the statements of operations and balance sheets for the years ended December 31:

	2001			2000			1999
Total profit for reportable segments	$	16,639		$	(5,168	)	$	53,172
Corporate general and administrative expense		(22,003	)		(20,306	)		(27,270	)
Other income (expense)		(17,762	)		19,549			(18,847	)
Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting principle	$	(23,126	)	$	(5,925	)	$	7,055

		2001		2000		1999
Total assets for reportable segments		$	724,749	$	662,680	$	366,820
Unallocated corporate assets			185,487		354,283		117,518
Net assets of discontinued operations			—		—		280,287
	Total assets	$	910,236	$	1,016,963	$	764,625

	2001		2000		1999
Total depreciation and amortization for reportable segments	$	34,355	$	22,551	$	16,521
Corporate depreciation and amortization		3,613		2,732		2,377
Depreciation and amortization of discontinued operations		—		5,159		27,889
Total depreciation and amortization	$	37,968	$	30,442	$	46,787

        Two of the Company's segments include revenues generated from both Company-owned and franchised centers. The following table sets forth the components of total revenues of these segments at December 31:

		K-12 Education Services						English Language Instruction
		2001		2000		1999		2001		2000		1999
Company-owned centers		$	144,409	$	130,101	$	118,752	$	36,989	$	31,342	$	30,848
Franchise centers			40,129		37,205		37,653		18,748		18,404		22,000
	Total revenues	$	184,538	$	167,306	$	156,405	$	55,737	$	49,746	$	52,848

        Direct costs for these segments relate primarily to the Company-owned centers. Costs related to the franchised centers are included in the Company's general segment expenses. It is not practical to quantify these costs separately.

76

        Revenue and long-lived assets information by geographic area for the years ended December 31 is as follows:

		2001		2000		1999
Revenues
	United States	$	213,492	$	188,582	$	167,851
	Mexico		112,554		9,912		—
	Spain		72,277		69,733		62,629
	Other foreign countries		86,481		46,512		45,853
	Consolidated total	$	484,804	$	314,739	$	276,333
Long-Lived Assets
	United States	$	41,712	$	34,948	$	27,220
	Mexico		29,208		16,310		—
	Spain		78,670		82,156		85,965
	Switzerland		28,731		23,665		—
	Other foreign countries		23,187		16,477		2,633
	Consolidated total	$	201,508	$	173,556	$	115,818

        Revenues are attributed to countries based on the location of the customer. Revenues in individual foreign countries other than Mexico and Spain and long-lived assets in individual foreign countries other than Mexico, Spain and Switzerland did not exceed 10% of consolidated amounts in any of the years presented.

Note 17—Restructuring

        During the fourth quarter of 1999, the Company completed an analysis of its operating structure to improve operating efficiency and to enhance shareholder value. As a result of this analysis, management approved a formal restructuring plan in 1999, and the Company recorded a restructuring charge to operations of approximately $3,600. The restructuring plan was comprised of employee termination and facility exit costs resulting primarily from the Company's plan to exit certain activities outside the core business of providing educational instruction. The Company eliminated 40 professional and administrative positions as a result of the plan. Facility exit costs include approximately $2,500 of costs to close schools and school-based facilities. The Company completed the implementation of the plan by the end of fiscal 2000. During the years ended December 31, 2000 and 1999, the Company paid $602 and $2,967, respectively related to the restructuring plan.

Note 18—Supplemental Cash Flow Information

        Cash flow information for the Company reflects the total cash flows including continuing operations and discontinued operations.

        Interest payments were approximately $9,701, $2,981 and $5,090 for the years ended December 31, 2001, 2000 and 1999, respectively. Income tax payments were $93,680, $25,112 and $15,514 for the years ended December 31, 2001, 2000, and 1999, respectively.

77

Note 19—Quarterly Financial Data (Unaudited)

        The following 2001 financial information reflects all normal recurring adjustments, which are, in the opinion of management, necessary for a fair statement of the results of the interim periods. Summarized operating data is as follows:

		Quarter Ended
2001
		March 31			June 30			September 30		December 31
Revenues		$	116,219		$	126,246		$	104,918	$	137,421
Operating income			644			11,113			1,595		11,522
Net income (loss)		$	(11,584	)	$	(13,434	)	$	8,369	$	(797	)
Earnings (loss) per common share:
	Basic	$	(0.31	)	$	(0.35	)	$	.22	$	(0.02	)
	Diluted	$	(0.31	)	$	(0.35	)	$	.20	$	(0.02	)
Shares used in computation:
	Basic		37,441			37,877			38,472		38,708
	Diluted		37,441			37,877			46,553		38,708

        During the quarter ended June 30, 2001, the Company recognized a loss on investment of $14,231 as a result of the bankruptcy filing of Caliber Learning Network, Inc. (see Note 6). During the quarter ended September 30, 2001, the Company sold its investment in Classwell Learning Group, Inc. and recognized an investment gain of $24,724 (see Note 6). Scholarships and discounts for the period from January 1, 2001 through September 30, 2001 have been reclassified from expenses to reduce revenues. Revenues as previously reported were $120,446 for the quarter ended March 31, 2001, $130,395 for the

78

quarter ended June 30, 2001, and $107,749 for the quarter ended September 30, 2001. This reclassification of scholarships and discounts has no effect on the net income (loss) of the Company.

		Quarter Ended
2000
		March 31			June 30			September 30			December 31
Revenues		$	75,203		$	81,882		$	59,967		$	97,687
Operating income (loss)			4,827			4,968			(3,790	)		1,184
Income (loss) from continuing operations before Cumulative effect of change in accounting principle			3,410			6,626			(3,337	)		(8,316	)
Income (loss) from discontinued operations, net of tax			(3,868	)		(1,957	)		1,903			(46	)
Gain on disposal of discontinued operations, net of tax			288,454			—			—			22,353
Net income (loss)		$	287,996		$	4,669		$	(1,434	)	$	13,991
Earnings (loss) per common share, basic:
	Income (loss) from continuing operations before Cumulative effect of change in accounting principle	$	0.07		$	0.14		$	(0.08	)	$	(0.22	)
	Income (loss) from discontinued operations		(0.08	)		(0.04	)		0.05			—
	Gain on disposal of discontinued operations		5.68			—			—			0.60
	Net income (loss)	$	5.67		$	0.10		$	(0.03	)	$	0.38
Earnings (loss) per common share, diluted:
	Income (loss) from continuing operations before Cumulative effect of change in accounting principle	$	0.07		$	0.14		$	(0.08	)	$	(0.22	)
	Income (loss) from discontinued operations		(0.08	)		(0.04	)		0.05			—
	Gain on disposal of discontinued operations		5.59			—			—			0.60
	Net income (loss)	$	5.58		$	0.10		$	(0.03	)	$	0.38
Shares used in computation:
	Basic		50,802			45,110			41,084			37,274
	Diluted		51,570			45,825			41,084			37,274

        See Note 3 for a discussion of discontinued operations in 2000. Scholarships and discounts for all quarters have been reclassified from expenses to reduce revenues. Revenues as previously reported were $75,539 for the quarter ended March 31, 2000, $82,229 for the quarter ended June 30, 2000, $59,969 for the quarter ended September 30, 2000 and $98,913 for the quarter ended December 31, 2001. This reclassification of scholarships and discounts has no effect on income (loss) from continuing operations or net income (loss) of the Company.

        Earnings per share are computed independently for each of the quarters present. Therefore, the sum of the quarterly net earnings per share will not necessarily equal the total for the year.

79

EX-23.01

                                 EXHIBIT 23.01

             CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

We consent to the incorporation by reference in the following Registration
Statements of our report dated February 20, 2002, with respect to the
consolidated financial statements of Sylvan Learning Systems, Inc. included in
the Annual Report (Form 10-K) for the year ended December 31, 2001.

We also consent to the incorporation by reference in the following Registration
Statements of our reports on the following affiliates of Sylvan Learning
Systems, Inc., included as an exhibit in the Annual Report (Form 10-K) for the
year ended December 31, 2001.

AFFILIATES OF SYLVAN LEARNING SYSTEMS, INC.:



Date of Report                         Name of Entity
- --------------                         --------------
                                    
February 1, 2002                       HigherMarkets, Inc.
March 22, 2002                         Mindsurf, Inc.


REGISTRATION STATEMENTS ON FORM S-3:



Registration Number                    Date Filed
- -------------------                    ----------
                                    
33-92014                               May 8, 1995
33-92852                               May 30, 1995
333-1674                               February 26, 1996
333-16111                              November 14, 1996
333-21261                              February 6, 1997
333-26633                              May 7, 1997
333-31273                              July 15, 1997
333-39535                              November 5, 1997
333-43355                              December 29, 1997
333-46747                              February 23, 1998
333-48997                              March 31, 1998
333-50993                              April 24, 1998
333-61083                              August 25, 1998
333-65197                              October 1, 1998
333-67727                              December 4, 1998
333-78961                              May 20, 1999
333-82992                              February 19, 2002


REGISTRATION STATEMENTS ON FORM S-8:




Name                                                         Registration Number         Date Filed
- ----                                                         -------------------         ----------
                                                                                   
1987-1991 Employee Stock Option Plan                         33-77384                    April 6, 1994
1993 Director Stock Option Plan                              33-77386                    April 6, 1994
1993 Employee Stock Option Plan                              33-77390                    April 6, 1994
1993 Management Stock Option Plan                            33-77388                    April 6, 1994
1997 Employee Stock Purchase Plan                            333-21963                   February 18, 1997
1998 Stock Incentive Plan                                    333-62011                   August 21, 1998
1993 Employee Stock Option Plan and Employee Stock
Purchase Plan                                                33-77390                    September 14, 1998




Baltimore, Maryland
March 26, 2002

EX-23.02

                                                                   Exhibit 23.02


CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS


As independent public accountants, we hereby consent to the incorporation of our
report included in this Form 10-K into the Company's previously filed
registration statements:

REGISTRATION STATEMENTS ON FORM S-3:




Registration Number                    Date Filed
- -------------------                    ----------
                                    
33-92014                               May 8, 1995
33-92852                               May 30, 1995
333-1674                               February 26, 1996
333-16111                              November 14, 1996
333-21261                              February 6, 1997
333-26633                              May 7, 1997
333-31273                              July 15, 1997
333-39535                              November 5, 1997
333-43355                              December 29, 1997
333-46747                              February 23, 1998
333-48997                              March 31, 1998
333-50993                              April 24, 1998
333-61083                              August 10, 1998
333-65197                              October 1, 1998
333-67727                              November 23, 1998
333-78961                              May 20, 1999
333-82992                              February 19, 2002


REGISTRATION STATEMENTS ON FORM S-8:




Name                                                         Registration Number         Date Filed
- ----                                                         -------------------         ----------
                                                                                   
1987-1991 Employee Stock Option Plan                         33-77384                    April 6, 1994
1993 Director Stock Option Plan                              33-77386                    April 6, 1994
1993 Employee Stock Option Plan                              33-77390                    April 6, 1994
1993 Management Stock Option Plan                            33-77388                    April 6, 1994
1997 Employee Stock Purchase Plan                            333-21963                   February 18, 1997
1998 Stock Incentive Plan                                    333-62011                   August 21, 1998
1993 Employee Stock Option Plan and
     Employee Stock Purchase Plan                            33-77390                    September 14, 1998



/s/ ARTHUR ANDERSEN LLP

Baltimore, Maryland,
March 25, 2002

EX-23.03

                                                                   Exhibit 23.03


                         Consent of Independent Auditors

We consent to the incorporation by reference in the following Registration
Statements of Sylvan Learning Systems, Inc. of our report dated October 31,
2001, with respect to the consolidated financial statements of Chancery Software
Ltd. included in the Annual Report (Form 10-K) of Sylvan Learning Systems, Inc.
for the year ended December 31, 2001.

REGISTRATION STATEMENTS ON FORM S-3:




Registration Number                    Date Filed
- -------------------                    ----------
                                    
33-92014                               May 8, 1995
33-92852                               May 30, 1995
333-1674                               February 26, 1996
333-16111                              November 14, 1996
333-21261                              February 6, 1997
333-26633                              May 7, 1997
333-31273                              July 15, 1997
333-39535                              November 5, 1997
333-43355                              December 29, 1997
333-46747                              February 23, 1998
333-48997                              March 31, 1998
333-50993                              April 24, 1998
333-61083                              August 25, 1998
333-65197                              October 1, 1998
333-67727                              December 4, 1998
333-78961                              May 20, 1999
333-82992                              February 19, 2002



REGISTRATION STATEMENTS ON FORM S-8:



Name                                                         Registration Number         Date Filed
- ----                                                         -------------------         ----------
                                                                                   
1987-1991 Employee Stock Option Plan                         33-77384                    April 6, 1994
1993 Director Stock Option Plan                              33-77386                    April 6, 1994
1993 Employee Stock Option Plan                              33-77390                    April 6, 1994
1993 Management Stock Option Plan                            33-77388                    April 6, 1994
1997 Employee Stock Purchase Plan                            333-21963                   February 18, 1997
1998 Stock Incentive Plan                                    333-62011                   August 21, 1998
1993 Employee Stock Option Plan and Employee Stock
Purchase Plan                                                33-77390                    September 14, 1998




"PricewaterhouseCoopers LLP"

Chartered Accountants
Vancouver, Canada
March 26, 2002

EX-99.1

                                                                    Exhibit 99.1



CHANCERY SOFTWARE LTD.

Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
(tabular amounts expressed in thousands
of U.S. dollars)







AUDITORS' REPORT

TO THE DIRECTORS AND SHAREHOLDERS OF
CHANCERY SOFTWARE LTD.


We have audited the consolidated balance sheets of CHANCERY SOFTWARE LTD. as at
September 30, 2001 and 2000 and the consolidated statements of operations,
changes in shareholders' deficiency and cash flows for the years ended
September 30, 2001 and 2000. 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 auditing standards generally accepted
in the United States. Those standards require that we plan and perform an audit
to obtain reasonable assurance whether the financial statements are free of
material misstatement. An audit 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.

In our opinion, these consolidated financial statements present fairly, in all
material respects, the financial position of the company as at September 30,
2001 and 2000 and the results of its operations and its cash flows for the years
ended September 30, 2001 and 2000 in accordance with generally accepted
accounting principles in the United States.


"PricewaterhouseCoopers LLP"


CHARTERED ACCOUNTANTS

Vancouver, Canada
October 31, 2001





CHANCERY SOFTWARE LTD.
Consolidated Balance Sheets
AS AT SEPTEMBER 30, 2001 AND 2000



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

(tabular amounts expressed in thousands of U.S. dollars)


                                                                                                     2001               2000
                                                                                                        $                  $
                                                                                                                
ASSETS

CURRENT ASSETS
Cash and cash equivalents                                                                            4,567              6,311
Short-term investments                                                                                   -              7,399
Accounts receivable (note 4)                                                                         4,259              2,956
Prepaid expenses and deposits                                                                          613                511
Work-in-process                                                                                          -                169
Inventory                                                                                              104                132
Restricted cash (note 5)                                                                               400                  -
                                                                                           ------------------------------------
                                                                                                     9,943             17,478

LONG-TERM ACCOUNTS RECEIVABLE                                                                            -                100

PROPERTY AND EQUIPMENT (note 4)                                                                      2,143              1,804

INTANGIBLE ASSETS (note 4)                                                                             554              1,308

GOODWILL                                                                                                 -              1,991
                                                                                           ------------------------------------

                                                                                                    12,640             22,681
                                                                                           ====================================




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





CHANCERY SOFTWARE LTD.
Consolidated Balance Sheets...CONTINUED
AS AT SEPTEMBER 30, 2001 AND 2000



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

(tabular amounts expressed in thousands of U.S. dollars)

                                                                                                     2001               2000
                                                                                                        $                  $
                                                                                                         
LIABILITIES

CURRENT LIABILITIES
Accounts payable and accrued liabilities (note 4)                                                    3,845              2,160
Income taxes payable                                                                                    65                 42
Note payable (note 6)                                                                                    -                500
                                                                                           ------------------------------------
                                                                                                     3,910              2,702

Unearned revenue                                                                                     6,478              5,736
                                                                                           ------------------------------------

TOTAL CURRENT LIABILITIES                                                                           10,388              8,438

LONG-TERM ACCOUNTS PAYABLE                                                                              63                  -

DEFERRED INCOME TAXES                                                                                    -                268
                                                                                           ------------------------------------

                                                                                                    10,451              8,706
                                                                                           ------------------------------------

MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK (note 8)
Authorized
      100,000,000 Class A Voting Mandatorily Redeemable Convertible Preferred shares,
           no par value, 4% cumulative dividend

Issued and outstanding
      4,667,419 (2000 - 4,667,419) Class A Voting Redeemable Convertible Preferred
           shares (including accretion of cumulative dividend of $1,309,747 (2000 -
           $629,997) and net of issuance costs of $326,000)                                         33,514             32,204
                                                                                           ------------------------------------

STOCKHOLDERS' DEFICIENCY

CAPITAL STOCK (note 9)
Authorized
      500,000,000 voting common shares, no par value

Issued and outstanding
      7,430,404 (2000 - 7,028,348) voting common shares (net of issuance
           costs of $86,600)                                                                         4,504              4,399

OTHER CAPITAL ACCOUNTS                                                                                  (9)               (72)

ACCUMULATED OTHER COMPREHENSIVE INCOME                                                               2,503              1,558

DEFICIT                                                                                            (38,323)           (24,114)
                                                                                           ------------------------------------

                                                                                                   (31,325)           (18,229)
                                                                                           ------------------------------------

                                                                                                    12,640             22,681
                                                                                           ====================================
NATURE OF OPERATIONS (note 1)

COMMITMENTS (note 12)




                             Director                                   Director
- ---------------------------               -----------------------------


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





CHANCERY SOFTWARE LTD.
Consolidated Statements of Operations
FOR THE YEARS ENDED SEPTEMBER 30, 2001 AND 2000



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

(tabular amounts expressed in thousands of U.S. dollars)


                                                                                                 2001                   2000
                                                                                                    $                      $
                                                                                                        
REVENUE                                                                                         18,498                14,029

COSTS                                                                                            7,516                 3,786
                                                                                      -----------------------------------------

GROSS PROFIT                                                                                    10,982                10,243
                                                                                      -----------------------------------------

EXPENSES
Sales and marketing                                                                              7,002                 5,946
Research and development                                                                         5,784                 5,170
General and administration                                                                       5,152                 3,616
Write-off of goodwill, intangible assets and capital assets                                      2,146                     -
Restructuring charges                                                                            1,004                     -
Depreciation                                                                                       900                   489
Amortization of goodwill                                                                           749                   398
Amortization of intangible assets                                                                  683                   330
Business development                                                                               579                     -
                                                                                      -----------------------------------------
                                                                                                23,999                15,949
                                                                                      -----------------------------------------

                                                                                               (13,017)               (5,706)

FOREIGN EXCHANGE GAIN                                                                            1,037                   656

INTEREST INCOME                                                                                    456                   421

GAIN ON SALE OF INVESTMENT                                                                           -                   945
                                                                                      -----------------------------------------

LOSS BEFORE INCOME TAXES                                                                       (11,524)               (3,684)

(RECOVERY OF) PROVISION FOR INCOME TAXES                                                          (223)                  167
                                                                                      -----------------------------------------

LOSS FOR THE YEAR                                                                              (11,301)               (3,851)
                                                                                      =========================================




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





CHANCERY SOFTWARE LTD.
Consolidated Statements of Changes in Shareholders' Deficiency
FOR THE YEARS ENDED SEPTEMBER 30, 2001 AND 2000



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

(tabular amounts expressed in thousands of U.S. dollars)


                                                              OTHER CAPITAL ACCOUNTS
                                                          -----------------------------
                                                                                           ACCUMU-
                                                                                       LATED OTHER                     TOTAL
                                          COMMON STOCK       ADDITIONAL     DEFERRED       COMPRE-                    STOCK-
                                -----------------------        PAID-IN       COMPEN-       HENSIVE                    HOLDERS'
                                    SHARES      AMOUNT         CAPITAL        SATION        INCOME      DEFICIT     EFICIENCY
                                                     $               $             $             $            $              $
                                                                                               
BALANCE - SEPTEMBER 30, 1999    18,095,715       9,360             692          (198)        1,098     (10,431)           521
Issuance of shares for cash      1,002,028         329               -             -             -           -            329
Issuance on acquisition of
   Misty City Software Inc.        467,835         546               -             -             -           -            546
Redemption                     (12,537,230)     (5,836)           (715)            -             -      (8,067)       (14,618)
Class A Preferred Stock
   cumulative dividend                   -           -               -             -             -        (630)          (630)
Adjustment of Class A
   Preferred Stock to
   redemption value                      -           -               -             -             -      (1,135)        (1,135)
Employee option grants                   -           -              23           (23)            -           -              -
Amortization of deferred
   compensation expense                  -           -               -           149             -           -            149
Comprehensive income (loss)
   Accumulated other
      comprehensive income -
      foreign currency
      translation                        -           -               -             -           460           -
   Loss for the year                     -           -               -             -             -      (3,851)
Total comprehensive loss                 -           -               -             -             -           -         (3,391)
                               ------------------------------------------------------------------------------------------------

BALANCE - SEPTEMBER 30, 2000     7,028,348       4,399               -           (72)        1,558     (24,114)       (18,229)
Issuance of shares for cash        403,271         106               -             -             -           -            106
Repurchase of common shares         (1,215)         (1)              -             -             -           -             (1)
Class A Preferred Stock
   cumulative dividend                   -           -               -             -             -      (1,310)        (1,310)
Adjustment of Class A
   Preferred Stock to
   redemption value                      -           -               -             -             -      (1,598)        (1,598)
Amortization of deferred
   compensation expense                  -           -               -            63             -           -             63
Comprehensive income (loss)
   Accumulated other
      comprehensive income -
      foreign currency
      translation                        -           -               -             -           945           -
   Loss for the year                     -           -               -             -             -     (11,301)
Total comprehensive loss                 -           -               -             -             -           -        (10,356)
                               ------------------------------------------------------------------------------------------------

BALANCE - SEPTEMBER 30, 2001     7,430,404       4,504               -            (9)        2,503     (38,323)       (31,325)
                               ================================================================================================



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





CHANCERY SOFTWARE LTD.
Consolidated Statements of Cash Flows
FOR THE YEARS ENDED SEPTEMBER 30, 2001 AND 2000



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

(tabular amounts expressed in thousands of U.S. dollars)


                                                                                                 2001                   2000
                                                                                                    $                      $
                                                                                                             
CASH FLOWS USED IN OPERATING ACTIVITIES
Loss for the year                                                                              (11,301)               (3,851)
Adjustments to reconcile loss for the year to net cash used in
      operating activities
      Non-cash revenue                                                                               -                  (506)
      Depreciation                                                                                 900                   489
      Write-off of goodwill, intangible assets and capital assets                                2,146                     -
      Amortization of intangible assets                                                            683                   330
      Amortization of goodwill                                                                     749                   398
      Gain on sale of investment                                                                     -                  (945)
      Stock-based compensation                                                                      63                   149
      Foreign exchange gain                                                                     (1,037)                 (656)
      Deferred income taxes                                                                       (268)                  125
      Changes in operating working capital items
           Accounts receivable                                                                  (1,348)                  177
           Prepaid expenses and deposits                                                          (112)                 (202)
           Work-in-process                                                                         166                  (169)
           Inventory                                                                                23                   (16)
           Restricted cash                                                                        (412)                    -
           Long-term accounts receivable                                                            98                  (100)
           Accounts payable and accrued liabilities                                              1,776                  (437)
           Income taxes payable                                                                     24                    42
           Long-term accounts payable                                                               63                     -
           Unearned revenue                                                                        791                 1,041
                                                                                      -----------------------------------------
                                                                                                (6,996)               (4,131)
                                                                                      -----------------------------------------

CASH FLOWS USED IN INVESTING ACTIVITIES
Proceeds on sale of investment                                                                       -                   951
Purchase of Misty City Software Inc.                                                                 -                (1,225)
Cash acquired on acquisition of Misty City Software Inc.                                             -                   102
Purchase of property and equipment                                                              (1,439)               (1,582)
Purchase of intangible assets                                                                     (751)                 (236)
Purchase of short-term investments                                                                   -                (7,399)
Proceeds on sale of short-term investments                                                       7,246                     -
                                                                                      -----------------------------------------
                                                                                                 5,056                (9,389)
                                                                                      -----------------------------------------

CASH FLOWS USED IN FINANCING ACTIVITIES
Redemption of common shares                                                                         (1)              (14,618)
Issuance of common stock for cash                                                                  106                   329
Issuance of Redeemable Convertible Preferred Stock for cash                                          -                31,574
Repayment of note payable                                                                         (500)                 (500)
                                                                                      -----------------------------------------
                                                                                                  (395)               16,785
                                                                                      -----------------------------------------
FOREIGN EXCHANGE EFFECT ON CASH                                                                    591                   466
                                                                                      -----------------------------------------
(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                                                (1,744)                3,731
CASH AND CASH EQUIVALENTS - BEGINNING OF YEAR                                                    6,311                 2,580
                                                                                      -----------------------------------------
CASH AND CASH EQUIVALENTS - END OF YEAR                                                          4,567                 6,311
                                                                                      =========================================


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





CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


1     NATURE OF OPERATIONS

      Chancery Software Ltd. (the company) is incorporated under the laws of
      British Columbia, Canada. The company develops, markets, and sells Student
      Management Solutions software primarily to schools and school districts in
      the K-12 market.


2     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

      PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION

      These financial statements consolidate the accounts of the company and its
      wholly owned subsidiaries. All significant intercompany balances and
      transactions have been eliminated on consolidation.

      USE OF ESTIMATES

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

      FOREIGN CURRENCY TRANSLATION AND TRANSACTIONS

      The company has adopted the U.S. dollar as its reporting currency. The
      functional currency of the company's operations located outside the U.S.
      is the Canadian currency. The consolidated financial statements are
      translated to U.S. dollars using the period-end exchange rate for assets
      and liabilities and weighted-average exchange rates for the period for
      revenues and expenses. Translation gains and losses are deferred and
      accumulated as a component of other comprehensive income in shareholders'
      equity. Net gains and losses resulting from foreign exchange transactions
      are included in the consolidated statement of operations.

      CASH AND CASH EQUIVALENTS

      Cash and cash equivalents consists of cash on deposit and highly liquid
      short-term interest bearing securities with maturity at the date of
      acquisition of three months or less.

      SHORT-TERM INVESTMENTS

      Short-term investments consist of highly liquid short-term interest
      bearing securities with maturities at the date of acquisition greater than
      three months. Interest earned is recognized immediately in the
      consolidated statement of operations.


                                                                             (1)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      FAIR VALUE OF FINANCIAL INSTRUMENTS

      The company's financial instruments, consisting of cash and cash
      equivalents, accounts receivable, and accounts payable and accrued
      liabilities are carried at cost, which approximates their fair value due
      to the short-term maturity of these instruments.

      INVENTORY

      Inventory consists of finished product and raw materials for the company's
      products. Inventory is valued at the lower of cost, determined on the
      first-in first-out basis, and net realizable value.

      PROPERTY AND EQUIPMENT

      Property and equipment are stated at historical cost. Depreciation and
      amortization are computed using the straight-line method over the
      estimated useful lives of the assets, generally five years or less.

      INTANGIBLE ASSETS

      Goodwill and other intangible assets resulting from the acquisition of
      Misty City Software Inc. (Misty City) were estimated by management to be
      primarily associated with the intellectual property of Misty City's core
      product and to the acquired customer list. As a result of the rapid
      technological changes occurring in the software industry, goodwill and
      other intangible assets are amortized on a straight-line basis over 36
      months, being the estimated periods of benefit. See note 6 - Acquisition.

      Acquired computer software, including third party installation charges, is
      recorded at cost and is amortized on a straight-line basis over 36 months.

      INTANGIBLE ASSETS - WEB SITE DEVELOPMENT COSTS

      The company accounts for web site development costs in accordance with
      Emerging Issues Task Force Abstract (EITF) No. 00-02, "Accounting for Web
      Site Development Costs". EITF No. 00-02 requires the capitalization of
      certain web site development costs incurred in the production and building
      of a web site for quarters beginning after June 30, 2000. Costs related to
      planning and web site maintenance are expensed as incurred. Amounts
      capitalized are capitalized in accordance with AICPA Statement of Position
      (SOP) 98-1, "Accounting for the Costs of Computer Software Developed or
      Obtained for Internal Use". Prior to June 30, 2000, the company expensed
      all web site development costs as part of research and development
      expenses. Web site development costs are amortized on a straight-line
      basis over 36 months, being the estimated period of benefit.

      IMPAIRMENT OF LONG-LIVED ASSETS

      The company evaluates the recoverability of long-lived assets in
      accordance with Statement of Financial Accounting Standards (SFAS) No.
      121, "Accounting for the Impairment of Long-Lived Assets and for
      Long-Lived Assets to be Disposed of". SFAS No. 121 requires recognition of
      impairment of long-lived assets in the event the net book value of such
      assets exceeds the future undiscounted cash flows attributable to such
      assets.


                                                                             (2)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      REVENUE RECOGNITION

      Revenues are recognized in accordance with AICPA SOP 97-2, "Software
      Revenue Recognition". The company generally sells product with multiple
      elements, including software, post-contract customer support,
      implementation consulting, and training. For these transactions, the
      company recognizes revenue for delivered elements upon delivery, when the
      company's fee is fixed and determinable, collection is probable and
      persuasive evidence of an arrangement exists. The fair value of the
      undelivered elements, based on vendor-specific objective evidence, is
      deferred and recognized as revenue upon the ultimate delivery of such
      elements.

      The company also sells post-contract customer support and consulting
      services. For post-contract customer support, the company recognizes
      revenue rateably over the period, when the company's fee is fixed and
      determinable and collection is probable. For consulting services, the
      company recognizes revenue as services are performed, when the company's
      fee is fixed and determinable and collection is probable.

      Revenue from a contract to develop state specific reporting templates has
      been accounted for on the completed contract basis. Direct costs of the
      contract are included in work-in-process at the lower of cost and net
      realizable value. Provision is made for all anticipated losses as soon as
      they become evident.

      RESEARCH AND DEVELOPMENT

      Research and development costs include expenses incurred by the company to
      develop, enhance, and manage the company's suite of software products, as
      well as to enhance, manage, monitor, and operate the company's various web
      sites. Research and development costs are expensed as incurred.

      STOCK-BASED COMPENSATION

      The company accounts for stock-based employee compensation arrangements in
      accordance with the provisions of Accounting Principles Board (APB)
      Opinion No. 25, "Accounting for Stock Issued to Employees", the Financial
      Accounting Standards Board (FASB) Interpretation (FIN) No. 44 "Accounting
      for Certain Transactions Involving Stock Compensation on interpretation of
      APB No. 25", and complies with the disclosure provisions of SFAS No. 123,
      "Accounting for Stock-Based Compensation". Under APB No. 25, compensation
      expense is based on the difference, if any, on the date of the grant,
      between the estimated fair value of the company's stock and the exercise
      price. Compensation expense is recognized immediately for past services
      and rateably for future services over the option vesting period. The
      company accounts for stock issued to non-employees in accordance with the
      provisions of SFAS No. 123 and EITF 96-18.

      INCOME TAXES

      Income taxes are accounted for using an asset and liability approach,
      which requires the recognition of taxes payable or refundable for the
      current year and deferred tax liabilities and assets for the future tax
      consequences of events that have been recognized in the company's
      consolidated financial statements or tax returns. The measurement of the
      current and deferred tax liabilities and assets are based on the
      provisions of enacted tax law; the effects of future changes in tax laws
      or rates are not anticipated. The measurement of deferred tax assets is
      reduced, if necessary, by a valuation allowance where, based on available
      evidence, the probability of realization of the deferred tax asset does
      not meet a more likely than not criteria.


                                                                             (3)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      INVESTMENT TAX CREDITS

      Prior to the completion of a financing in March 2000, the company was a
      Canadian Controlled Private Corporation (CCPC). A CCPC is entitled to an
      investment tax credit at a rate of 35% of the first $2 million (20% on
      amounts in excess of $2 million) of eligible current research and
      development expenditures. Investment tax credits on current expenditures
      earned at the 35% rate are fully refundable in cash to the company upon
      filing a claim and having it approved by taxation authorities. Current
      investment tax credits earned on capital expenditures at a rate of 35% and
      on excess current expenditures at a rate of 20% are refundable in cash at
      a rate of 40% of the amount of the credit. The non-refundable investment
      tax credit component can be applied against future income taxes payable.

      Non-CCPC corporations are entitled to investment tax credits at a rate of
      20%, with no refundable cash components available, on both current and
      capital expenditures.

      On March 30, 2000, the company lost its CCPC status as a result of the
      issuance of Redeemable Convertible Preferred Stock. Accordingly, the
      company is not entitled to the refundable component of investment tax
      credits for the years ending September 30, 2001 and 2000.

      The refundable and non-refundable portion of investment tax credits are
      accounted for as a reduction of the related expenditure for items of a
      current expense nature and a reduction of the related assets for items of
      a long-term nature, when the company has reasonable assurance that the
      credit will be realized.

      COMPREHENSIVE INCOME

      The company accounts for comprehensive income in accordance with SFAS No.
      130, "Reporting Comprehensive Income". Comprehensive income, as defined,
      includes all changes in equity (net assets) during a period from non-owner
      sources. The company's comprehensive income consists of foreign currency
      translation adjustments and net income.

      RECENT ACCOUNTING PRONOUNCEMENTS

      In June 1998, the FASB issued Statement No. 133 "Accounting for Derivative
      Instruments and Hedging Activities" (SFAS No. 133). SFAS No. 133
      establishes accounting and reporting standards for derivative instruments,
      embedded in other contracts, and for hedging activities. It requires that
      an entity recognize all derivatives as either assets or liabilities in the
      statement of financial position and measure those instruments at fair
      value. The accounting for changes in fair value of the derivative depends
      on the intended use of the derivative and the resulting designation. The
      company does not expect that the adoption of SFAS No. 133 will have a
      material impact on its consolidated financial position or results of
      operations, as it does not use financial derivative instruments.

      In July 2001, the FASB issued SFAS No. 141, "Business Combinations", and
      SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS No. 141
      requires that the purchase method of accounting be used for all business
      combinations subsequent to June 30, 2001 and specifies criteria for
      recognizing intangible assets acquired in a business combination. SFAS No.
      142 requires that goodwill and intangible assets with indefinite useful
      lives no longer be amortized, but instead be tested for impairment at
      least annually. Intangible assets with definite useful lives will continue
      to be amortized over their respective estimated useful lives. The


                                                                             (4)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)

      company does not expect that the implementation of these guidelines will
      have a material impact on its consolidated financial position or results
      of operations.

      In August 2001, the FASB issued SFAS No. 143, "Accounting for Asset
      Retirement Obligations". SFAS No. 143 requires that asset retirement
      obligations be recognized when they are incurred, and be capitalized as
      part of the asset's carrying value and displayed as liabilities. SFAS No.
      143 also requires increased disclosure surrounding asset retirement
      obligations. SFAS No. 143 is effective for fiscal years beginning after
      June 15, 2002. The company does not expect that the implementation of
      these guidelines will have a material impact on its consolidated financial
      position or results of operations.

      In October 2001, the FASB issued SFAS No. 144, "Accounting for the
      Impairment or Disposal of Long-Lived Assets". SFAS No. 144 requires that
      long-lived assets be classified as assets either to be held and used, to
      be disposed of other than by sale, or to be disposed of by sale. It also
      prescribes various approaches to valuing these types of long-lived assets.
      SFAS No. 144 is effective for fiscal years beginning after December 15,
      2001. The company does not expect that the implementation of these
      guidelines will have a material impact on its consolidated financial
      position or results of operations.


3     SUPPLEMENTAL CASH FLOW INFORMATION




                                                                                                  2001                   2000
                                                                                                     $                      $
                                                                                                              
      Cash paid for income taxes                                                                     5                     -
      Cash paid for interest                                                                        47                    35

      NON-CASH INVESTING AND FINANCING ACTIVITIES
      Issuance of promissory note on purchase of Misty City                                          -                 1,000
      Issuance of common stock on purchase of Misty City                                             -                   546




                                                                             (5)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


4     BALANCE SHEET COMPONENTS



                                                                                                  2001                  2000
                                                                                                     $                     $
                                                                                                              
      Accounts receivable
           Trade accounts receivable                                                             4,332                 2,738
           Other                                                                                    28                   292
           Less:  Allowance for doubtful accounts                                                 (101)                  (74)
                                                                                      -----------------------------------------

                                                                                                 4,259                 2,956
                                                                                      =========================================
      Property and equipment
           Computer equipment                                                                    3,315                 2,636
           Furniture and fixtures                                                                1,348                 1,024
           Leasehold improvements                                                                  392                   341
           Capital lease equipment                                                                 438                   445
                                                                                      -----------------------------------------

                                                                                                 5,493                 4,446
           Less:  Accumulated depreciation                                                      (3,350)               (2,642)
                                                                                      -----------------------------------------

                                                                                                 2,143                 1,804
                                                                                      =========================================
      Intangible assets
           Computer software acquired                                                            1,148                   667
           Website development                                                                       -                   160
           Acquired technology                                                                       -                   842
           Acquired customer list                                                                    -                   123
           Human capital                                                                             -                    30
                                                                                      -----------------------------------------
                                                                                                 1,148                 1,822
           Less:  Accumulated amortization                                                        (594)                 (514)
                                                                                      -----------------------------------------
                                                                                                   554                 1,308
                                                                                      =========================================



      During 2001, the company's revenues from the key product of Misty City did
      not meet expectations, and the company therefore adjusted its future
      estimates with regard to this product. As a result, the company also
      assessed the carrying value of the intangible assets and goodwill which
      arose on the acquisition of Misty City. The company determined that the
      undiscounted expected future cash flows from the sales of the product were
      less than the carrying value of these intangible assets.

      As a result, the company has determined the fair value, based on
      discounted expected future cash flows, of the intangible assets and
      goodwill to be $nil. Accordingly, the company has written off the
      remaining carrying value of the goodwill, acquired technology, and
      customer list as at September 30, 2001, which amounted to $1,242,000,
      $421,000, and $61,000, respectively.


                                                                             (6)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)

      During 2001, the company determined that the costs incurred to develop one
      of its web sites no longer met the criteria for capitalization and, as a
      result, the company wrote off its unamortized web site development costs
      in the amount of $422,000.



                                                                                                  2001                  2000
                                                                                                     $                     $
                                                                                                             
      Accounts payable and accrued liabilities
           Trade                                                                                 1,336                   884
           Accrued sales and marketing                                                             289                   180
           Accrued compensation and related benefits                                               553                   683
           Other accrued liabilities                                                             1,667                   413
                                                                                      -----------------------------------------
                                                                                                 3,845                 2,160
                                                                                      =========================================


5     RESTRICTED CASH

      The company maintains a restricted deposit totalling $400,000 as a form of
      security over payroll payments.


6     ACQUISITION OF MISTY CITY SOFTWARE INC.

      On April 6, 2000, the company acquired 100% of the common stock of Misty
      City, which develops, markets, and sells software aimed at the educational
      industry. The agreement stated a purchase price of $3,000,000 consisting
      of 467,835 shares of the company stock, a note payable for $1,000,000 and
      cash of $1,200,000. Under APB No. 16, the shares have been valued at the
      announcement date which resulted in the common stock being recorded at
      $546,000. The acquisition has been accounted for using the purchase method
      of accounting and accordingly, the purchase price of $2,771,000, including
      related expenses of approximately $25,000, consisting primarily of legal
      and other professional service fees, has been allocated to the tangible
      and intangible assets acquired and liabilities assumed on the basis of
      their respective fair values on the acquisition date.

      The purchase price was allocated to net tangible liabilities assumed
      ($471,000) and intangible assets, including completed technology
      ($842,000), customer list ($123,000), human capital ($31,000), and
      goodwill ($2,246,000). The intangible assets are being amortized over
      their estimated useful lives of 36 months.

      As at September 30, 2000, $500,000 of the note payable was outstanding
      with the remaining instalments of $250,000 were paid on December 31, 2000
      and March 31, 2001 with interest at 6% per annum.


                                                                             (7)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)



7     INCOME TAXES

      INCOME BEFORE INCOME TAXES

      Income before income taxes was generated by both domestic and U.S.
      operations during 2001 and 2000.

      The components of income before equity income, income taxes and minority
      interest are as follows:



                                                                                                  2001                   2000
                                                                                                     $                      $
                                                                                                           
           Canadian                                                                             (9,067)               (3,996)
           U.S.                                                                                 (2,457)                  312
                                                                                      -----------------------------------------
                                                                                               (11,524)               (3,684)
                                                                                      =========================================



      CURRENT INCOME TAXES

      The provision for current income taxes consists of the following:



                                                                                                  2001                  2000
                                                                                                     $                     $
                                                                                                               
           Current
                Canadian                                                                             -                    17
                U.S. federal                                                                        45                    25
                                                                                      -----------------------------------------
                                                                                                    45                    42
           Deferred
                U.S. federal                                                                      (268)                  125
                                                                                      -----------------------------------------
                                                                                                  (223)                  167
                                                                                      =========================================



                                                                             (8)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      The provision for income taxes differs from the amount computed by
      applying the statutory income tax rate to net income before taxes as
      follows:



                                                                                                  2001                  2000
                                                                                                     %                     %
                                                                                                            
           Canadian statutory rate                                                              (44.62)               (45.62)
           Change in valuation allowance                                                         35.66                 47.93
           Foreign tax at other than Canadian statutory rate                                     (0.40)                (1.98)
           Non-deductible expenses                                                                4.14                  7.62
           Non-taxable income                                                                        -                 (3.88)
           Write-off of goodwill                                                                  4.90                     -
           Other                                                                                 (1.62)                 0.46
                                                                                      -----------------------------------------
                                                                                                 (1.94)                 4.53
                                                                                      =========================================


      DEFERRED INCOME TAXES

      Significant components of the company's deferred tax assets and
liabilities are as follows:



                                                                                                  2001                  2000
                                                                                                     $                     $
                                                                                                            
           Deferred tax assets
                Capital and intangible assets                                                      941                   479
                Other                                                                              326                   199
                Tax losses carryforward                                                          5,184                 1,259
                Scientific research and experimental development expenditures
                      carried forward                                                              655                   792
                                                                                      -----------------------------------------
                                                                                                 7,106                 2,729
                Valuation allowance                                                             (7,106)               (2,997)
                                                                                      -----------------------------------------
           Net deferred tax liability                                                                -                  (268)
                                                                                      =========================================


      Management believes that, based on a number of factors, it is more likely
      than not that the deferred tax assets will not be utilized. Accordingly, a
      valuation allowance for the full amount of the deferred tax assets has
      been recorded.

      The company has non-capital losses of approximately $11,619,000, and
      scientific research and experimental development (SR&ED) expenditures of
      approximately $1,468,000, which are available for carryforward against
      taxable income earned in Canada in future years.


                                                                             (9)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      The SR&ED expenditures carry forward indefinitely, and non-capital losses
       expire as follows:



                                                                                                    $
                                                                                    
           2002                                                                                    838
           2003                                                                                    171
           2007                                                                                  3,488
           2008                                                                                  7,122
                                                                                      ------------------
                                                                                                11,619
                                                                                      ==================



8     MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK

      On March 15, 2000, the company cancelled its previously authorized Class
      A, B, C, and D Preferred Stock. None of this stock was issued and
      outstanding at the date of cancellation.

      On March 15, 2000, the company authorized 100,000,000 shares of Class A
      Voting Mandatorily Redeemable Convertible Preferred Stock.

      CLASS A MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK

      On March 30, 2000, the company issued 4,667,419 shares of its Class A
      Mandatorily Redeemable Convertible Preferred Stock (Class A Preferred
      Stock) for $31,900,000.

      The Class A Preferred Stock entitles holders to a 4% cumulative stock
      and/or cash dividend accruing from the date of issuance. Holders of the
      Class A Preferred Stock are entitled to the number of votes equal to the
      number of common shares into which the Class A Preferred Stock could be
      converted at the time of the vote, and vote on an equal basis with holders
      of the company's common stock, together as a single class. The Class A
      Preferred Stock ranks senior to all classes of capital stock upon
      liquidation, dissolution, and wind-up, and ranks junior in right of
      payment of all indebtedness of the company and its subsidiaries.

      The Class A Preferred Stock has a mandatory redemption on the earlier of
      March 31, 2005, liquidation, dissolution, or wind-up of the company,
      change in control of the company, a sale of substantially all the assets
      of the company, bankruptcy of the company, or any material breach of the
      terms and conditions surrounding the Class A Preferred Stock. The Class A
      Preferred Stock is redeemable at a liquidation value of the greater of (a)
      $6.82 per share plus all accrued but unpaid cumulative dividends thereon,
      or (b) the fair market value of the Preferred Stock, on an after
      conversion basis, based upon the number of shares of common stock the
      Class A Preferred Stock is convertible into and the market price, as
      determined by a published market (if one exists), of the common stock. At
      the option of the company, any accrued but unpaid cumulative dividends may
      be settled by issuance of additional Class A Preferred Stock, the number
      of shares to be determined by dividing the accrued but unpaid cumulative
      dividends by $6.82.

      Upon a qualified underwritten initial public offering, each share of the
      Class A Preferred Stock will be converted into common stock of the company
      at a ratio of five for one. A qualified underwritten initial public
      offering is one in which net proceeds to the company are at least $40
      million, occurs prior to March 31, 2005, and occurs at a price not less
      than four times the initial issue price of the Class A Preferred Stock,
      which was


                                                                            (10)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      $6.82. If the underwritten initial public offering occurs prior to
      March 31, 2001, the price need only be two times the initial issue
      price, and if prior to September 30, 2001, the price need only be three
      times the initial issue price, in order to be qualified.

      The Class A Preferred Stock may be converted by the holders into common
      stock at any time, at a ratio of five for one. At the option of the
      company, any accrued but unpaid cumulative dividends may be settled by
      issuance of additional Class A Preferred Stock, the number of shares to be
      determined by dividing the accrued but unpaid cumulative dividends by
      $6.82. In addition, the holders of the Class A Preferred Stock have
      anti-dilution protection.


9     CAPITAL STOCK

      SHARE CAPITAL TRANSACTIONS

      On March 30, 2000, 12,537,230 shares of common stock were redeemed for
      $14,618,000. The redemption has been recorded as a reduction in common
      stock of $5,836,000, a reduction in additional paid-in capital of $715,000
      and a charge to deficit of $8,067,000.

      On April 6, 2000, in connection with the acquisition of Misty City, the
      company issued 467,835 shares of common stock. The issuance was recorded
      at $546,000, being the estimated fair value of the shares of common stock
      at the date of acquisition.

      On June 29, 2000, the board of directors approved a five-for-one share
      split of the company's common stock. All share amounts have been presented
      on a post stock split basis.

      During 2001, the company issued 403,271 shares of common stock to
      employees of the company, substantially pursuant to employee stock option
      exercises. Total proceeds of these transactions was $106,000. In addition,
      the company repurchased 1,215 shares of common stock from various
      employees for $1,000.


10    STOCK-BASED COMPENSATION

      STOCK OPTION PLAN

      In December 1998, the company's board of directors adopted the Stock
      Option Plan (the Plan) and reserved 10,000,000 shares of common stock for
      issuance thereunder. The Plan provides for the granting of stock options
      to Eligible Persons (defined as directors, officers, employees, or
      consultants of the company or any of its subsidiaries). No person shall be
      eligible to receive more than 5% of the total number of outstanding common
      shares at the date of the grant.

      Terms and conditions of options granted under the Plan are determined
      solely by the Compensation Committee (the Committee) of the board of
      directors, however, generally are granted for periods not exceeding eight
      years at prices equal to the fair value of the shares on the date of grant
      as determined by the Committee. Exercise prices for the company's stock
      options are fixed in Canadian dollars.


                                                                            (11)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      Options under the Plan are not immediately exercisable and generally vest
      over a period of 36 months. The vesting schedule for each grant is
      determined by the Committee.

      The following table summarizes activity under the company's stock option
      plan for the years ended September 30, 2001 and 2000:



                                                                          2001                                          2000
                                        -----------------------------------------     -----------------------------------------
                                                                      WEIGHTED                                      WEIGHTED
                                                                       AVERAGE                 SHARES                AVERAGE
                                                                EXERCISE PRICE                                EXERCISE PRICE
                                                  SHARES                  CDN$                                          CDN$
                                                                                         (as restated)          (as restated)
                                                                                                
           STOCK OPTIONS
           Outstanding -
              Beginning of year                7,984,838                   1.41              4,670,905                  0.56
                Granted                          743,957                   2.50              3,783,532                  2.37
                Exercised                       (377,744)                  0.41               (234,700)                 0.41
                Forfeited                     (1,169,867)                  1.42               (234,899)                 0.88
                Expired                                -                      -                      -                     -
                                        -------------------                           ------------------
           Outstanding -
              End of year                      7,181,184                   1.50              7,984,838                  1.41
                                       ====================                           ==================
           Exercisable -
              September 30                     4,743,165                                     3,159,825
                                       ====================                           ==================

           Weighted average fair
              value of options
              granted during the
              year                                                         0.02                                         0.08


      For the year ended September 30, 2000, the number of shares granted and
      cancelled and the weighted average exercise price amounts have been
      restated. There was no financial statement impact for these changes.

      The following table summarizes information about fixed stock options
      outstanding and exercisable at September 30, 2001:



                                                                               OPTIONS OUTSTANDING        OPTIONS EXERCISABLE
                      ------------------------------------------------------------------------------    -----------------------
                                   EXERCISE                                              REMAINING
                                      PRICE                      NUMBER           CONTRACTUAL LIFE                     NUMBER
                                       CDN$                 OUTSTANDING                    (YEARS)                EXERCISABLE
                                                                                               
                                       0.53                   3,209,372                        5.2                  2,985,101
                                       1.00                     547,000                        6.0                    359,819
                                       2.50                   3,424,812                        6.8                  1,398,245
                      ---------------------------------------------------------------------------------------------------------
                                       1.50                   7,181,184                        6.1                  4,743,165
                      =========================================================================================================



                                                                            (12)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)


      FAIR VALUE DISCLOSURES

      The company calculated the minimum fair value of each option grant on the
      date of grant using the Black-Scholes option pricing model as prescribed
      by SFAS No. 123 using the following assumptions:



                                                                                                  2001                  2000
                                                                                                     %                     %
                                                                                                                
           Risk-free interest rate                                                                 4.6                   6.3
           Expected lives (in years)                                                               3.0                   3.0
           Dividend yield                                                                          0.0                   0.0
           Expected volatility                                                                     0.0                   0.0



      The fair value of each option grant was determined using the minimum value
      method. The effect of compensation cost on net income and loss per share
      for the years ended September 30, 2001 and 2000 is as follows:



                                                                                                  2001                  2000
                                                                                                     $                     $
                                                                                                                
           Loss
                As reported                                                                    (11,301)               (3,851)
                Pro forma                                                                      (11,338)               (3,927)



      UNEARNED STOCK-BASED COMPENSATION

      In connection with certain stock option grants during the years ended
      September 30, 2001 and 2000, the company unearned compensation totalling
      $nil and $23,000, respectively, which is being amortized over the three
      year vesting periods of the related options. Amortization expense
      recognized during the years ended September 30, 2001 and 2000 totalled
      approximately $63,000 and $149,000, respectively.


                                                                            (13)



CHANCERY SOFTWARE LTD.
Notes to Consolidated Financial Statements
SEPTEMBER 30, 2001 AND 2000
- --------------------------------------------------------------------------------

(tabular amounts expressed in thousands of U.S. dollars)

11    CONCENTRATION OF CREDIT RISK

      Financial instruments that potentially subject the company to a
      significant concentration of credit risk consist mainly of cash and cash
      equivalents and accounts receivable. The company limits its exposure to
      credit loss by placing its cash and cash equivalents with high credit,
      quality financial institutions.

      Concentration of credit risk with respect to accounts receivable is
      considered to be limited due to the credit quality of the customers
      comprising the company's customer base. The company's customer base
      consists primarily of government-funded organizations including schools,
      school districts, and state and provincial governments. The company
      performs ongoing credit evaluations of the financial condition of those
      customers not represented by this customer base, in order to determine the
      need for an allowance for doubtful accounts. The company maintains an
      allowance for doubtful accounts receivable based upon the expected
      collectibility of accounts receivable. The company has not experienced any
      significant credit losses to date.


12    COMMITMENTS

      The company leases certain facilities and equipment used in its operations
      under operating leases. Future minimum lease payments under these lease
      agreements at September 30, 2001 are as follows:



                                                                                                    $
                                                                                          
           2002                                                                                  1,132
           2003                                                                                    639
           2004                                                                                    394
           2005                                                                                    374
           2006                                                                                    312



                                                                            (14)

EX-99.2

                                                                    Exhibit 99.2

FINANCIAL STATEMENTS

HigherMarkets, Inc. (a development stage company)
For the year ended December 31, 2001, for the period from
February 15, 2000 (inception) through December 31, 2000 and for the period from
February 15, 2000 (inception) through December 31, 2001 with Report of
Independent Auditors



                               HigherMarkets, Inc.
                          (a development stage company)

                              Financial Statements

            For the year ended December 31, 2001, for the period from
 February 15, 2000 (inception) through December 31, 2000 and for the period from
             February 15, 2000 (inception) through December 31, 2001

                                    CONTENTS
                                                                            
Report of Independent Auditors.................................................1

Audited Financial Statements

Balance Sheets.................................................................2
Statements of Operations.......................................................3
Statements of Redeemable Convertible Preferred Stock and Stockholders' Deficit.4
Statements of Cash Flows.......................................................6
Notes to Financial Statements..................................................8





                         Report of Independent Auditors

The Board of Directors and Stockholders
 HigherMarkets, Inc.

We have audited the accompanying balance sheets of HigherMarkets, Inc. (a
development stage company) as of December 31, 2001 and 2000 and the related
statements of operations, redeemable convertible preferred stock and
stockholders' deficit, and cash flows for the year ended December 31, 2001, for
the period from February 15, 2000 (inception) through December 31, 2000 and for
the period from February 15, 2000 (inception) through December 31, 2001. 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 auditing standards generally accepted
in the 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 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 HigherMarkets, Inc. at December
31, 2001 and 2000, and the results of its operations and its cash flows for the
year ended December 31, 2001, for the period from February 15, 2000 (inception)
through December 31, 2000 and for the period from February 15, 2000 (inception)
through December 31, 2001, in conformity with generally accepted accounting
principles in the United States.

The accompanying financial statements have been prepared assuming that
HigherMarkets will continue as a going concern. As more fully described in Note
1, the Company has incurred operating losses since inception. This condition
raises substantial doubt about the Company's ability to continue as a going
concern. The financial statements do not include any adjustments to reflect the
possible future effects on the recoverability and classification of assets or
the amounts and classification of liabilities that may result from the outcome
of this uncertainty.

/s/ Ernst & Young LLP

February 1, 2002

                                                                               1


                               HigherMarkets, Inc.
                          (a development stage company)

                                 Balance Sheets



                                                                                         DECEMBER 31,
                                                                                    2001               2000
                                                                                -------------------------------
                                                                                          
ASSETS
Current assets:
  Cash                                                                          $   1,397,851   $    7,686,139
  Restricted cash                                                                           -          507,422
  Restricted short-term investments                                                    40,919           39,074
  Prepaid expenses and other current assets                                            59,733          122,029
                                                                                ------------------------------
Total current assets                                                                1,498,503        8,354,664

Property and equipment, net                                                         1,791,428        2,956,408
Restricted certificate of deposit                                                     471,953          469,942
Other assets                                                                           96,182           24,406
                                                                                ------------------------------
Total assets                                                                    $   3,858,066   $   11,805,420
                                                                                ==============================

LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
  Accounts payable                                                              $     255,500   $    1,323,250
  Accrued expenses                                                                     34,512           40,492
  Accrued rent                                                                        151,808                -
  Due to related party                                                                160,409          160,409
  Capital lease obligations, current portion                                           41,094           93,862
                                                                                ------------------------------
Total current liabilities                                                             643,323        1,618,013

Capital lease obligations                                                                   -           41,094
Accrued rent                                                                          468,076                -
Deferred rent                                                                          26,372                -

Redeemable convertible Series B preferred stock, $0.001 par value,
  liquidation preference of $41,408,778 at December 31, 2001 and
  $41,514,002 at December 31, 2000:
    Authorized shares - 11,440,323
    Issued and outstanding shares - 11,131,392 at December 31, 2001
      and 11,159,678 at December 31, 2000                                          15,254,758       14,182,793

Stockholders' deficit:
  Series A preferred stock, $0.001 par value, liquidation preference of
  $1,400,001 at December 31, 2001and 2000:
    Authorized shares - 4,839,746
    Issued and outstanding shares - 3,589,746 at December 31, 2001
      and 2000                                                                          3,590            3,590
  Common stock, $0.001 par value:
    Authorized shares - 27,250,000
    Issued and outstanding shares - 7,242,606 at December 31,
      2001 and 7,324,500 at December 31, 2000                                           7,243            7,325
  Additional paid-in capital                                                        1,674,323        1,506,137
  Deferred compensation                                                                (5,375)          (6,650)
  Deficit accumulated during the development stage                                (14,214,244)      (5,546,882)
                                                                                ------------------------------
Total stockholders' deficit                                                       (12,534,463)      (4,036,480)
                                                                                ------------------------------
Total liabilities and stockholders' deficit                                     $   3,858,066   $   11,805,420
                                                                                ==============================


SEE ACCOMPANYING NOTES.

                                                                               2


                               HigherMarkets, Inc.
                          (a development stage company)

                            Statements of Operations



                                                                     PERIOD FROM          PERIOD FROM
                                                                     FEBRUARY 15,         FEBRUARY 15,
                                                                        2000                 2000
                                                                     (INCEPTION)          (INCEPTION)
                                               YEAR ENDED              THROUGH              THROUGH
                                                DECEMBER             DECEMBER 31,          DECEMBER 31,
                                                  2001                  2000                  2001
                                            ------------------------------------------------------------
                                                                              
Operating expenses:
  Product development                       $       2,895,384      $     2,134,929     $       5,030,313
  General and administrative                        2,118,153            2,153,249             4,271,402
  Sales and marketing                               1,709,763              702,436             2,412,199
  Depreciation and amortization                     1,606,144               94,551             1,700,695
                                            ------------------------------------------------------------
Total operating expenses                            8,329,444            5,085,165            13,414,609

Other income and (expense):
  Interest income                                     227,210              112,448               339,658
  Other income                                        581,914                    -               581,914
  Interest and other expense                          (40,002)            (297,405)             (337,407)
                                            ------------------------------------------------------------
Net other                                             769,122             (184,957)              584,165
                                            ------------------------------------------------------------
Net loss                                    $      (7,560,322)     $    (5,270,122)    $     (12,830,444)
                                            ============================================================


SEE ACCOMPANYING NOTES.

                                                                               3


                               HigherMarkets, Inc.
                          (a development stage company)

 Statements of Redeemable Convertible Preferred Stock and Stockholders' Deficit

       Year ended December 31, 2001 and the period from February 15, 2000
                     (inception) through December 31, 2000



                                                                                         STOCKHOLDERS' DEFICIT
                                                                        ------------------------------------------------------------
                                          REDEEMABLE CONVERTIBLE               CONVERTIBLE
                                         PREFERRED STOCK SERIES B        PREFERRED STOCK SERIES A          COMMON STOCK
                                      ----------------------------------------------------------------------------------------------
                                         SHARES           AMOUNT           SHARES        AMOUNT          SHARES        AMOUNT
                                      ----------------------------------------------------------------------------------------------
                                                                                                    
Issuance of common stock to
   founders and investor for cash,
   net of issuance costs of $4,020                    -    $         -             -     $         -    6,174,500     $     6,175
Issuance of Series A preferred
   stock, net of issuance costs of
   $25,464                                            -              -     3,589,746           3,590            -               -
Issuance of common stock to
   employee for cash                                  -              -             -               -    1,150,000           1,150
Repurchase of common stock from
   founder for cash, net of
   compensation expense                               -              -             -               -     (375,000)           (375)
Issuance of common stock to
   employee for cash                                  -              -             -               -      375,000             375
Issuance of warrants to purchase
   Series B redeemable convertible
   preferred stock in conjunction
   with issuance of convertible
   notes payable                                      -        291,000             -               -            -               -
Issuance of Series B redeemable
   convertible preferred stock for
   cash and conversion of convertible
   note payable and related accrued
   interest, net of issuance costs
   of $222,968                               11,159,678     13,615,033             -               -            -               -


                                                                    STOCKHOLDERS' DEFICIT
                                             ---------------------------------------------------------------
                                                                                 DEFICIT
                                                                               ACCUMULATED
                                              ADDITIONAL                        DURING THE        TOTAL
                                               PAID-IN            DEFERRED     DEVELOPMENT    STOCKHOLDERS'
                                               CAPITAL          COMPENSATION      STAGE         DEFICIT
                                             --------------------------------------------------------------
                                                                                  
Issuance of common stock to
   founders and investor for cash,
   net of issuance costs of $4,020           $     (4,020)      $          -   $          -   $       2,155
Issuance of Series A preferred
   stock, net of issuance costs of
   $25,464                                      1,370,947                  -              -       1,374,537
Issuance of common stock to
   employee for cash                               90,850                  -              -          92,000
Repurchase of common stock from
   founder for cash, net of
   compensation expense                           (32,915)                 -              -         (33,290)
Issuance of common stock to
   employee for cash                               74,625                  -              -          75,000
Issuance of warrants to purchase
   Series B redeemable convertible
   preferred stock in conjunction
   with issuance of convertible
   notes payable                                        -                  -              -               -
Issuance of Series B redeemable convertible
preferred stock for cash and
   conversion of convertible note payable
and related accrued interest, net of
   issuance costs of $222,968                           -                  -              -               -


                                                                               4


                               HigherMarkets, Inc.
                          (a development stage company)

 Statements of Redeemable Convertible Preferred Stock and Stockholders' Deficit
                                   (continued)

       Year ended December 31, 2001 and the period from February 15, 2000
                     (inception) through December 31, 2000



                                                                                            STOCKHOLDERS' DEFICIT
                                                                  ------------------------------------------------------------------
                                            REDEEMABLE CONVERTIBLE           CONVERTIBLE
                                            PREFERRED STOCK SERIES B    PREFERRED STOCK SERIES A          COMMON STOCK
                                            ----------------------------------------------------------------------------------------
                                               SHARES        AMOUNT        SHARES        AMOUNT        SHARES         STAGE
                                            ----------------------------------------------------------------------------------------
                                                                                                    
Issuance of common stock warrants
   in connection with office lease                    -   $          -             -     $         -            -     $         -
Dividend accrual in conjunction
   with Series B redeemable
   convertible preferred stock                        -        276,760             -               -            -               -
Net loss and comprehensive loss                       -              -             -               -            -               -
                                             ---------------------------------------------------------------------------------------
Balance at December 31, 2000                 11,159,678     14,182,793     3,589,746           3,590    7,324,500           7,325
Cancellation of Series B redeemable
   convertible preferred stock                  (28,286)       (35,075)
Repurchase of common stock from
   founders                                           -              -             -               -      (91,894)            (92)
Issuance of common stock in
   connection with exercise of
   stock options for cash                             -              -             -               -       10,000              10
Issuance of warrants                                  -              -             -               -            -               -
Compensation related to acceleration
   of vesting on common shares and
   options granted to nonemployees                    -              -             -               -            -               -
Amortization of deferred
   compensation related to warrants                   -              -             -               -            -               -
Dividend accrual in conjunction
   with Series B redeemable
   convertible preferred stock                        -      1,107,040             -               -            -               -
Net loss and comprehensive loss                       -              -             -               -            -               -
                                             ---------------------------------------------------------------------------------------
Balance at December 31, 2001                 11,131,392   $ 15,254,758     3,589,746     $     3,590    7,242,606     $     7,243
                                             =======================================================================================


                                                             STOCKHOLDERS' DEFICIT
                                            --------------------------------------------------------------
                                                                                 DEFICIT
                                                                               ACCUMULATED
                                             ADDITIONAL                        DURING THE       TOTAL
                                              PAID-IN            DEFERRED      DEVELOPMENT   STOCKHOLDERS'
                                              CAPITAL          COMPENSATION      DEFICIT       DEFICIT
                                            --------------------------------------------------------------
                                                                                 
Issuance of common stock warrants
   in connection with office lease          $      6,650       $     (6,650)  $          -   $           -
Dividend accrual in conjunction
   with Series B redeemable
   convertible preferred stock                         -                  -       (276,760)       (276,760)
Net loss and comprehensive loss                        -                  -     (5,270,122)     (5,270,122)
                                            --------------------------------------------------------------
Balance at December 31, 2000                   1,506,137             (6,650)    (5,546,882)     (4,036,480)
Cancellation of Series B redeemable
   convertible preferred stock
Repurchase of common stock from
   founders                                            -                  -              -             (92)
Issuance of common stock in
   connection with exercise of
   stock options for cash                            790                  -              -             800
Issuance of warrants                             115,000                  -              -         115,000
Compensation related to acceleration
   of vesting on common shares and
   options granted to nonemployees                52,396                  -              -          52,396
Amortization of deferred
   compensation related to warrants                    -              1,275              -           1,275
Dividend accrual in conjunction
   with Series B redeemable
   convertible preferred stock                         -                  -     (1,107,040)     (1,107,040)
Net loss and comprehensive loss                        -                  -     (7,560,322)     (7,560,322)
                                            --------------------------------------------------------------
Balance at December 31, 2001                $  1,674,323       $     (5,375)  $(14,214,244)  $ (12,534,463)
                                            ==============================================================


SEE ACCOMPANYING NOTES.

                                                                               6


                               HigherMarkets, Inc.
                          (a development stage company)

                            Statements of Cash Flows



                                                                                PERIOD FROM       PERIOD FROM
                                                                                FEBRUARY 15,      FEBRUARY 15,
                                                                                   2000              2000
                                                                                (INCEPTION)       (INCEPTION)
                                                                YEAR ENDED        THROUGH           THROUGH
                                                                 DECEMBER       DECEMBER 31,      DECEMBER 31,
                                                                   2001            2000              2001
                                                            ----------------------------------------------------
                                                                                       
OPERATING ACTIVITIES
Net loss                                                    $     (7,560,322)  $   (5,270,122)  $    (12,830,444)
Adjustments to reconcile net loss to net cash
  used in operating activities:
    Depreciation and amortization                                  1,606,144           94,551          1,700,695
    Interest expense in connection with Series B
      Stock warrants                                                       -          291,000            291,000
    Interest expense on convertible notes payable                          -            1,727              1,727
    Interest income accrued on certificate of deposit                 (2,011)               -             (2,011)
    Compensation expense related to repurchase
       of shares from founder                                              -           41,710             41,710
    Compensation expense related to acceleration
       of vesting on common shares and
       nonemployee stock options                                      52,396                -             52,396
    Amortization of deferred compensation                              1,275                -              1,275
    Loss on disposal of equipment                                     20,980                -             20,980
    Amortization of warrant issued in connection
       with a strategic alliance agreement                            33,541                -             33,541
    Changes in operating assets and liabilities:
       Restricted cash and short-term investments                    507,422         (507,422)                 -
       Prepaid expenses and other assets                              36,904         (146,435)          (109,531)
       Accounts payable                                           (1,067,750)       1,323,250            255,500
       Accrued expenses                                               (5,980)          40,492             34,512
       Accrued rent                                                  619,884                -            619,884
       Deferred rent                                                  26,372                -             26,372
       Due to related party                                                -          160,409            160,409
                                                            ----------------------------------------------------
Net cash used in operating activities                             (5,731,145)      (3,970,840)        (9,701,985)

INVESTING ACTIVITIES
Purchases of property and equipment                                 (462,144)      (2,855,923)        (3,318,067)
Purchases of short-term investments and certificate of
  deposit                                                            (40,919)        (509,016)          (549,935)
Maturities of short-term investments                                  39,074                -             39,074
                                                            ----------------------------------------------------
Net cash used in investing activities                               (463,989)      (3,364,939)        (3,828,928)

FINANCING ACTIVITIES
Net proceeds from issuance of convertible Series A
  preferred stock                                                          -        1,374,537          1,374,537
Net proceeds from issuance of redeemable
  convertible Series B preferred stock                                     -       12,803,306         12,803,306
Principal payments on capital lease obligations                      (93,862)         (60,080)          (153,942)
Net proceeds from issuance of common stock                               800          169,155            169,955
Repurchase of common stock from founder                                  (92)         (75,000)           (75,092)
Proceeds from issuance of convertible notes
  payable                                                                  -          810,000            810,000
                                                            ----------------------------------------------------
Net cash (used in) provided by financing
activities                                                           (93,154)      15,021,918         14,928,764
                                                            ----------------------------------------------------
Net (decrease) increase in cash                                   (6,288,288)       7,686,139          1,397,851
Cash at beginning of period                                        7,686,139                -                  -
                                                            ----------------------------------------------------
Cash at end of period                                       $      1,397,851   $    7,686,139   $      1,397,581
                                                            ====================================================


                                                                               8


                               HigherMarkets, Inc.
                          (a development stage company)

                       Statement of Cash Flows (continued)



                                                                                PERIOD FROM       PERIOD FROM
                                                                                FEBRUARY 15,      FEBRUARY 15,
                                                                                   2000              2000
                                                                                (INCEPTION)       (INCEPTION)
                                                              YEAR ENDED          THROUGH           THROUGH
                                                               DECEMBER         DECEMBER 31,      DECEMBER 31,
                                                                 2001              2000              2001
                                                            ----------------------------------------------------
                                                                                       
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
Property, plant and equipment acquired under
  capital lease obligations                                 $              -   $      195,036   $        195,036
                                                            ====================================================
Deferred compensation related to stock option
  grants and common stock issuances and
  issuance of common stock warrants                         $              -   $        6,650   $          6,650
                                                            ====================================================
Accrual of dividend on redeemable convertible
  Series B preferred stock                                  $      1,107,040   $      276,760   $      1,383,800
                                                            ====================================================
Conversion of convertible notes payable and
  related accrued interest to redeemable
  convertible Series B preferred stock                      $              -   $      811,727   $        811,727
                                                            ====================================================
Issuance of warrant in connection with a
  strategic alliance agreement                              $        115,000   $            -   $        115,000
                                                            ====================================================


SEE ACCOMPANYING NOTES.

                                                                               9


                               HigherMarkets, Inc.
                          (a development stage company)

                          Notes to Financial Statements

                           December 31, 2001 and 2000

1.  COMPANY AND BASIS OF PRESENTATION

HigherMarkets, Inc. (the "Company") was incorporated in the state of Delaware on
February 15, 2000. The Company is a service provider that has developed an
e-procurement solution for universities and other educational institutions. The
Company's activities since inception have consisted primarily of raising
capital, recruiting key personnel and the initial design and development of the
e-procurement software. Accordingly, the Company is considered to be in the
development stage.

The Company has generated operating losses since inception and forecasts that it
may not have sufficient cash to fund its operations through 2002. This situation
raises substantial doubt about the Company's ability to continue as a going
concern. Management is actively marketing its e-procurement solution to several
customers and is also pursuing additional sources of financing. However, there
can be no assurances that the Company will be able to generate sufficient cash
flow from operations, that additional financing will be available in sufficient
amounts to meet its operating needs, or that such financing would be available
on terms acceptable to the Company.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

RECLASSIFICATIONS

Certain reclassifications of prior-year amounts have been made to conform to the
current-year presentation.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make certain estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent liabilities in the financial statements and
accompanying notes. Actual results could differ materially from those estimates.

                                                                              10


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

CASH AND CASH EQUIVALENTS

The Company considers all highly liquid investments with a maturity of three
months or less at the date of purchase to be cash equivalents. The Company's
cash equivalents consist mainly of money market funds and certificates of
deposit.

RESTRICTED INVESTMENTS

The certificate of deposit is restricted and secures a letter of credit related
to the Company's lease agreement (see Note 5). The certificate of deposit is
with a bank, bears interest at 2.42% per annum and will mature on October 29,
2002. The carrying amount approximates fair value.

The Company maintains two short-term restricted cash balances in accordance with
a lease agreement. The balances are held with a bank and expire at the end of
the lease which is in June 2002.

CONCENTRATION OF CREDIT RISK

The Company is subject to concentrations of credit risk from its cash
investments. The Company's credit risk is managed through monitoring the
stability of the financial institutions utilized and diversification of its
financial resources.

PROPERTY AND EQUIPMENT

Property and equipment is stated at cost less accumulated depreciation.
Depreciation is computed using the straight-line method over estimated useful
lives of the respective assets, ranging from two to five years.

The Company capitalizes costs associated with software developed or obtained for
internal use subsequent to the establishment of technological feasibility in
accordance with Statement of Position 98-1, ACCOUNTING FOR THE COSTS OF COMPUTER
SOFTWARE DEVELOPED OR OBTAINED FOR INTERNAL USE. Capitalized internal use
software costs with an expected useful life in excess of one year are amortized
on a straight-line basis over their estimated useful lives ranging from 18
months to three years.

                                                                              11


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

                                                                              12


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

IMPAIRMENT OF LONG-LIVED ASSETS

The Company reviews long-lived assets (property and equipment) for impairment
whenever events or changes in circumstances indicate the carrying value may not
be recoverable. The Company records impairment losses on long-lived assets used
in operations when events and circumstances indicate that the assets might be
impaired and the undiscounted cash flows estimated to be generated by those
assets are less than the carrying amounts of those assets.

INCOME TAXES

The Company utilizes the liability method of accounting, under which deferred
tax assets and liabilities are determined based on differences between financial
reporting and tax reporting bases of assets and liabilities. Deferred tax assets
and liabilities are measured using enacted tax rates and laws that will be in
effect when the differences are expected to reverse. Valuation allowances are
established, when necessary, to reduce deferred tax assets to the net amounts
expected to be realized.

COMPREHENSIVE INCOME (LOSS)

The Company has no other components of comprehensive income (loss) and,
accordingly, net loss is equal to comprehensive loss for the year ended December
31, 2001, for the period from February 15, 2000 (inception) through December 31,
2000 and for the period from February 15, 2000 (inception) through December 31,
2001.

STOCK BASED COMPENSATION

The Company has elected to follow Accounting Principles Board Opinion No. 25,
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES (APB 25), and related interpretations
in accounting for its employee stock options rather than the alternative fair
value accounting allowed by Statement of Financial Accounting Standards No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION ("SFAS 123"). APB No. 25 provides that
the compensation expense relative to the Company's employee stock options is
measured based on the intrinsic value of the stock option. SFAS 123 requires
companies that continue to follow APB 25 to provide a pro forma disclosure of
the impact of applying the fair value of SFAS 123 (see Note 7).

                                                                              13


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

STOCK BASED COMPENSATION (CONTINUED)

The Company complies with Financial Accounting Standards Board ("FASB")
Interpretation No. 44 ("FIN 44"), ACCOUNTING FOR CERTAIN TRANSACTIONS INVOLVING
STOCK COMPENSATION, an interpretation of APB No. 25. FIN 44 clarifies guidance
for certain issues that arose in the application of APB No. 25. FIN 44 was
effective and applied prospectively to all new awards, modifications to
outstanding awards and changes in employee status on or after July 1, 2000.

RECENTLY ISSUED ACCOUNTING STANDARDS

In August 2001, the FASB issued Statement of Financial Accounting Standards No.
144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS ("SFAS
144"). SFAS 144 supercedes SFAS 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED
ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF, and the accounting and reporting
provisions of Accounting Principals Board Opinion No. 30, REPORTING THE RESULTS
OF OPERATIONS-REPORTING THE EFFECTS OF DISPOSAL OF A SEGMENT OF A BUSINESS, AND
EXTRAORDINARY, UNUSUAL AND INFREQUENTLY OCCURRING EVENTS AND TRANSACTIONS, for
the disposal of a segment of a business. SFAS 144 establishes a single
accounting model for assets to be disposed of by sale whether previously held
and used or newly acquired. SFAS 144 retains the provisions of APB No. 30 for
presentation of discontinued operations in the income statements, but broadens
the presentation to include a component of an entity. SFAS 144 is effective for
fiscal years beginning after December 15, 2001 and the interim periods within.
The Company does not believe that the adoption of SFAS 144 on January 1, 2002
will have a material impact on the Company's financial position or results of
operations.

                                                                              14


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

3. PROPERTY AND EQUIPMENT

Property and equipment consists of the following:



                                                                                  DECEMBER 31,
                                                                             2001              2000
                                                                      -----------------------------------
                                                                                  
Computers and equipment                                               $        320,800  $        317,518
Furniture and fixtures                                                           8,000            17,744
Capitalized software                                                         2,834,796         2,440,195
Leasehold improvements                                                         283,123           275,502
                                                                      -----------------------------------
                                                                             3,446,719          3,050,959
Less: accumulated depreciation and amortization                             (1,655,291)           (94,551)
                                                                      -----------------------------------
                                                                      $      1,791,428  $       2,956,408
                                                                      ===================================


The Company leases certain furniture, office and computer equipment under
noncancelable lease agreements that are accounted for as capital leases. Such
cost for furniture, office and computer equipment under capital lease
arrangements, included in property and equipment, aggregated $195,036 at
December 31, 2001 and 2000. Related accumulated amortization was $124,431 and
$26,913 at December 31, 2001 and 2000, respectively.

Amortization expense related to the capitalized software was $1,380,147, $54,158
and $1,434,305 for the year ended December 31, 2001, for the period from
February 15, 2000 (inception) through December 31, 2000 and for the period from
February 15, 2000 (inception) through December 31, 2001, respectively.

The Company wrote off idle computers and furniture and fixtures during the year
ended December 31, 2001 with a net book value of $20,980. The loss on disposal
was recorded in general and other administrative expenses.

                                                                              15


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

4. INCOME TAXES

As of December 31, 2001 and 2000, the Company had deferred tax assets of
approximately $5,400,000 and $2,100,000, respectively. Realization of the
deferred tax assets is dependent upon future taxable income, if any, the amount
and timing of which are uncertain. Accordingly, the net deferred tax assets have
been fully offset by a valuation allowance. The net valuation allowance
increased by approximately $3,300,000, $2,100,000 and $5,400,000 for the year
ended December 31, 2001, for the period from February 15, 2000 (inception)
through December 31, 2000 and for the period from February 14, 2000 (inception)
through December 31, 2001, respectively. Deferred tax assets primarily relate to
net operating loss carryforwards.

As of December 31, 2001, the Company had federal and state net operating loss
carryforwards of approximately $12,900,000. The net operating loss carryforwards
will expire at various dates beginning in 2010, if not utilized.

Utilization of the net operating loss carryforwards and credits may be subject
to a substantial annual limitation due to the ownership change limitations
provided by the Internal Revenue Code of 1986, as amended, and similar, state
provisions. The annual limitation may result in the expiration of net operating
losses and credits before utilization.

5. COMMITMENTS AND CONTINGENCIES

CAPITAL AND OPERATING LEASES

The Company leases its office space under an operating lease with fixed
escalating rental payments through January 2006. As such, the Company has
recorded deferred rent of $26,372 at December 31, 2001. Under the lease
arrangement, the Company is required to maintain a standby letter of credit
totaling $464,305. The standby letter of credit will be reduced by $35,000
beginning January 2, 2003 and on each January 2 thereafter throughout the term
of the lease.

                                                                              16


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

5. COMMITMENTS AND CONTINGENCIES (CONTINUED)

CAPITAL AND OPERATING LEASES (CONTINUED)

Future minimum commitments under noncancelable capital leases and operating
leases with initial terms of one year or more are as follows:



                                                                         CAPITAL        OPERATING LEASES
                                                                          LEASES
                                                                      -----------------------------------
                                                                                  
2002                                                                  $         42,756  $         457,980
2003                                                                                 -            521,150
2004                                                                                 -            584,324
2005                                                                                 -            647,496
2006 and thereafter                                                                  -             28,953
                                                                      -----------------------------------
Total minimum lease payments                                                    42,756  $       2,239,903
                                                                                        =================
Less interest                                                                    1,662
                                                                      ----------------
Present value of minimum lease payments                                         41,094
Less current portion                                                            41,094
                                                                      ----------------
Capital lease obligations, less current portion                       $              -
                                                                      ================


Rent expense totaled $550,855, $116,891 and $667,746 for the year ended December
31, 2001, for the period from February 15, 2000 (inception) through December 31,
2000 and for the period from February 15, 2000 (inception) through December 31,
2001, respectively.

At December 31, 2001, the Company had vacant and idle office space. No sublease
arrangements have been entered into for this vacant space. Accordingly, the
Company has accrued $619,884 at December 31, 2001 to reflect the remaining
rental charges to be incurred for this idle space over the remaining lease term.
This charge is included in general and administrative expenses.

                                                                              17


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

5.  COMMITMENTS AND CONTINGENCIES (CONTINUED)

OTHER COMMITMENTS

The Company has executed a three-year contract with an internet service provider
to host its Website and e-procurement software. The contract contains a
cancellation penalty equal to the net present value of $4,000 per month for the
remaining term, discounted at 5%. Future commitments under this agreement are
$222,000 for 2002 and $148,000 in 2003. The contract term ends in July 2003.

The Company is obligated to pay a minimum royalty of 1% of annual revenue in
connection with software it has licensed from a third party. No royalty
liability has been incurred to date.

6.  CONVERTIBLE NOTES AND REDEEMABLE CONVERTIBLE SERIES B PREFERRED STOCK

CONVERTIBLE NOTES PAYABLE

In September 2000, the Company issued convertible notes payable for total cash
proceeds of $810,000. The notes were convertible into shares of Series B
redeemable preferred stock at approximately $1.24 per share. The notes had an
original maturity date of March 2001 and were subject to interest at 6% per
annum. The notes and $1,727 in accrued but unpaid interest were converted into
shares of Series B redeemable convertible preferred stock in September 2000. In
conjunction with this debt issuance, the company issued to the holders of the
notes warrants to purchase 162,000 shares of the Company's Series B redeemable
convertible preferred stock at an exercise price of $1.24 per share. The
warrants have a contractual life of ten years. The amount was recorded as a
discount to convertible notes payable. The fair value of the warrants and the
resulting beneficial conversion associated with the notes, determined in
accordance with EITF 00-27, APPLICATION OF EITF ISSUE NO. 98-5, "ACCOUNTING FOR
CONVERTIBLE SECURITIES WITH BENEFICIAL CONVERSION FEATURES OR CONTINGENTLY
ADJUSTABLE CONVERSION RATIOS," TO CERTAIN CONVERTIBLE INSTRUMENTS totaled
$291,000 and were recorded as interest expense. None of the warrants were
exercised as of December 31, 2001.

                                                                              18


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

6.  CONVERTIBLE NOTES AND REDEEMABLE CONVERTIBLE SERIES B PREFERRED STOCK
    (CONTINUED)

SERIES B REDEEMABLE CONVERTIBLE PREFERRED STOCK

In September 2000, the Company issued 11,159,678 shares of Series B redeemable
preferred stock ("Series B") at $1.24 per share in exchange for cash proceeds of
$13,026,274 and the conversion of notes payable and related accrued interest
expense of $811,127, net of issuance costs of $222,968.

Each share of the Series B redeemable convertible preferred stock is, at the
option of the holder, convertible into shares of common stock, subject to
certain antidilution adjustments, in accordance with the conversion formula
provided in the Company's Articles of Incorporation (currently a 1:1 ratio).
Outstanding Series B shares automatically convert into common stock as follows:
(a) at the election of at least a majority of the outstanding shares or (b) upon
the closing of an initial public offering of the Company's common stock in which
gross proceeds exceed $25,000,000 and a minimum per share price equal to or in
excess of $4.96 per share, subject to certain antidilution adjustments.

Holders of Series B are entitled to receive a cumulative cash dividend of
$0.0992 per share per annum. A dividend of $1,383,800 has been accrued at
December 31, 2001, but is not subject to payment until declared by the Board of
Directors.

Series B stockholders are entitled to the number of votes equal to the number of
shares of common stock into which their shares could be converted. In addition,
Series B stockholders have the right to elect two directors voting together as a
single class.

At any time after September 29, 2005, upon the written consent of a majority of
the holders of the outstanding shares of Series B, the Company must redeem all
issued, outstanding and unconverted Series B shares. The redemption price for
each share of Series B is an amount equal to the greater of the original issue
price for Series B or the fair value of such shares. The difference between the
original purchase price of the Series B shares and its fair value will be
accreted via a charge to accumulated deficit over the period extending to
September 29, 2005. There was no charge to accumulated deficit through December
31, 2001.

                                                                              19


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

6.  CONVERTIBLE NOTES AND REDEEMABLE CONVERTIBLE SERIES B PREFERRED STOCK
    (CONTINUED)

SERIES B REDEEMABLE CONVERTIBLE PREFERRED STOCK (CONTINUED)

Upon liquidation, the Series B preferred stockholders would receive a return
equal to $3.72 per share and any accrued but unpaid dividends. In the event of a
liquidation not sufficient to satisfy the intended liquidation provisions,
Series B preferred stockholders will generally have preference over Series A
preferred stockholders.

In December 2001, the Company rescinded 28,286 shares of Series B redeemable
convertible preferred stock with a purchase price of $35,075 from a shareholder.
The related warrant to purchase Series B redeemable convertible preferred stock
was also canceled.

7.  STOCKHOLDERS' DEFICIT

SERIES A CONVERTIBLE PREFERRED STOCK

In March, May and July 2000, the Company issued a total of 3,589,746 shares of
Series A Convertible Preferred Stock for cash proceeds of $1,374,537, net of
issuance costs of $25,464.

Each share of the Series A convertible preferred stock is, at the option of the
holder, convertible into shares of common stock, subject to certain antidilution
adjustments, in accordance with the conversion formula provided in the Company's
Articles of Incorporation (currently a 1:1 ratio). Outstanding Series A
preferred shares automatically convert into common stock as follows: (a) at the
election of at least a majority of the outstanding Series A shares or (b) upon
the closing of an initial public offering of the Company's common stock in which
gross proceeds exceed $10,000,000 and a minimum per share price equal to or in
excess of $1.17 per share, subject to certain antidilution adjustments.

Each share of convertible preferred stock is entitled to the number of votes
equal to the number of shares of common stock into which such shares could be
converted. In addition, Series A stockholders have the right to elect one
director, voting together as a single class.

                                                                              20


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

7.  STOCKHOLDERS' DEFICIT (CONTINUED)

SERIES A CONVERTIBLE PREFERRED STOCK (CONTINUED)

Upon liquidation, Series A preferred stockholders will receive $0.39 per share
plus any declared but unpaid dividends. In the event of a liquidation not
sufficient to satisfy the intended liquidation provisions, Series B preferred
stockholders will be given preference over the Series A preferred stockholders.

COMMON STOCK

Under certain conditions, the Company has the option to repurchase all or a
portion of the unvested shares of common stock issued to the Company's founders
and certain employees of the Company at the original purchase price per share.
At December 31, 2001, 1,277,187 shares were unvested and will continue to vest
at various rates through October 2004.

As of December 31, 2001, two of the Company's three founders had been
involuntarily terminated. According to their employment agreements, a specific
number of shares would become immediately vested in the event of involuntary
termination. In addition, the Company accelerated the vesting of shares that
would have originally been subject to repurchase on the termination date.
Accordingly, the Company recorded $47,758 in compensation expense in 2001
related to this award modification.

2000 STOCK PLAN

In July 2000, the Board approved the adoption of the 2000 Stock Plan (the
"Plan"), which authorizes the issuance of 2,800,000 shares of common stock under
the plan. Under the terms of the Plan, the Board of Directors may grant
incentive stock options ("ISOs") to employees and nonstatutory stock options
("NSOs") to employees, officers, directors and consultants.

Generally, the Company grants stock options at a price not less than 85% of the
fair market value of the common stock on the date of the grant, as determined by
the Company's Board of Directors. Options generally vest over a four-year period
at a rate of 25% one year from the grant date and 1/48 monthly thereafter and
expire a maximum of ten years from the date of grant. The stock options are
exercisable immediately upon vesting.

                                                                              21


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

7.  STOCKHOLDERS' DEFICIT (CONTINUED)

2000 STOCK PLAN (CONTINUED)

A summary of activity under the Plan is as follows:



                                                                              OUTSTANDING OPTIONS
                                                                      -----------------------------------
                                                        SHARES                              WEIGHTED-
                                                     AVAILABLE FOR        NUMBER OF      AVERAGE EXERCISE
                                                        GRANT               SHARES       PRICE PER SHARE
                                                    -----------------------------------------------------
                                                                                
Initial authorized shares                                 2,800,000                  -   $              -
   Granted                                               (1,521,500)         1,521,500               0.11
   Canceled                                                  75,000            (75,000)              0.08
                                                    -----------------------------------------------------
Outstanding at December 31, 2000                          1,353,500          1,446,500   $           0.11
   Granted                                                 (828,000)           828,000               0.25
   Exercised                                                      -            (10,000)              0.08
   Canceled                                               1,344,500         (1,344,500)              0.17
                                                    -----------------------------------------------------
Outstanding at December 31, 2001                          1,870,000            920,000   $           0.17
                                                    =====================================================


The weighted average fair value of options granted to employees under the Plan
in 2001 was $0.23 per share. The weighted average remaining contractual life of
options outstanding under the Plan at December 31, 2001 was 8.60 years.

                                                                              22


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued)

7. STOCKHOLDERS' DEFICIT (CONTINUED)

2000 STOCK PLAN (CONTINUED)

The following table summarizes information about stock options outstanding and
exercisable at December 31, 2001:



                                            OUTSTANDING OPTIONS
                         ---------------------------------------------------------
                                                                  WEIGHTED-
                                                WEIGHTED-          AVERAGE
                                                AVERAGE          REMAINING          NUMBER OF
                            NUMBER OF        EXERCISE PRICE      CONTRACTUAL         OPTIONS
      EXERCISE PRICE         SHARES            PER  SHARE        LIFE (YEARS)      EXERCISABLE
- -------------------------------------------------------------------------------------------------
                                                                         
       $    0.08             460,000         $    0.08                8.26           184,375
            0.20             225,000              0.20                8.79            67,969
            0.25             235,000              0.25                9.09            15,000
                        -----------------                                         ---------------
                             920,000                                                 267,344
                        =================                                         ===============


PRO FORMA DISCLOSURES OF THE EFFECT OF STOCK-BASED COMPENSATION

The Company has elected to follow APB 25 and related interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under FAS 123 requires the use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, when the exercise price of the Company's employee
stock options equals or exceeds the market price of the underlying common stock
on the grant date, no compensation expense is recorded.

                                                                              23


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued

7. STOCKHOLDERS' DEFICIT (CONTINUED)

PRO FORMA DISCLOSURES OF THE EFFECT OF STOCK-BASED COMPENSATION (CONTINUED)

For the period ended December 31, 2001, pro forma net loss and pro forma net
loss per share were as follows:



                                                               PERIOD FROM         PERIOD FROM
                                                               FEBRUARY 15,        FEBRUARY 15,
                                                                  2000                2000
                                                              (INCEPTION)          (INCEPTION)
                                           YEAR ENDED           THROUGH              THROUGH
                                          DECEMBER 31,         DECEMBER 31,        DECEMBER 31,
                                             2001                 2000                 2001
                                         --------------------------------------------------------
                                                                        
Net loss                                  $(7,560,322)       $ (5,270,122)       $ (12,830,444)
Net loss - pro forma                      $(7,604,322)       $ (5,285,763)       $ (12,890,085)


The fair value of each option grant is estimated at the date of grant using a
Black-Scholes option pricing model, assuming no expected dividends and with the
following weighted-average assumptions for the period ended December 31, 2001:

                                                                                  
Volatility                                                                              1.0
Risk-free interest rate                                                                   5%
Expected life of the option                                                          10 years
Expected dividend yield                                                                   0%



The pro forma impact of options on the net loss for the year ended December 31,
2001 is not representative of the effects on net income (loss) for future years,
as future years will include the effects of additional years of stock option
grants.

COMMON STOCK WARRANTS AND OPTIONS

The Company granted a warrant to purchase 35,000 shares of common stock to
certain lessors. Such warrants were fully vested and exercisable at the issuance
date and expire in December 2010. The fair value of these warrants is charged to
expense over the period of the related lease term or the period in which
services are received. The

                                                                              24


                               HIGHERMARKETS, INC.
                          (a development stage company)

                    Notes to Financial Statements (continued

7. STOCKHOLDERS' DEFICIT (CONTINUED)

COMMON STOCK WARRANTS AND OPTIONS (CONTINUED)

Company also granted 10,000 options to a service provider that vested during
2000. The fair value of these warrants and options of $6,650 is being amortized
and included in general and administrative expenses. The value of the warrant
and options was estimated using the Black-Scholes option pricing model based on
a weighted-average, risk-free interest rate of approximately 6%, an exercise
period equal to the life of the warrant and option, volatility of 1.0 and no
dividend yield.

In March 2001, the Company granted options to purchase 55,000 shares of common
stock to members of the Company's strategic advisory council. The associated
expense of $4,638 is included in general and administrative expenses.

In May 2001, the Company granted a warrant to purchase up to 500,000 shares of
Series A preferred stock to a strategic partner for an exercise price of $1.24
per share. The fair value of the warrant of $115,000 is included in other assets
in the accompanying balance sheet and will be charged to expense over the
service term of two years. The value of the warrant and options was estimated
using the Black-Scholes option pricing model based on a weighted-average, risk
free interest rate of 5%, an exercise period equal to the life of the warrant or
option, volatility of 1.0 and no dividend yield. As of December 31, 2001,
$33,541 has been charged to expense for the warrant.

COMMON STOCK RESERVED FOR FUTURE ISSUANCE

The following shares of common stock were reserved at December 31, 2001:

                                                                         
Stock option plan                                                            2,790,000
Conversion of common stock warrants                                             35,000
Conversion of Series A preferred stock                                       4,839,746
Exercise and conversion of Series A preferred stock warrants                   500,000
Conversion of Series B redeemable preferred stock                           11,440,323
Exercise and conversion of Series B redeemable preferred stock warrants        124,998
                                                                          ---------------
                                                                            19,730,067
                                                                          ===============




                                                                              25


8.  RELATED PARTY TRANSACTIONS

The Company will reimburse a holder of Series B Redeemable Convertible Preferred
Stock for $160,409 of legal expenses incurred in connection with the purchase of
Series B redeemable convertible shares. This amount is accrued as of December
31, 2001 and 2000.

                                                                              26

EX-99.3

                                                                    Exhibit 99.3

iLEARNING, INC.

CONSOLIDATED FINANCIAL STATEMENTS
AS OF DECEMBER 31, 2001 AND 2000
TOGETHER WITH REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors of
iLearning, Inc.:

We have audited the accompanying consolidated balance sheets of iLearning, Inc.
and subsidiary (the Company) (a Delaware corporation) as of December 31, 2001
and 2000, and the related consolidated statements of operations, redeemable
securities and stockholders' deficit, and cash flows for the years then ended.
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 auditing standards generally accepted
in the 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 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 iLearning, Inc. and subsidiary
as of December 31, 2001 and 2000, and the results of their operations and their
cash flows for the years then ended in conformity with accounting principles
generally accepted in the United States.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Company has suffered recurring losses from operations
and has a net capital deficiency that raises substantial doubt about its ability
to continue as a going concern. Management's plans in regard to these matters
are also described in Note 1. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.


/s/  ARTHUR ANDERSEN LLP

Baltimore, Maryland
February 18, 2002



iLEARNING, INC.

TABLE OF CONTENTS

                                                                             
CONSOLIDATED BALANCE SHEETS
   As of December 31, 2001 and 2000.............................................1

CONSOLIDATED STATEMENTS OF OPERATIONS
  For the years ended December 31, 2001 and 2000................................2

CONSOLIDATED STATEMENTS OF REDEEMABLE SECURITIES AND STOCKHOLDERS' DEFICIT
  For the years ended December 31, 2001 and 2000................................3

CONSOLIDATED STATEMENTS OF CASH FLOWS
  For the years ended December 31, 2001 and 2000.............................. .4

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
  December 31, 2001 and 2000.................................................. .5





iLEARNING, INC.

CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 2001 AND 2000



                                                                2001              2000
                                                          ---------------   ----------------
                                                                      
ASSETS

CURRENT ASSETS:
  Cash and cash equivalents                               $        46,805   $        780,857
  Accounts receivable                                             507,202            100,139
  Accounts receivable from affiliates                             293,881                 --
  Current portion of unbilled revenue                             300,000                 --
  Inventory                                                        15,472            103,491
  Prepaid expenses                                                  2,809            186,681
                                                          ---------------   ----------------
Total current assets                                            1,166,169          1,171,168

PROPERTY AND EQUIPMENT, NET                                       359,712            172,462
UNBILLED REVENUE, NET OF CURRENT PORTION                          522,495                 --
UNBILLED REVENUE DUE FROM AFFILIATES                              597,615                 --
SOFTWARE DEVELOPMENT COSTS, NET                                   285,846            443,675
ACQUIRED INTANGIBLES, NET                                         895,263                 --
OTHER ASSETS, NET                                                 176,273          1,126,920
                                                          ---------------   ----------------
Total assets                                              $     4,003,373   $      2,914,225
                                                          ===============   ================
LIABILITIES AND STOCKHOLDERS' DEFICIT

CURRENT LIABILITIES:
  Accounts payable                                        $     1,389,070   $      1,256,871
  Accounts payable to affiliates                                  268,198            772,800
  Accrued expenses                                                308,725            268,947
  Current portion of deferred revenue                             696,813            568,400
  Current portion of deferred revenue from affiliates             358,614                 --
  Line of credit from affiliates                                1,110,000                 --
  Current portion of capital lease obligation                      36,571                 --
  Note payable                                                    386,387                 --
  Current portion of note payable to affiliate                         --            285,000
                                                          ---------------   ----------------
Total current liabilities                                       4,554,378          3,152,018

DEFERRED REVENUE, NET OF CURRENT PORTION                          707,799                 --

DEFERRED REVENUE FROM AFFILIATES, NET OF CURRENT
PORTION                                                         1,174,250                 --

CAPITAL LEASE OBLIGATION, NET OF CURRENT PORTION                   64,463                 --

NOTE PAYABLE TO AFFILIATE, NET OF CURRENT PORTION                 606,645            570,000
                                                          ---------------   ----------------
Total liabilities                                               7,107,535          3,722,018
                                                          ---------------   ----------------
COMMITMENTS AND CONTINGENCIES

REDEEMABLE CONVERTIBLE PREFERRED STOCK:
  Series A redeemable convertible preferred
  stock, convertible into one share of common
  stock, liquidation preference of $5.56 per
  share plus accrued dividends, $.01 par
  value, 10,000,000
  shares authorized, 4,752,950 issued and outstanding          17,785,875         12,306,870

STOCKHOLDERS' DEFICIT:
  Class A common stock, $.01 par value,
  25,000,000 shares authorized, 5,405,000
  shares issued and
  outstanding                                                      54,050             54,040
  Additional paid-in capital                                           --            661,569
  Accumulated deficit                                         (20,944,087)       (13,830,272)
                                                          ---------------   ----------------
Total stockholders' deficit                                   (20,890,037)       (13,114,663)
                                                          ---------------   ----------------
Total liabilities and stockholders' deficit               $     4,003,373   $      2,914,225
                                                          ===============   ================


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

1


iLEARNING, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2001 AND 2000



                                                                2001            2000
                                                         --------------- ---------------
                                                                    
REVENUES                                                  $   3,150,763   $   1,152,224

REVENUES FROM AFFILIATES                                      2,273,035              --
                                                          -------------   -------------
Total revenues                                                5,423,798       1,152,224

COST OF REVENUES                                              4,055,174       2,260,140
                                                          -------------   -------------
Gross margin                                                  1,368,624      (1,107,916)
                                                          -------------   -------------
OPERATING EXPENSES:

  Product development                                           691,599         794,980

  Sales and marketing                                         1,760,968       3,169,595

  General and administrative                                  3,297,896       4,289,282
                                                          -------------   -------------
Total operating expenses                                      5,750,463       8,253,857
                                                          -------------   -------------
Loss from operations                                         (4,381,839)     (9,361,773)

INTEREST (EXPENSE) INCOME, NET                                   (1,090)         34,994
                                                          -------------   -------------
NET LOSS                                                  $  (4,382,929)  $  (9,326,779)
                                                          =============   =============


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

2


iLEARNING, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE SECURITIES AND STOCKHOLDERS' DEFICIT
FOR THE YEARS ENDED DECEMBER 31, 2001 AND 2000



                                                                     REDEEMABLE CONVERTIBLE PREFERRED    STOCKHOLDERS' DEFICIT
                                                                                   STOCK                 -----------------------
                                                                     ---------------------------------       MEMBERS'
                                                                         SHARES             AMOUNT           CAPITAL
                                                                     --------------    ---------------   ---------------
                                                                                                
BALANCE, DECEMBER 31, 1999                                                       --    $            --   $     1,887,500
   Issuance of common stock in iLearning, Inc.                                   --                 --        (1,887,500)
   Issuance of Redeemable Convertible Preferred Stock                     4,003,388         11,129,419                --
   Issuance of common stock for services                                         --                 --                --
   Accretion of Redeemable Convertible Preferred Stock                           --          1,177,451                --
   Net loss                                                                      --                 --                --
                                                                     --------------    ---------------   ---------------
BALANCE, DECEMBER 31, 2000                                                4,003,388         12,306,870                --
   Issuance of common stock in iLearning, Inc.                                   --                 --                --
   Issuance of Redeemable Convertible Preferred Stock                       749,562          2,083,780                --
   Accretion of Redeemable Convertible Preferred Stock                           --          3,395,225                --
   Net loss                                                                      --                 --                --
                                                                     --------------    ---------------   ---------------
BALANCE, DECEMBER 31, 2001                                                4,752,950    $    17,785,875   $            --
                                                                     ==============    ===============   ===============


                                                                             STOCKHOLDERS' DEFICIT
                                                        --------------------------------------------------------------------
                                                             COMMON STOCK                                     ADDITIONAL
                                                        -----------------------------     SUBSCRIPTION         PAID-IN
                                                        SHARES             AMOUNT          RECEIVABLE          CAPITAL
                                                        -----------   ---------------   ---------------    -----------------
                                                                                               
BALANCE, DECEMBER 31, 1999                                      --    $            --   $      (210,000)   $            --
   Issuance of common stock in iLearning, Inc.           5,402,000             54,020           210,000          1,833,480
   Issuance of Redeemable Convertible Preferred Stock           --                 --                --                 --
   Issuance of common stock for services                     2,000                 20                --              5,540
   Accretion of Redeemable Convertible Preferred Stock          --                 --                --         (1,177,451)
   Net loss                                                     --                 --                --                 --
                                                        -----------   ---------------   ---------------    ---------------
BALANCE, DECEMBER 31, 2000                               5,404,000             54,040                --            661,569
   Issuance of common stock in iLearning, Inc.               1,000                 10                --              2,770
   Issuance of Redeemable Convertible Preferred Stock           --                 --                --                 --
   Accretion of Redeemable Convertible Preferred Stock          --                 --                --           (664,339)
   Net loss                                                     --                 --                --                 --
                                                        -----------   ---------------   ---------------    ---------------
BALANCE, DECEMBER 31, 2001                               5,405,000    $        54,050   $            --    $            --
                                                        ==========    ===============   ===============    ===============


                                                              STOCKHOLDERS' DEFICIT
                                                        ----------------------------------
                                                                                TOTAL
                                                                             STOCKHOLDERS'
                                                            ACCUMULATED         EQUITY
                                                              DEFICIT         (DEFICIT)
                                                         ---------------    --------------
                                                                      
BALANCE, DECEMBER 31, 1999                               $    (4,503,493)   $   (2,825,993)
   Issuance of common stock in iLearning, Inc.                        --           210,000
   Issuance of Redeemable Convertible Preferred Stock                 --                --
   Issuance of common stock for services                              --             5,560
   Accretion of Redeemable Convertible Preferred Stock                --        (1,177,451)
   Net loss                                                   (9,326,779)       (9,326,779)
                                                         ---------------    --------------
BALANCE, DECEMBER 31, 2000                                   (13,830,272)      (13,114,663)
   Issuance of common stock in iLearning, Inc.                        --             2,780
   Issuance of Redeemable Convertible Preferred Stock                 --                --
   Accretion of Redeemable Convertible Preferred Stock        (2,730,886)       (3,395,225)
   Net loss                                                   (4,382,929)       (4,382,929)
                                                         ---------------    --------------
BALANCE, DECEMBER 31, 2001                               $   (20,944,087)   $  (20,890,037)
                                                         ===============    ==============




iLEARNING, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2001 AND 2000



                                                               2001               2000
                                                           --------------    --------------
                                                                       
CASH FLOWS FROM OPERATING ACTIVITIES:

  Net loss                                                 $   (4,382,929)   $   (9,326,779)
  Adjustments to reconcile net loss to net cash used
  in operating activities-
     Depreciation and amortization                                612,180           271,924
     Noncash revenue                                              (10,000)               --
     Noncash general and administrative expense                     2,780             5,560
     Loss on disposal of fixed assets                              55,815                --
     Changes in assets and liabilities:
       Accounts receivable                                       (407,063)          (15,521)
       Accounts receivable from affiliates                       (293,881)               --
       Unbilled revenue                                          (822,495)               --
       Unbilled revenue from affiliates                          (597,615)               --
       Prepaid expenses                                           183,872           (86,681)
       Inventory                                                   88,019          (103,491)
       Other assets                                               (12,609)         (225,427)
       Accounts payable                                           518,586        (1,199,788)
       Accounts payable to affiliates                            (504,602)               --
       Accrued liabilities                                         39,778           185,029
       Deferred revenue                                           469,212           568,400
       Deferred revenue from affiliates                         1,532,864                --
                                                           --------------    --------------
NET CASH FLOWS USED IN OPERATING ACTIVITIES                    (3,528,088)       (9,926,774)
                                                           --------------    --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Purchase of property and equipment                             (167,040)         (146,145)
  Software development costs                                      (24,640)         (543,302)
                                                           --------------    --------------
NET CASH FLOWS USED IN INVESTING ACTIVITIES                      (191,680)         (689,447)
                                                           --------------    --------------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Repayments on notes payable                                    (155,000)         (285,000)
  Payments of capital lease obligations                           (53,064)               --
  Proceeds from line of credit from affiliates                  1,110,000                --
  Proceeds from issuance of preferred stock                     2,083,780        11,129,419
  Proceeds from subscription receivable                                --           210,000
                                                           --------------    --------------
NET CASH FLOWS PROVIDED BY FINANCING ACTIVITIES                 2,985,716        11,054,419
                                                           --------------    --------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS             (734,052)          438,198

CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR                      780,857           342,659
                                                           --------------    --------------
CASH AND CASH EQUIVALENTS, END OF YEAR                     $       46,805    $      780,857
                                                           ==============    ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
  Cash paid for interest                                   $        7,424    $       13,846
                                                           ==============    ==============
  Cash paid for income taxes                               $           --    $           --
                                                           ==============    ==============
SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS
  Purchase price adjustment for LANWrights transaction     $      700,000    $           --
                                                           ==============    ==============
  Capital lease obligations incurred                       $      154,098    $           --
                                                           ==============    ==============


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

4


iLEARNING, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2001 AND 2000

1.  ORGANIZATION AND NATURE OF BUSINESS:

iLearning, Inc.(iLearning or the Company, formerly Leaplt.com, Inc.) was
incorporated in the State of Delaware on April 14, 2000. A Subscription
Agreement between LeapIt.com, LLC and LeapIt.com Inc., was entered into on April
20, 2000, whereby LeapIt.com, LLC subscribed to purchase common shares of
LeapIt.com, Inc., in consideration for the transfer, conveyance and delivery of
all the assets and liabilities of LeapIt.com, LLC to the Company as of its March
31, 2000, balance sheet. The transaction was intended to qualify as a tax-free
exchange under Section 351 of the Internal Revenue Code of 1986, as amended. As
both entities had previously been under common control, this transaction has
been accounted for similar to a pooling of interests transaction, with
presentation of the transaction as if it occurred at the beginning of the period
with all assets and liabilities recorded at their carryover basis.

iLearning, Inc. provides Web-based knowledge services and builds Internet
solutions centered on organizational management and transfer of critical
information. With products customized to each organization's knowledge
management needs, iLearning offers enterprise platforms based on XML/XSL
programming, making its solutions more cost effective, easier and faster to
implement. iLearning's flagship product, the iPlatform, provides an integrated
online portal environment, complete with full e-commerce, communication tools
including threaded discussions and chats, online learning user registration and
profiles, and a dynamic career management forum. Using proprietary technology,
the iPlatform delivers streaming video and audio, as well as synchronized slides
to any user with access to the Internet and a 28.8 dial-up connection - without
plug-ins, downloads or firewall issues. Additionally, iLearning offers iGateway,
a total online learning solution, and iLibrary, with more than 2,500 hours of
customized, vendor approved courses covering business skills, project
management, IT systems, applications and certifications. Content conversion
services are offered to customers wishing to make their existing content
available over the Internet. LeapIt.com, an online community for IT
professionals, is a working example of iLearning's technology and courses.
iLearning signed its first iPlatform client in November 2000.

In January 2000, Leaplt.com, LLC entered into a Stock Purchase Agreement to
acquire all of the issued and outstanding shares of capital stock of LANWrights,
Inc., a Texas corporation. The purchase price for the shares was $1,140,000
payable 25 percent at closing and 25 percent on each of January 1, 2001, 2002
and 2003, with the final payment subject to offset for an EBITDA adjustment. The
acquisition was accounted for under the purchase method of accounting, whereby
the purchase price was allocated to net assets and acquired intangibles for
$93,000 and $1,047,000, respectively. On December 20, 2001, the Stock

5


Purchase Agreement was amended. The amended purchase price for the shares was
$490,000, of which $440,000 had been paid as of December 31, 2001. The remaining
payment of $50,000 is deferred and payable January 31, 2003. This deferred
payment is subject to the seller's employment status as of January 31, 2003, and
an adjustment based on LANWrights' EBITDA as of December 31, 2002. The amendment
resulted in a $700,000 reduction of the amount of goodwill recorded by the
Company for the LANWrights, Inc. acquisition. LANWrights provides
network-oriented writing, training, and consulting and supplies accurate, timely
information on cutting-edge technologies and certification. LANWrights is known
for developing technical materials for companies such as Microsoft, Novell, GTE,
Symantec and SUN Microsystems.

In October 2001, iLearning acquired certain assets of Caliber Learning Network,
Inc. from Sylvan Learning Systems, Inc. Caliber's technology enables iLearning
to offer a web event broadcast solution that fully integrates studio
origination, event management and desktop delivery technologies with
professional services to deliver high impact, just-in-time content to globally
dispersed, Internet-connected audiences. The acquisition includes certain of
Caliber's client relationships, intellectual property, software and equipment.
The Caliber assets round out iLearning's comprehensive set of training and
communications solutions.

Since inception, iLearning has incurred cumulative losses of approximately $18.2
million. During 2001, iLearning experienced operating losses and negative cash
flows from operations due to software development and sales and marketing
expenses associated with developing, branding and launching its technology. In
2001, iLearning raised approximately $2 million in funding and has raised $15
million since inception. Total funding consists of $7.5 million in venture
funding and $7.5 million in private equity financing. iLearning intends to raise
additional capital during fiscal 2002. The recurring losses and need for
additional capital raise substantial doubt about the continued viability of the
organization. Management remains committed to taking all appropriate and
necessary actions to enact timely cost reductions and cash preservation in the
event that management's revenue and cash flow expectations are not substantially
met during fiscal 2002. Management believes that, based on its plans, including
raising new capital, iLearning will have sufficient cash to support operations
during fiscal 2002. The accompanying financial statements have been prepared
assuming that iLearning will continue as a going concern. However, iLearning
cannot assure that it will be able to obtain the financing necessary to continue
to support its business.

2.  SUMMARY OF ACCOUNTING POLICIES:

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of iLearning, Inc.
and its subsidiary. All material intercompany accounts and transactions have
been eliminated in consolidation.

6


USE OF ESTIMATES

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

CASH AND CASH EQUIVALENTS

Cash and cash equivalents consist of cash on hand and highly liquid investments
with an original maturity of three months or less when purchased.

CONCENTRATION OF RISK

In 2001, the Company had revenues from three customers that were individually
greater than 10 percent of revenues. Combined, these three customers amounted to
46 percent of revenues and 16 percent of accounts receivable at December 31,
2001. No customers accounted for more than 10 percent of the Company's revenues
in 2000.

ACCOUNTS RECEIVABLE

As of December 31, 2001, accounts receivable includes approximately $178,000 of
unearned income related to the sale of software licenses. The Company expects to
recognize the revenue on a straight-line basis over the term of its licensing
agreements.

INVENTORY

Inventory consists of courseware books and other peripherals sold as
supplemental materials for the Company's online courses. Inventory is valued at
the cost of acquisition and relieved against cost of revenue for sales.

PREPAID EXPENSES

Prepaid expenses consisted of the following as of December 31, 2001 and 2000:



                                                                 2001              2000
                                                           --------------    --------------
                                                                       
Prepaid content license fees                               $           --    $      179,375

Other prepaid expenses                                              2,809             7,306
                                                           --------------    --------------
Total prepaid expenses                                     $        2,809    $      186,681
                                                           ==============    ==============


7


PROPERTY AND EQUIPMENT

Property and equipment are recorded at cost. Depreciation and amortization are
provided for using the straight-line method over the estimated useful lives of
the assets, generally three to seven years for furniture and equipment, and over
the shorter of the estimated useful life of leasehold improvements or the
related lease term for such improvements. Upon the disposition of assets, the
costs and related accumulated depreciation are removed from the accounts and any
resulting gain or loss is included in the consolidated statement of operations.
Expenditures for repairs and maintenance are expensed as incurred.

SOFTWARE DEVELOPMENT COSTS

The Company follows the guidelines established by Statement of Financial
Accounting Standards (SFAS) No. 86, "Accounting for the Costs of Computer
Software to be Sold, Leased, or Otherwise Marketed." The Company's policy is to
expense the costs incurred prior to the establishment of technological
feasibility as product development costs. The establishment of technological
feasibility and the ongoing assessment of recoverability of software development
costs requires considerable judgment by management with respect to certain
external factors, including anticipated future gross revenue, estimated economic
life and changes in technologies. Based on the Company's product development
process, technological feasibility is established upon completion of a working
model and related testing. Development costs incurred beyond the point of
technological feasibility are capitalized. Capitalized software development
costs currently are all related to the Company's proprietary iPlatform
technology and were incurred after the Company developed a working model in 2000
and until the iPlatform technology was first launched in May 2000. Amortization
begins when the product/functionality is available for general release and is
computed using the straight-line method over the estimated economic life of
three years. For the years ended December 31, 2001 and 2000, amortization
expense related to software development costs was $182,469 and $99,627,
respectively.

Development costs incurred to establish technological feasibility are reflected
as product development costs on the accompanying statement of operations, net of
any capitalized development costs and amounted to approximately $0 and $735,000
for the years ended December 31, 2001 and 2000, respectively.

OTHER ASSETS

Other assets consist principally of content licenses
that provide the Company with the right to resell the content through its
website and goodwill.

LONG-LIVED ASSETS

The Company assesses potential impairments of its long-lived assets when there
is evidence that events or changes in circumstances have made recovery of the
asset's carrying value unlikely. An impairment loss would be recognized when the
sum of the expected future undiscounted net cash flows is less than the carrying
amount of the asset. The Company has identified no such impairment losses.

8


DEFERRED REVENUE

Deferred revenues are related to the sale of software licenses and deposits for
services to be performed.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The Company's financial instruments consist primarily of cash and cash
equivalents, accounts receivable, prepaid expenses, accounts payable, accrued
expenses and notes payable. In management's opinion, the carrying amount of
these financial instruments approximated their fair values at December 31, 2001
and 2000.

REVENUE RECOGNITION

Revenue sources for 2001 consisted of software license sales product
(supplemental courseware books and peripherals) sales, royalty income and
services income. Product sales revenue is derived completely from online sales.
Software license revenues were deferred in accordance with Statement of Position
97-2, "Software Revenue Recognition." The Company recognizes the license fee
revenue on a straight-line basis over the term of its licensing agreements.
Revenues for product sales are recorded on a monthly basis as products are
shipped. Royalty revenue is recognized at the time royalty checks are received
from the third party agent due to uncertainties over the completion of the
earnings process until that time. Revenue from consulting services is recognized
when the work is completed or on a time and materials basis over the course of
the engagement.

CUSTOMERS

The Company's customers consist primarily of national and international
associations, training/staffing businesses, educational enterprises and
corporate users.

COST OF REVENUES

Cost of revenues include software enhancement
costs, direct consulting costs, content conversion fees, content acquisition and
license fees, hosting and product delivery, fulfillment and maintenance.

ADVERTISING COSTS

Advertising costs for producing and communicating advertising
are expensed when incurred. Total advertising expense for the years ended
December 31, 2001 and 2000, including initial branding and development of
collateral, was $110,513 and $2,652,908, respectively.

9


ACCOUNTING FOR INCOME TAXES

The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), which
requires that deferred tax assets and liabilities be recognized for the
estimated future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. The recognition of net deferred assets is reduced,
if necessary, by a valuation allowance for the amount of any tax benefits that,
based on available evidence, are not expected to be realized. Deferred tax
assets and liabilities are measured using expected tax rates in effect for the
year in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income tax expense in the period that includes the
enactment date.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, FASB issued Statement of Financial Accounting Standards No. 142
(SFAS No, 142) "Goodwill and Other Intangible Assets." This pronouncement
requires a nonamortization approach to account for purchased goodwill and
certain other intangible assets. Under a nonamortization approach, goodwill and
certain intangibles are not amortized into results of operations but, instead,
are reviewed for impairment and written down and charged to results of
operations only in the periods in which the recorded value of goodwill and
certain intangibles is more than the assets' fair value. The provisions of this
statement will apply to goodwill and intangible assets acquired prior to June
30, 2001, and will be adopted by the Company on January 1, 2002. The provisions
of this statement that apply to goodwill and other indefinite life intangible
assets acquired after June 30, 2001, were adopted by the Company on July 1,
2001. The adoption of these accounting standards may result in certain of the
intangibles being subsumed into goodwill and would have the impact of reducing
the amortization of goodwill and intangibles commencing January 1, 2002. The
Company does not expect the adoption of this pronouncement to have a material
impact on the Company's financial statements.

In August 2001, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standard No. 144 (SFAS No. 144), " Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement addresses financial
accounting and reporting for the impairment or disposal of long-lived assets and
supersedes SFAS No. 121 and APB Opinion No. 30. This pronouncement retains the
fundamental provisions of Statement No. 121 that require the Company to test
long-lived assets for impairment using undiscounted cash flows; however, the
statement eliminates the requirement to allocate goodwill to these long-lived
assets. The statement also requires that long-lived assets held for sale must be
recorded at the lower of the carrying amount or the fair value less the cost to
sell the asset. Any loss resulting from the write-down of the assets shall be
recognized in income from continuing operations. The provisions of this
statement are effective for financial statements issued for fiscal years
beginning after December 31, 2001. The Company does not expect the adoption of
SFAS No. 144 to have a material impact on its financial statements.

10


RECLASSIFICATIONS

Certain amounts in the 2000 financial statements have been reclassified to
conform to the 2001 presentation.

3.  ACQUIRED INTANGIBLES:

Acquired intangibles consisted of the following as of December 31, 2001 and
2000:



                                                                2001              2000
                                                           --------------    --------------
                                                                       
Software technology                                        $      793,561    $           --

Customer contracts                                                134,995                --
                                                           --------------    --------------
                                                                  928,556                --

Less- accumulated amortization                                    (33,293)               --
                                                           --------------    --------------
Acquired intangibles, net                                  $      895,263    $           --
                                                           ==============    ==============


4.  PROPERTY AND EQUIPMENT:

Property and equipment consisted of the following as of December 31, 2001 and
2000:



                                                               2001              2000
                                                           --------------    --------------
                                                                       
Equipment                                                  $      527,726    $      168,750

Furniture and fixtures                                              3,537            73,566

Leasehold improvements                                                 --            18,020
                                                           --------------    --------------
                                                                  531,263           260,336

Less- accumulated depreciation and amortization                  (171,551)          (87,874)
                                                           --------------    --------------
Property and equipment, net                                $      359,712    $      172,462
                                                           ==============    ==============


Depreciation and amortization expense related to property and equipment was
$123,162 and $51,643 in 2001 and 2000, respectively.

5.  ACCRUED LIABILITIES:

Accrued liabilities consisted of the following as of December 31, 2001 and 2000:



                                                               2001              2000
                                                           --------------    --------------
                                                                       
Accrued bonus and payroll                                  $      237,649    $      204,166

Deferred salaries payable                                          25,657            62,394

Other accrued liabilities                                          45,419             2,387
                                                           --------------    --------------
Total accrued liabilities                                  $      308,725    $      268,947
                                                           ==============    ==============


11


6.  CAPITAL LEASE OBLIGATION:

In April 2001, the Company entered into a three-year capital lease agreement for
computer hardware and software. Future minimum lease payments for the above
assets under capital leases at December 31, 2001, are as follows:

                                                                         
2002                                                                         $       40,325

2003                                                                                 53,767

2004                                                                                 13,442
                                                                             --------------
Total minimum lease payments                                                        107,534

Less- interest                                                                       (6,500)
                                                                             --------------
Present value of minimum lease payments                                             101,034

Current portion of capital lease obligation                                          36,571
                                                                             --------------
Capital lease obligation, net of current portion                             $       64,463
                                                                             ==============



Accumulated amortization of the capital lease assets as of December 31, 2001,
was approximately $39,000.


7.  NOTE PAYABLE:

In August 2001, iLearning entered a General Release and Mutual Settlement
Agreement in the form of a noninterest-bearing note with HCL Technologies
America, Inc. (HCL) for services provided by HCL to iLearning. The settlement
amount was $560,387. Payments of $58,000 are to be made monthly beginning August
2001 through March 2002, with a final payment of $96,387 to be made in 2002.

8.  NOTE PAYABLE TO AFFILIATE:

In October 2001, iLearning acquired from Sylvan Learning Systems, Inc., an
affiliate of an investor in the Company, certain assets formerly belonging to
Caliber Learning Network, Inc. The assets consisted of technology and contracts
with a value of approximately $924,000, and furniture, fixtures and equipment
with a value of approximately $50,000. The asset purchase was secured by a note
payable to Sylvan Learning Systems, Inc. in the amount of $606,645 and the
assumption of an obligation for services due a former Caliber Learning Network,
Inc. client in the amount of $367,289. The note is secured by substantially all
of the assets of the Company.

The note is due on the earlier of October 25, 2004, or the date on which
iLearning closes an equity financing, or series of equity financing, and the
interest rate is 8% per annum. Interest expense for the year ended December 31,
2001, was approximately $9,200.

12


9.  LINE OF CREDIT FROM AFFILIATES:

In October 2001, iLearning entered into a line of credit arrangement with
related party investors. The line of credit allows for maximum borrowings of
$1,400,000. The interest rate on the line of credit is 12% per annum and the
maturity date of the line of credit is January 31, 2002, at which time the
balance of the line of credit used by iLearning and all accrued and unpaid
interest is due and payable. The note is secured by substantially all of the
assets of the Company and is junior to the note payable described in Note 8.
Interest expense for the year ended December 31, 2001, was approximately
$13,000. As of December 31, 2001, $1,110,000 was outstanding in connection with
this line of credit. This amount was not repaid as of January 31, 2002. The
Company is currently negotiating a new agreement with its lenders.

10. REDEEMABLE CONVERTIBLE PREFERRED STOCK:

In April 2000, the Company raised $11.1 million through the sale of 4,003,388
shares of its Series A Redeemable Convertible Preferred Stock (the Series A
Stock). The Series A Stock is redeemable at the option of the holder for $5.56
per share plus all accumulated and unpaid dividends at any time after April 20,
2005, and before April 20, 2006, if the Company receives a notice from at least
50 percent of the outstanding shares of the Series A Stock. Additionally,
holders of the Series A Stock are entitled to receive dividends at a rate of
$0.139 per share when and if declared by the Board of Directors of the Company.
The carrying amount of the securities is being accreted to the redemption value
of $5.56 per share plus declared dividends (no dividends have been declared
through December 31, 2001) using the effective interest method. The accretion
period is from the date of issuance of the Series A Stock to the earliest date
at which these securities become redeemable at the option of the holder.

Each share of Series A Stock is convertible, at anytime by the holder, into one
share of common stock. The Series A stockholders are also entitled to
liquidation preferences of $2.78 per share. The Series A stockholders have one
vote for each share of Series A Stock owned.

In 2001, the Company raised approximately $2.1 million through the sale of
749,562 shares of Series A Stock.

An investor of the Company maintains an option to purchase up to 719,424 shares
of Series A stock at $2.78 per share. The option expires April 19, 2002.

13


11. STOCK-BASED COMPENSATION:

The Company has a stock option plan (the Plan) authorizing the grant of options
to employees, consultants and nonemployee directors. Under the Plan, the Company
may grant options to purchase up to 2,200,000 shares of common stock. Stock
options expire ten years from the date granted and vest over periods ranging
from six months to four years. Shares available for future grants amounted to
969,850 as of December 31, 2001. The Plan also allows for the granting of
nonqualified options, restricted stock and restricted stock units.



                                                              2001               2000
                                                           --------------    --------------
                                                                       
Net loss:

  As reported                                              $   (4,382,929)   $   (9,326,779)

  Pro forma                                                    (4,392,328)       (9,338,057)


A summary of qualified option transactions during the years ended December 31,
2001 and 2000, is as follows:



                                                                                 WEIGHTED
                                                                                 AVERAGE
                                                                                 EXERCISE
                                                             OPTIONS              PRICE
                                                           --------------    --------------
                                                                       
Outstanding, December 31, 1999                                         --    $           --

2000 activity:

  Granted                                                         435,500              2.42

  Forfeited                                                        31,500              2.78
                                                           --------------    --------------
Outstanding, December 31, 2000                                    404,000              2.39
2001 activity:

  Granted                                                         794,650              2.78

  Forfeited                                                       220,000              2.38
                                                           --------------    --------------
Outstanding, December 31, 2001                                    978,650    $         2.71
                                                           ==============    ==============


At December 31, 2001, there were 361,386 qualified options that were
exercisable.

The weighted average fair value of qualified options granted to employees during
the year ended December 31, 2001, was not significant as the options were
granted at prices that exceeded the fair market value at the time of grant. The
qualified options granted during the year ended December 31, 2001, were granted
at an exercise price of $2.78 per share and had a weighted average remaining
contractual life of 9.34 years.

14


The Company has computed, for pro forma disclosure purposes, the value of all
options granted during the year ended December 31, 2001, using the Black-Scholes
option pricing model as prescribed by SFAS No. 123 and the following weighted
average assumptions:

                                                                                 
Risk-free interest rate                                                                4.27%

Expected life                                                                       5 years

Volatility                                                                              1.0%

Dividend rate                                                                             0%



12. INCOME TAXES:

At December 31, 2001, the Company had approximately $8.7 million of tax net
operating loss carryforwards (NOLs) which expire in 2020 and 2021. SFAS No. 109
requires that the tax benefit of such NOLs be recorded as an asset to the extent
that management assesses the utilization of such NOLs to be "more likely than
not". Realization of the future tax benefits is dependent on the Company's
ability to generate taxable income within the carryforward period and also is
limited under certain circumstances, if the Company has a change in control, as
defined. Future levels of operating income are dependent upon general economic
conditions, including interest rates and general levels of economic activity,
competitive pressure on sales and margins and other factors beyond the Company's
control. Therefore, no assurance can be given that sufficient taxable income
will be generated for full utilization of the NOLs.

Based on the Company's history of earnings, future earnings of the Company may
not be sufficient to utilize these NOLs prior to their expiration. Accordingly,
the Company has recorded a deferred tax asset and a full valuation allowance as
of December 31, 2001 and 2000. The Company will continue to evaluate the
likelihood of future profits and the necessity of future adjustments to the
deferred tax asset valuation allowance.

The difference between the recorded income tax benefit and the "expected" tax
benefit, based on the statutory federal income tax rate, is as follows as of
December 31, 2001 and 2000:



                                                                2001               2000
                                                           --------------    --------------
                                                                       
Tax benefit at federal statutory rates                     $    1,490,196    $    3,171,105

State income taxes, net of federal income tax effect              197,232           419,705

Other, net                                                       (185,201)          (59,483)

Valuation allowance                                            (1,502,227)       (3,531,327)
                                                           --------------    --------------
Benefit for income taxes                                   $           --    $           --
                                                           ==============    ==============


15


Deferred 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 taxes consisted of the following as of December 31, 2001 and
2000:



                                                               2001              2000
                                                           --------------    --------------
                                                                       
Deferred tax assets

  Deferred revenue                                         $      426,680    $      192,500

  Amortization of software development costs                      132,928            59,712

  Net operating loss                                            3,346,113         3,147,655

  Accrued liabilities                                             341,962            92,470

  Amortization of organization costs                               23,011            38,990
                                                           --------------    --------------
Total deferred tax assets                                       4,270,694         3,531,327

Valuation allowance                                            (4,270,694)       (3,531,327)
                                                           --------------    --------------
Net deferred tax asset                                     $           --    $           --
                                                           ==============    ==============


13. EMPLOYEE BENEFIT PLAN:

The Company has a 401(k) Profit Sharing Plan (the 401(k) Plan) available to all
employees meeting certain eligibility criteria which permits participants to
contribute up to certain limits as established by the Internal Revenue Service.
The 401(k) Plan provides for discretionary matching contributions by the Company
in an amount to be determined on an annual basis. In 2001 and 2000, the Company
did not match employee contributions.

14. RELATED PARTIES:

In November 2000, iLearning entered into a one-year Training Product Sales
Representative Agreement with an entity in which one of iLearning's investors
owned a minority interest, pursuant to which the entity would market and sell
iLearning courses in consideration for revenue sharing proceeds. No revenue was
recognized in 2000 related to this agreement. The Company recognized revenues of
$1.1 million for the year ended December 31, 2001, related to this agreement.

In November 2000, iLearning entered into a Master Web Site Development and
Hosting Services Agreement with an entity controlled by one of iLearning's
investors, pursuant to which iLearning has agreed to develop and operate the
customer's web site portal. The terms of the agreement are similar to those of
other Master Web Site Development and Hosting Services Agreements entered into
with other third parties. Revenues will be recognized over the five-year term of
the agreement. No revenue was recognized in 200 related to this agreement. The
Company recognized revenue of $784,900 for the year ended December 31, 2001,
related to this agreement.

16


In January 2001, iLearning entered into an iGateway Testing Content Deployment
Agreement with an entity controlled by one of iLearning's investors, pursuant to
which iLearning has agreed to deliver web-enabled testing content to the
customer's client base. The terms of the agreement are similar to those of other
iGateway Testing Content Deployment Agreements entered into with other third
parties. Revenues will be recognized over the five-year term of the agreement.
The Company recognized revenue of $70,967 for the year ended December 31, 2001,
related to this agreement.

In March 2001, iLearning entered into a Business Relationship Agreement with one
of its investors, pursuant to which iLearning has agreed to operate a mutually
branded web site specifically for the promotion and sale of practice exams
developed by the investor in consideration for revenue sharing proceeds.
Revenues will be recognized on a monthly basis, based on actual courses sold.
The Company recognized revenue of $27,454 for the year ended December 31, 2001,
related to this agreement.

In September 2001, iLearning entered into an iPlatform Agreement with an entity
controlled by one of iLearning's investors, pursuant to which iLearning has
agreed to develop and operate the customer's web site portal. The terms of the
agreement are similar to those of other iPlatform Agreements entered into with
other third parties. Revenues will be recognized over the five-year term of the
agreement. The Company recognized revenue of $169,558 for the year ended
December 31, 2001, related to this agreement.

In November 2001, iLearning renewed its Training Product Sales Representative
Agreement with an entity controlled by one of iLearning's investors, pursuant to
which the entity will market and sell iLearning courses in consideration for
revenue sharing proceeds. Revenues will be recognized on a monthly basis, based
on actual courses sold. The Company recognized revenue of $20,426 for the year
ended December 31, 2001, related to this agreement.

In management's opinion, these transactions have been entered into on an
arms-length basis.

15. COMMITMENTS AND CONTINGENCIES:

OPERATING LEASES

The Company leases office space and certain office equipment under noncancelable
operating leases expiring through 2003. Future minimum annual rental commitments
under the lease agreements for the years ending December 31 are as follows:

                                                                          
2002                                                                         $      320,277

2003                                                                                154,563
                                                                             --------------
Total minimum lease payments                                                 $      474,840
                                                                             ==============



Rent expense for the years ended December 31, 2001 and 2000, was $209,532 and
$119,931, respectively.

17


LITIGATION

The Company, from time to time, is involved in routine legal matters incidental
to its normal operations. In management's opinion, the resolution of such
matters will not have a material adverse effect on the Company's consolidated
financial condition, results of operations or liquidity.

18

EX-99.4

                                                                    Exhibit 99.4

MINDSURF, INC.

Audited Consolidated Financial Statements

Year ended December 31, 2001 and the period October 25, 2000 (date of
inception) through December 31, 2000 with Report of Independent Auditors






                                 Mindsurf, Inc.

                    Audited Consolidated Financial Statements

    Year ended December 31, 2001 and the period October 25, 2000 (date of
                      inception) through December 31, 2000


                                    CONTENTS

                                                                                                     
Report of Independent Auditors...........................................................................1

Audited Consolidated Financial Statements

Consolidated Balance Sheets..............................................................................2
Consolidated Statements of Operations....................................................................4
Consolidated Statements of Stockholders' Equity (Deficit)................................................5
Consolidated Statements of Cash Flows....................................................................7
Notes to Consolidated Financial Statements...............................................................8











                         Report of Independent Auditors

The Board of Directors and Stockholders
Mindsurf, Inc.

We have audited the accompanying consolidated balance sheets of Mindsurf, Inc.,
as of December 31, 2001 and 2000, and the related consolidated statements of
operations, stockholders' equity (deficit) and cash flows for the year ended
December 31, 2001 and the period October 25, 2000 (date of inception) through
December 31, 2000. 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 auditing standards generally accepted
in the 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 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 consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Mindsurf, Inc. at
December 31, 2001 and 2000, and the results of its operations and its cash flows
for the year ended December 31, 2001 and the period October 25, 2000 (date of
inception) through December 31, 2000, in conformity with accounting principles
generally accepted in the United States.

The accompanying consolidated financial statements have been prepared assuming
that Mindsurf, Inc. will continue as a going concern. As more fully described in
Note 18, the Company's current and projected operating losses and limited
committed funding raise substantial doubt about its ability to continue as a
going concern. Management's plans to address this matter are also described in
Note 18. The consolidated financial statements do not include any adjustments to
reflect the possible future effects on the recoverability and classification of
assets or the amounts and classification of liabilities that may result from the
outcome of this uncertainty.


                                                     /s/ Ernst & Young LLP

Baltimore, Maryland
March 22, 2002





                                 Mindsurf, Inc.

                           Consolidated Balance Sheets




                                                                                   DECEMBER 31
                                                                             2001              2000
                                                                       ------------------------------------
                                                                                   
ASSETS
Current assets:
   Cash and cash equivalents                                               $   807,217      $ 1,925,545
   Restricted cash                                                                   -          160,215
   Accounts receivable                                                         782,809                -
   Deferred costs                                                              289,841                -
   Prepaid expenses and other current assets                                   185,436          178,728
                                                                       ------------------------------------
Total current assets                                                         2,065,303        2,264,488

Property and equipment:
   Furniture and equipment                                                   1,769,550        1,488,310
   Software                                                                  1,067,349          970,020
   Leasehold improvements                                                            -           22,955
                                                                       ------------------------------------
                                                                             2,836,899        2,481,285
   Accumulated depreciation                                                   (972,377)        (139,182)
                                                                       ------------------------------------
                                                                             1,864,522        2,342,103

Intangible assets:
   Goodwill                                                                          -       20,481,386
   Purchased software development costs                                      2,822,779                -
   Assembled workforce                                                         323,780        4,868,500
                                                                       ------------------------------------
                                                                             3,146,559       25,349,886
   Accumulated amortization                                                   (409,909)      (1,170,113)
                                                                       ------------------------------------
                                                                             2,736,650       24,179,773

Deferred costs, less current portion                                            88,809                -
Security deposits                                                              419,172          513,156
                                                                       ------------------------------------
Total assets                                                                $7,174,456      $29,299,520
                                                                       ====================================




                                                                               2



                                 Mindsurf, Inc.

                     Consolidated Balance Sheet (continued)




                                                                                   DECEMBER 31
                                                                             2001              2000
                                                                       ------------------------------------
                                                                                    
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
   Accounts payable and accrued expenses                                 $   1,023,806      $ 2,875,027
   Accrued compensation                                                        259,648          258,706
   Deferred revenue                                                            545,644                -
   Due to related parties for services and other charges                        14,505        1,333,266
   Current portion of capital lease obligations                                104,321           99,398
   Dividends payable                                                           284,048           43,397
                                                                       ------------------------------------
Total current liabilities                                                    2,231,972        4,609,794

Capital lease obligations, less current portion                                 74,865          183,619
Deferred revenue, less current portion                                         127,000                -
Convertible debt to related parties                                         13,200,000                -
Accrued interest on convertible debt to related parties                        498,411                -

Stockholders' equity:
   Series Y Preferred Stock, par value $.01 per share - 23,391,812 shares
     authorized, issued and outstanding in 2001 and 2000; aggregate liquidation
     value of $16,284,048 and $16,043,397 in
     2001 and 2000, respectively                                               233,918          233,918
   Series B Convertible Preferred Stock, par value $.01 per share -
     8,040,936 shares authorized, issued and outstanding in 2001 and
     2000; aggregate liquidation value of $6,027,004 and $5,579,562 in
     2001 and 2000, respectively                                                80,409           80,409
   Series A Convertible Preferred Stock, par value $.01 per share
     -69,122,807 and 28,500,000 shares authorized in 2001 and 2000,
     respectively; 42,807,017 and 17,543,860 shares issued and outstanding in
     2001 and 2000, respectively; aggregate liquidation value of $11,923,897 and
     $10,144,658 in 2001 and 2000,
     respectively                                                              428,071          175,439
   Series C Convertible Preferred Stock, par value $.01 per share -
     7,044,115 shares authorized, issued and outstanding in 2001;
     aggregate liquidation value of $2,123,937 in 2001                          70,441                -
   Series X Preferred Stock, par value $.01 per share - 70,175,439 and
     28,500,000 shares authorized in 2001 and 2000, respectively;
     1,052,632 shares issued and outstanding in 2001; aggregate
     liquidation value of $600,000 in 2001                                      10,526                -
   Common stock, par value $.01 per share - 40,000,000 shares
     authorized in 2001 and 2000; 99,093 shares issued and outstanding
     in 2001                                                                       991                -
   Additional paid-in capital                                               48,159,175       31,946,136
   Unearned compensation                                                       (34,224)        (291,891)
   Accumulated deficit                                                     (57,907,099)      (7,637,904)
                                                                       ------------------------------------
Total stockholders' equity (deficit)                                        (8,957,792)      24,506,107
                                                                       ------------------------------------
Total liabilities and stockholders' equity (deficit)                     $   7,174,456      $29,299,520
                                                                       ====================================


SEE ACCOMPANYING NOTES.


                                                                               3



                                 Mindsurf, Inc.

                      Consolidated Statements of Operations




                                                                                            PERIOD
                                                                                        OCTOBER 25, 2000
                                                                YEAR ENDED             (DATE OF INCEPTION)
                                                               DECEMBER 31,            THROUGH DECEMBER 31,
                                                                   2001                       2000
                                                            -----------------------------------------------
                                                                             
Revenues                                                    $     327,483                  $         -
Cost of sales                                                     204,802                            -
                                                            -----------------------------------------------
Gross margin                                                      122,681                            -

Costs and expenses:
   Sales and marketing                                          5,893,937                    1,330,731
   General and administrative                                  11,002,370                    2,673,018
   Research and development                                    13,783,297                    2,314,094
   Services and other charges from related parties              1,468,120                    1,333,266
   Loss on write-off of intangible assets                      17,842,301                            -
                                                            -----------------------------------------------
Total operating costs and expenses                             49,990,025                    7,651,109
                                                            -----------------------------------------------

Loss from operations                                          (49,867,344)                  (7,651,109)
Interest expense on convertible debt to related parties          (498,411)                           -
Interest income                                                    96,560                       13,205
                                                            -----------------------------------------------
Net loss                                                     $(50,269,195)                 $(7,637,904)
                                                            ===============================================



SEE ACCOMPANYING NOTES.


                                                                               4


                                 Mindsurf, Inc.

            Consolidated Statements of Stockholders' Equity (Deficit)



                                                           SERIES B       SERIES A        SERIES C
                                         SERIES Y         CONVERTIBLE    CONVERTIBLE     CONVERTIBLE    SERIES X
                                         PREFERRED         PREFERRED      PREFERRED       PREFERRED     PREFERRED     COMMON
                                           STOCK             STOCK          STOCK           STOCK         STOCK        STOCK
                                        -----------       -----------    ------------    ------------  -----------   ---------
                                                                                                   
Issuance of 14,298,246 shares of
  Series A Convertible Preferred
  Stock at inception for cash of
  $8,150,000, net of direct costs
  of issuance of $140,001 (see
  Note 10)                                 $      -         $      -     $    142,983     $      -     $      -     $    -
Issuance of 8,040,936 shares of
  Series B Convertible Preferred
  Stock on October 25, 2000 valued
  at $5,500,000 in connection with
  acquisition of HiFusion (see
  Note 3)                                         -           80,409                -            -            -          -
Issuance of 23,391,812 shares of
  Series Y Preferred Stock on
  October 25, 2000 valued at
  $16,000,000 in connection with
  acquisition of HiFusion (see
  Note 3)                                   233,918                -                -            -            -          -
Conversion of liabilities assumed
  in acquisition of HiFusion to
  3,245,614 shares of Series A
  Convertible Preferred Stock at
  face value of $1,850,000 (see
  Note 10)                                        -                -           32,456            -            -          -
Value of options to purchase
  common stock to be issued in
  connection with acquisition of
  HiFusion (see Note 3)                           -                -                -            -            -          -
Amortization of unearned
  compensation                                    -                -                -            -            -          -
Accrued dividends on Series Y
  Preferred Stock                                 -                -                -            -            -          -
Net loss for the period October
  25, 2000 (date of inception)
  through December 31, 2000                       -                -                -            -            -          -
                                       ------------     ------------     ------------     --------     --------     ------
Balance at December 31, 2000                233,918           80,409          175,439            -            -          -
                                       ------------     ------------     ------------     --------     --------     ------



                                         ADDITIONAL
                                           PAID-IN           UNEARNED        ACCUMULATED
                                           CAPITAL         COMPENSATION        DEFICIT          TOTAL
                                       --------------     --------------    -------------    -----------
                                                                                 
Issuance of 14,298,246 shares of
  Series A Convertible Preferred
  Stock at inception for cash of
  $8,150,000, net of direct costs
  of issuance of $140,001 (see
  Note 10)                             $  7,867,016         $       -         $       -      $  8,009,999
Issuance of 8,040,936 shares of
  Series B Convertible Preferred
  Stock on October 25, 2000 valued
  at $5,500,000 in connection with
  acquisition of HiFusion (see
  Note 3)                                 5,419,591                 -                 -         5,500,000
Issuance of 23,391,812 shares of
  Series Y Preferred Stock on
  October 25, 2000 valued at
  $16,000,000 in connection with
  acquisition of HiFusion (see
  Note 3)                                15,766,082                 -                 -        16,000,000
Conversion of liabilities assumed
  in acquisition of HiFusion to
  3,245,614 shares of Series A
  Convertible Preferred Stock at
  face value of $1,850,000 (see
  Note 10)                                1,817,544                 -                 -         1,850,000
Value of options to purchase
  common stock to be issued in
  connection with acquisition of
  HiFusion (see Note 3)                   1,119,300          (310,421)                -           808,879
Amortization of unearned
  compensation                                    -            18,530                 -            18,530
Accrued dividends on Series Y
  Preferred Stock                           (43,397)                -                 -           (43,397)
Net loss for the period October
  25, 2000 (date of inception)
  through December 31, 2000                       -                 -        (7,637,904)       (7,637,904)
                                       ------------      ------------      ------------      ------------
Balance at December 31, 2000             31,946,136          (291,891)       (7,637,904)       24,506,107
                                       ------------      ------------      ------------      ------------


                                                                               5



                                 Mindsurf, Inc.

      Consolidated Statements of Stockholders' Equity (Deficit) (continued)



                                                      SERIES B       SERIES A       SERIES C
                                      SERIES Y       CONVERTIBLE   CONVERTIBLE    CONVERTIBLE    SERIES X
                                     PREFERRED        PREFERRED     PREFERRED      PREFERRED     PREFERRED     COMMON
                                       STOCK            STOCK         STOCK          STOCK         STOCK        STOCK
                                   --------------- -------------- --------------- ------------- ------------ ------------
                                                                                             
Balance at December 31, 2000         $233,918         $80,409        $175,439       $      -    $       -        $  -
Issuance of 26,315,789 shares of
  Series A Convertible Preferred
  Stock for cash of $15,000,000
  (see Note 10)                             -               -         263,158              -            -           -
Conversion of 1,052,632 shares of
  Series A Convertible Preferred
  Stock to Series X Preferred
  Stock (See Note 12)                       -               -         (10,526)             -       10,526           -
Options exercised for purchase of
  99,093 shares of common stock             -               -               -              -            -         991
Issuance of 7,044,115 shares of
  Series C Convertible Preferred
  Stock valued at $2,042,225 in
  connection with acquisition of
  Discourse (see Note 2)                    -               -               -         70,441            -           -
Amortization of unearned
  compensation for the year ended
  December 31, 2001, net of
  forfeitures                               -               -               -              -            -           -
Reduction of unearned compensation
  related to forfeited options              -               -               -              -            -           -
Accrued dividends on Series Y
  Preferred Stock                           -               -               -              -            -           -
Net loss for the year ended
  December 31, 2001                         -               -               -              -            -           -
                                   ----------         -------        --------        -------      -------       -----
                                     $233,918         $80,409        $428,071        $70,441      $10,526        $991
                                   ==========         =======        ========        =======      =======       =====





                                       ADDITIONAL
                                        PAID-IN       UNEARNED        ACCUMULATED
                                        CAPITAL      COMPENSATION       DEFICIT            TOTAL
                                      ------------   ------------     ------------      -----------
                                                                            
 Balance at December 31, 2000          $31,946,136     $(291,891)     $ (7,637,904)     $24,506,107
 Issuance of 26,315,789 shares of
   Series A Convertible Preferred
   Stock for cash of $15,000,000
   (see Note 10)                        14,736,842             -                 -       15,000,000
 Conversion of 1,052,632 shares of
   Series A Convertible Preferred
   Stock to Series X Preferred
   Stock (See Note 12)                           -             -                 -                -
 Options exercised for purchase of
   99,093 shares of common stock             2,950             -                 -            3,941
 Issuance of 7,044,115 shares of
   Series C Convertible Preferred
   Stock valued at $2,042,225 in
   connection with acquisition of
   Discourse (see Note 2)                1,971,784             -                 -        2,042,225
 Amortization of unearned
   compensation for the year ended
   December 31, 2001, net of
   forfeitures                                   -          (219)                -             (219)
 Reduction of unearned compensation
   related to forfeited options           (257,886)      257,886                 -                -
 Accrued dividends on Series Y
   Preferred Stock                        (240,651)            -                 -         (240,651)
 Net loss for the year ended
   December 31, 2001                             -             -       (50,269,195)     (50,269,195)
                                       -----------    ----------      ------------     ------------
                                       $48,159,175    $  (34,224)     $(57,907,099)    $ (8,957,792)
                                       ===========    ==========      ============     ============

                                                                               6



                                 Mindsurf, Inc.

                      Consolidated Statement of Cash Flows



                                                                                     PERIOD
                                                                                OCTOBER 25, 2000
                                                                                     (DATE OF
                                                                                    INCEPTION)
                                                                   YEAR ENDED         THROUGH
                                                                   DECEMBER 31,    DECEMBER 31,
                                                                       2001             2000
                                                                 --------------   -----------------
                                                                               
OPERATING ACTIVITIES
Net loss                                                           $(50,269,195)     $ (7,637,904)
Adjustments to reconcile net loss to
  net cash used in operating activities:
    Depreciation                                                        869,010           138,182
    Amortization of purchased software development costs                352,847              --
    Amortization of other intangible assets                           6,394,534         1,170,113
    Amortization of unearned compensation                                  (219)           18,530
    Loss on disposal of fixed assets                                     50,391              --
    Loss on write-off of intangible assets                           17,842,301              --
    Changes in operating assets and liabilities:
      Restricted cash                                                   160,215              --
      Accounts receivable                                              (603,940)             --
      Deferred costs                                                   (378,650)             --
      Prepaid expenses and other current assets                          89,811           (77,273)
      Accounts payable and accrued expenses                          (3,137,122)         (896,000)
      Accrued compensation                                                  942            47,008
      Due to related parties                                         (1,318,761)        1,333,266
      Deferred revenue                                                  609,415              --
      Accrued interest on convertible debt to related parties           498,411              --
                                                                   ------------      ------------
Net cash used in operating activities                               (28,840,010)       (5,904,078)

INVESTING ACTIVITIES
Purchase of property and equipment                                     (378,428)         (146,090)
                                                                   ------------      ------------
Net cash used in investing activities                                  (378,428)         (146,090)

FINANCING ACTIVITIES
Payments of capital lease obligations                                  (103,831)          (34,286)
Proceeds from issuance of convertible debt                           13,200,000              --
Issuance of Series A Convertible Preferred stock for cash            15,000,000         8,009,999
Issuance of common stock                                                  3,941              --
                                                                   ------------      ------------
Net cash provided by financing activities                            28,100,110         7,975,713
                                                                   ------------      ------------
Net change in cash and cash equivalents                              (1,118,328)        1,925,545
Cash and cash equivalents at the beginning of period                  1,925,545              --
                                                                   ------------      ------------
Cash and cash equivalents at the end of period                     $    807,217      $  1,925,545
                                                                   ============      ============


SEE ACCOMPANYING NOTES.

                                                                               7



                                 Mindsurf, Inc.

                   Notes to Consolidated Financial Statements

                                December 31, 2001


1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

ORGANIZATION

Mindsurf, Inc., (the Company), was incorporated on October 25, 2000 under the
laws of the state of Delaware for the purpose of providing one to one (one
computer to one student) computing solutions to the Kindergarten through 12th
grade sector (K-12) of the education community. The Company was established as a
strategic partnership between Sylvan Learning Systems, Inc. (Sylvan), Aether
Systems, Inc. (Aether) and Critical Path, Inc. (Critical Path). Prior to the
year ended December 31, 2001, the Company had been a development stage
enterprise.

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of Mindsurf, Inc. and
its wholly-owned subsidiaries. All material intercompany accounts and
transactions have been eliminated in consolidation.

USE OF ESTIMATES

The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.

CASH AND CASH EQUIVALENTS

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.

RESTRICTED CASH AND LETTER OF CREDIT

Restricted cash at December 31, 2000 consisted of cash pledged as collateral on
an outstanding letter of credit that was required under the Company's operating
lease for office space. Restricted cash consisted of a certificate deposit
bearing interest at 5.10%. During 2001, the outstanding letter of credit
expired, the Company's operating lease was terminated and the cash became
unrestricted. As of December 31, 2001, the Company does not have any outstanding
letters of credit or restrictions of cash.

                                                                               8


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

PROPERTY AND EQUIPMENT

Property and equipment is stated at cost and depreciated using the straight-line
method over estimated useful lives of three years. Assets held under capital
leases are stated at the lesser of the present value of future minimum lease
payments using the Company's incremental borrowing rate at the inception of the
lease or the fair value of the property at the inception of the lease. The
assets recorded under capital leases are generally amortized over the lesser of
the lease term or the estimated useful life of the assets in a manner consistent
with the Company's depreciation policy for owned assets. Amortization of assets
under capital leases is included in depreciation expense.

INTANGIBLE ASSETS

Intangible assets at December 31, 2001 consist of purchased software development
costs and assembled workforce recorded in connection with the acquisition of
Discourse on June 21, 2001. The Company amortizes its purchased software
development costs and assembled workforce using the straight-line method over
estimated useful lives of four and three years, respectively.

IMPAIRMENT OF LONG-LIVED ASSETS

Long-lived assets, including intangible assets, are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be fully recoverable. If an impairment indicator is present,
the Company evaluates whether an impairment exists on the basis of undiscounted
expected future cash flows from operations for the remaining amortization
period. If an impairment exists, the asset is reduced by the shortfall of the
asset's estimated fair value from the carrying value.

SECURITY DEPOSITS

Security deposits consist of amounts deposited with lessors to secure the
Company's obligations under certain capital lease obligations. These amounts
will be refunded to the Company upon the satisfaction of all payments under the
related leases that expire through 2003.

                                                                               9


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

REVENUE RECOGNITION

The Company derives revenue from arrangements that include software licenses,
postcontract customer support (PCS), and services. In addition, the Company for
the convenience of its customers, sells hardware and software purchased from
third parties. Postcontract customer support includes telephone support, bug
fixes, and rights to upgrades on a when-and-if available basis. Services
primarily include installation and training.

The Company allocates the total arrangement fee among each deliverable based on
the fair value of each of the deliverables determined based on vendor-specific
objective evidence. If vendor-specific objective evidence of fair value does not
exist for each of the deliverables, all revenue from the arrangement is deferred
until the earlier of the point at which sufficient vendor-specific objective
evidence of fair value or all elements of the arrangement have been delivered.
However, if the only undelivered element is PCS, the entire fee is recognized
ratably over the term of the PCS arrangement. All amounts billed or received in
excess of the revenue recognized is included in deferred revenue. In addition,
the Company defers all direct costs associated with revenue that has been
deferred. These amounts are classified as deferred costs in the accompanying
consolidated balance sheet.

RESEARCH AND DEVELOPMENT AND SOFTWARE DEVELOPMENT COSTS

Costs for the development of new software products are expensed as research and
development costs as incurred until technological feasibility is established, at
which time any additional development costs are capitalized until the product is
available for general release to customers. The Company defines technological
feasibility as the completion of a working model of the software product that
has been tested to be consistent with the product design specifications. As of
December 31, 2001, with the exception of purchased software development costs,
the Company has not established technological feasibility for its software under
development and therefore all costs have been expensed as research and
development costs.


                                                                              10


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

INCOME TAXES

The Company uses the liability method in accounting for income taxes. Under this
method, deferred income tax assets and liabilities are determined based on
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.

ADVERTISING

The Company expenses advertising costs as incurred. Advertising expense totaled
approximately $61,000 and $142,000 for year ended December 31, 2001 and the
period October 25, 2000 (date of inception ) to December 31, 2000, respectively.

RECLASSIFICATIONS

Certain amounts in the 2000 consolidated financial statements have been
reclassified to conform with the 2001 presentation.

NEW ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 141, BUSINESS COMBINATIONS, and No. 142,
GOODWILL AND OTHER INTANGIBLE ASSETS. Statement 141 requires that the purchase
method of accounting be used for all business combinations initiated after June
30, 2001. Statement 141 also includes guidance on the initial recognition and
measurement of goodwill and other intangible assets arising from business
combinations completed after June 30, 2001. Statement 142 prohibits the
amortization of goodwill and intangible assets with indefinite useful lives.
Statement 142 requires that these assets be reviewed for impairment at least
annually. Intangible assets with finite lives will continue to be amortized over
their estimated useful lives. Additionally, Statement 142 requires that goodwill
included in the carrying value of equity method investments no longer be
amortized. The Company will apply Statement 142 beginning in fiscal year 2002.
Application of the nonamortization and impairment provisions of Statement 142 is
not anticipated to be significant.


                                                                              11


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

NEW ACCOUNTING PRONOUNCEMENTS (CONTINUED)

In August 2001, the Financial Accounting Standards Board issued Statement of
Financial Standards No. 144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF
LONG-LIVED ASSETS, which addresses financial accounting and reporting for the
impairment or disposal of long-lived assets and supersedes Statement No. 121,
ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO
BE DISPOSED OF, and the accounting and reporting provisions of APB Opinion No.
30, REPORTING THE RESULTS OF OPERATIONS for a disposal of a segment of business.
Statement 144 is effective for fiscal years beginning after December 15, 2001,
with earlier application encouraged. The Company expects to adopt Statement 144
in fiscal year 2002 and it does not expect that the adoption of the Statement
will have a significant impact on the Company's financial position and results
of operations.

2. ACQUISITION OF DISCOURSE TECHNOLOGIES, INC.

On June 21, 2001, the Company acquired all of the outstanding common stock of
Discourse Technologies, Inc. (Discourse), a technology company whose primary
product was a one to one teaching application for use in the K-12 classroom
environment. The purchase price consisted of 7,044,115 shares of Series C
Convertible Preferred Stock (Series C) valued at $2,042,225. The securities
issued in connection with the acquisition were valued in good faith by the
Company based on an independent appraisal of the business acquired and other
pertinent factors.

The acquisition was accounted for using the purchase method of accounting, and
the results of operations of Discourse are included in the accompanying
consolidated statement of operations commencing June 21, 2001. The total
purchase price was allocated as follows:

         Current assets                       $     207,356
         Property and equipment                      63,393
         Current liabilities assumed             (1,375,083)
         Purchased software                       2,822,779
         Assembled workforce                        323,780
                                                 ----------
                                                 $2,042,225
                                                 ==========


                                                                              12


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

3. ACQUISITION OF HIFUSION AND LOSS ON WRITE-OFF OF INTANGIBLE ASSETS

On October 25, 2000, the Company acquired all of the outstanding common stock of
HiFusion, Inc. (HiFusion), an Internet education portal developer and service
provider for teachers, parents and students. The purchase price consisted of
8,040,936 shares of Series B Convertible Preferred Stock valued at $5,500,000
and 23,391,812 shares of Series Y Preferred Stock valued at $16,000,000. The
securities issued in the acquisition were valued in good faith by the Company
based on contemporaneous cash transactions in its equity securities and other
pertinent factors. In addition, the Company agreed to exchange all of the
outstanding vested and unvested options to purchase an aggregate of 2,899,250
shares of common stock of HiFusion for options to purchase the same number of
shares of common stock of the Company at an exercise price of $0.57 per share,
all of which were granted during 2001. The fair value of the options granted to
the former HiFusion option holders was estimated by the Company to be
$1,119,300, determined using the Black-Scholes option-pricing model. This amount
was included in the total purchase price, reduced by the portion related to
unearned employee compensation of $310,421.

The acquisition was accounted for using the purchase method of accounting, and
the results of operations of HiFusion have been included in the accompanying
consolidated statement of operations commencing October 25, 2000. The total
purchase price is summarized as follows:

         Series B Convertible Preferred Stock                $ 5,500,000
         Series Y Preferred Stock                             16,000,000
         Options to purchase common stock                      1,119,300
         Less unearned compensation                             (310,421)
                                                             -----------
                                                             $22,308,879
                                                             ===========

The total purchase price was allocated as follows:

         Current assets                                      $   699,655
         Property and equipment                                2,335,195
         Notes payable                                        (1,850,000)
         Other liabilities assumed                            (4,225,857)
         Goodwill                                             20,481,386
         Assembled workforce                                   4,868,500
                                                             -----------
                                                             $22,308,879
                                                             ===========

                                                                              13


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

3. ACQUISITION OF HIFUSION AND LOSS ON WRITE-OFF OF INTANGIBLE ASSETS
   (CONTINUED)

In December 2001, the Company determined that certain long-lived assets acquired
as part of the HiFusion acquisition should be written-off as a result of
strategic changes in its business. The identified assets, consisting of goodwill
and assembled workforce, were impaired as a result of changes in the business to
focus primarily on selling the Discourse software product as well as the
termination of substantially all of the employees obtained in the acquisition of
HiFusion. All other long-lived assets have been integrated into the ongoing
business are expected to be realized through future operations.

The changes in the goodwill and assembled workforce related to the HiFusion
acquisition are summarized as follows:

                                                              ASSEMBLED
                                             GOODWILL         WORKFORCE
                                           ------------      ------------

      Balance at December 31, 2000         $ 19,528,433      $  4,651,340
        Amortization of goodwill             (5,120,347)       (1,217,125)
        Write-off of intangible assets      (14,408,086)       (3,434,215)
                                           ------------      ------------
      Balanced at December 31, 2001        $       --        $       --
                                           ============      ============

Therefore, the accompanying consolidated statement of operations for the year
ended December 31, 2001 includes a loss on the write-off of intangible assets
totaling $17,842,301.

4. SERVICES AGREEMENTS WITH RELATED PARTIES

Upon formation, the Company entered into service agreements with each of three
principal stockholders, as described below.

Under the master services agreement with Sylvan, Sylvan will provide certain
marketing, product development, sales, financial, and other management or
administrative services upon request. Under the agreement, Sylvan will also
provide certain start-up resources such as interim facilities, recruitment,
financial accounting, and temporary labor to help accelerate the Company's
business plan. Under the agreement, the Company is required to pay a quarterly
fee that is based on Sylvan's good faith estimate of the cost of such services.
This agreement has a five-year term, is renewable for one additional year, and
can be terminated by either party with 60 days notice. Sylvan charged the
Company $346,176 and $736,918 under this master services agreement for the year
ended

                                                                              14


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

4. SERVICES AGREEMENTS WITH RELATED PARTIES (CONTINUED)

December 31, 2001 and the period October 25, 2000 (date of inception) through
December 31, 2000, respectively, principally related to administrative and
research and development activities, which is included in services and other
charges from related parties in the accompanying consolidated statements of
operations.

Under the master services agreement with Aether, Aether will provide wireless
systems integration technology, network implementation, and product support
services. Aether will charge an hourly rate for its personnel used during the
internal development and preparation of the network. The hourly rate will be
established and agreed upon in advance and will be invoiced on a monthly basis.
Any direct materials will be charged at Aether's cost. This agreement has a
five-year term, is renewable for one additional year, and can be terminated by
either party with 60 days notice. Aether charged the Company $1,093,640 and
$580,959 under this master services agreement for the year ended December 31,
2001 and the period October 25, 2000 (date of inception) through December 31,
2000, respectively, which is included in services and other charges from related
parties in the accompanying consolidated statements of operations.

Under the master services agreement with Critical Path, Critical Path will
provide professional services to develop Internet-based messaging services to be
integrated into the Company's product offerings, and related customer support
services. The cost of these services will be determined based on terms that are
commercially favorable and will be invoiced on a monthly basis. This agreement
has a five-year term, is renewable for one additional year and is can be
terminated by either party with 60 days notice. Critical Path charged the
Company $28,304 and $15,389 under this master services agreement for the year
ended December 31, 2001 and the period October 25, 2000 (date of inception)
through December 31, 2000, respectively, which is included in services and other
charges from related parties in the accompanying consolidated statements of
operations.

5. CONVERTIBLE DEBT TO RELATED PARTIES

During 2001, the Company issued convertible promissory notes with an aggregate
face value of $13,200,000 to Sylvan and Aether. The promissory notes bear
interest at a fixed rate of 12% per annum which is payable at the maturity date
of the notes. The notes mature five years from the date of issuance and are
convertible at any time at the option of the holders into Series A Convertible
Preferred Stock (Series A) at a conversion rate of $0.57 per share, subject to
adjustment upon the occurrence of certain specified dilutive events. The notes
will automatically convert into shares of Series A immediately prior to the
automatic conversion of the Series A into common stock as described in Note 10.

                                                                              15


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


5. CONVERTIBLE DEBT TO RELATED PARTIES (CONTINUED)

During 2001, the Company accrued interest expense totaling $498,411, which is
included in accrued interest on convertible debt to related parties in the
accompanying consolidated balance sheet.

6. INCOME TAXES

The significant components of the Company's deferred tax assets and liabilities
as of December 31, 2001 and 2000 are as follows:



                                                   DECEMBER 31
                                             2001             2000
                                          ------------    ------------
                                                    
   Deferred tax assets:
      Net operating loss carryforwards    $ 22,893,430    $  9,468,087
      Contribution carryforward                    614             614
      Vacation pay accrual                      60,277          76,045
      Deferred revenue                          70,211            --
      Depreciation                              34,146            --
                                          ------------    ------------
   Total deferred tax assets                23,058,678       9,544,746

   Deferred tax liabilities:
      Depreciation                                --            73,003
                                          ------------    ------------
   Net deferred tax assets                  23,058,678       9,471,743
   Valuation allowance for deferred tax
     assets                                (23,058,678)     (9,471,743)
                                          ------------    ------------
   Net deferred tax assets                $       --      $       --
                                          ============    ============


The Company has reported losses since inception. The losses have not resulted in
reported tax benefits because of increases in the valuation allowance for
deferred tax assets that result primarily from the inability to determine the
realizability of the net operating loss carryforwards. The Company paid no
income taxes during the year ended December 31, 2001 and the period October 25,
2000 (date of inception ) to December 31, 2000.

At December 31, 2001, the Company had net operating loss carryforwards of
approximately $59.3 million that begin to expire in 2020. Included in this
amount is approximately $18.2 million and $9.6 million of net operating loss
carryforwards acquired from HiFusion and Discourse, respectively, for which a
full valuation allowance was applied on the dates of the acquisition. These net
operating loss carryforwards begin to expire in 2018 and are available only to
offset certain types of future taxable income.

                                                                              16


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


6. INCOME TAXES (CONTINUED)

A reconciliation of the reported income tax expense to the amount that would
result by applying the U.S. federal statutory rate to the loss is as follows:




                                                                          PERIOD
                                                                     OCTOBER 25, 2000
                                                                    (DATE OF INCEPTION)
                                                    YEAR ENDED            THROUGH
                                                    DECEMBER 31,         DECEMBER 31,
                                                       2001                 2000
                                                  --------------    -------------------
                                                                  
Tax benefit at U.S. statutory rate of 34%          $(17,091,526)        $ (2,596,887)
Effect of permanent differences                       8,393,958              436,578
State income taxes, net of federal benefit           (1,181,847)            (293,548)
Effect of change in valuation allowance for
  deferred tax assets                                 9,879,415            2,453,857
                                                   ------------         ------------
Total                                              $       --           $       --
                                                   ============         ============


7. CAPITAL LEASE OBLIGATIONS

The Company has entered into capital lease agreements to acquire certain
equipment. Property and equipment in the accompanying consolidated balance
sheets includes the following balances with respect to equipment under capital
lease:

                                                      DECEMBER 31
                                                 2001             2000
                                               --------         --------
         Furniture and equipment               $336,763         $350,979
         Accumulated depreciation              (159,027)         (46,773)
                                               --------         --------
                                               $177,736         $304,206
                                               ========         ========

Amortization of the leased property is included in depreciation expense.


                                                                              17


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


7. CAPITAL LEASE OBLIGATIONS (CONTINUED)

Future minimum payments under capital lease obligations consist of the following
at December 31, 2001:

     2002                                                 $121,575
     2003                                                   77,508
                                                          --------
     Total minimum lease payments                          199,083
     Amounts representing interest                         (19,897)
                                                          --------
     Present value of net minimum lease payments
       (including current portion of $104,321)            $179,186
                                                          ========

8. SERIES Y PREFERRED STOCK

The Company has authorized the issuance of up to 177,775,109 shares of preferred
stock, par value $0.01 per share, of which 23,391,812 has been designated Series
Y Preferred Stock (Series Y). On October 25, 2000, in connection with the
acquisition of HiFusion (see Note 3), the Company issued 23,391,812 shares of
Series Y that were valued at $16,000,000.

DIVIDENDS

The holders of the Series Y are entitled to receive cumulative dividends at the
annual rate of $0.0103 per share out of assets of the Company legally available
for distribution, payable annually on each October 1. In the event of
nonpayment, the dividends will accrue at the annual rate of $0.0239 per share
until paid. After the third anniversary of the issuance date, the holders of the
Series Y are entitled to receive cumulative dividends at the annual rate of
$0.041 per share out of assets of the Company legally available for
distribution, payable annually on each October 1. In the event of nonpayment,
the dividends will accrue at the annual rate of $0.0547 per share until paid.
The dividend rights of the Series Y holders are superior to all other classes of
securities. As of December 31, 2001 and 2000, the Company has accrued dividends
payable to the Series Y holders of $284,048 and $43,397, respectively.

The Series Y was recorded at estimated fair value on the date of issuance,
assuming a constant dividend yield of 6% per annum. The excess of the redemption
value over the fair value of $1,918,610 is being accreted by periodic charges to
additional paid-in capital during the period from the date of issuance through
the commencement of the perpetual dividend payments using the interest method.


                                                                              18




                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


8. SERIES Y PREFERRED STOCK (CONTINUED)

LIQUIDATION

Each share of Series Y has a preference on liquidation equal to $0.684 per share
plus all accrued and unpaid dividends. The liquidation preference of the Series
Y is senior to the holders of all other securities.

VOTING RIGHTS

The holders of the Series Y are not entitled to vote.

REDEMPTION

At any time beginning immediately prior to the closing of an underwritten public
offering with at least $35 million of gross proceeds to the Company or the
change of control of the Company (a redemption event), the Company may redeem
all of part of the issued and outstanding shares of Series Y at a price equal to
$0.684 per share plus all accrued and unpaid dividends. If the Company does not
redeem all of the issued and outstanding shares of Series Y within 30 days of a
redemption event, the holders of the Series Y will be entitled to cash dividends
at an annual rate of $0.137 per share.

9. SERIES B CONVERTIBLE PREFERRED STOCK

The Company has authorized the issuance of up to 8,040,936 shares of Series B
Convertible Preferred Stock (Series B), par value $0.01 per share. On October
25, 2000, in connection with the acquisition of HiFusion (see Note 3), the
Company issued 8,040,936 shares of Series B that was valued at $5,500,000.

CONVERSION RIGHTS

The Series B is convertible into common stock, at the option of the holder,
beginning 18 months after the date of issuance. In addition, the Series B will
convert automatically into shares of common stock upon the closing of an
underwritten public offering with at least $35 million of gross proceeds to the
Company, upon the change of control of the Company, or upon the affirmative vote
of two-thirds of the Series B holders. Each share of Series B is initially
convertible into one share of common stock. This conversion ratio is subject to
adjustment upon the occurrence of certain specified dilutive events.

                                                                              19



                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


9. SERIES B CONVERTIBLE PREFERRED STOCK (CONTINUED)

DIVIDENDS

The holders of the Series B are entitled to receive cumulative dividends at the
annual rate of $0.0547 per share commencing on the date of issuance and
continuing until the third anniversary of issuance, when and if declared by the
Board of Directors, and regardless of whether there are actual profits or other
funds available for dividend payment. These dividend rights of the Series B
holders are superior to those of the common stockholders and equal to the rights
of the holders of the Series A Convertible Preferred Stock (Series A). After the
third anniversary of the issuance date, the holders of the Series B are entitled
to receive cumulative dividends at the annual rate of $0.041 per share out of
assets of the Company legally available for distribution, payable annually on
each October 1. In the event of nonpayment, the dividends will accrue at the
annual rate of $0.0547 per share until paid. These dividend rights of the Series
B holders are superior to both the common and Series A and Series C
stockholders. Dividends in arrears on the Series B were $519,372 and $79,562 at
December 31, 2001 and 2000, respectively.

LIQUIDATION

Each share of Series B has a preference on liquidation equal to $0.684 per share
plus all accrued and unpaid dividends. The liquidation preference of the Series
B is senior to the holders of the Series A and Series C but subordinate to the
holders of the Series Y.

VOTING RIGHTS

The holders of the Series B are not entitled to vote.

10. SERIES A CONVERTIBLE PREFERRED STOCK

The Company has authorized the issuance of up to 69,122,807 shares of Series A,
par value $0.01 per share. On October 25, 2000, the Company entered into a stock
purchase agreement with Sylvan, Aether, and Critical Path under which it has
agreed to sell an aggregate of up to 122,807,017 shares of Series A for gross
proceeds of $70,000,000. In connection with the execution of this agreement, the
Company issued 17,543,860 shares of Series A in exchange for cash of $8,150,000
and the termination of certain notes payable to Aether (assumed in the
acquisition of HiFusion) with an aggregate face value of $1,850,000. During
2001, an additional 26,315,789 shares of Series A were issued to Sylvan and
Aether for gross proceeds of $15,000,000.



                                                                              20


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


10. SERIES A CONVERTIBLE PREFERRED STOCK (CONTINUED)

CONVERSION RIGHTS

The Series A is convertible into common stock at the option of the holder at any
time. In addition, the Series A will convert automatically into shares of common
stock upon the closing of an underwritten public offering with at least $35
million of gross proceeds to the Company, upon the change of control of the
Company, or upon the affirmative vote of two-thirds of the Series A holders.
Each share of Series A is initially convertible into one share of common stock.
This conversion ratio is subject to adjustment upon the occurrence of certain
specified dilutive events.

DIVIDENDS

The holders of Series A are entitled to receive cumulative dividends at the
annual rate of $0.0456 per share when and if declared by the Board of Directors,
and regardless of whether there are actual profits or other funds available for
dividend payment. The dividend rights of the Series A holders are superior to
those of the Series C and common stockholders. Dividends in arrears on the
Series A were $1,912,234 and $144,658 at December 31, 2001 and 2000,
respectively.

LIQUIDATION

Each share of Series A has a preference on liquidation equal to $0.57 per share
plus all accrued and unpaid dividends. The liquidation preference of the Series
A is subordinate to the holders of the Series B and the Series Y.

VOTING RIGHTS

Each share of Series A has substantially the same voting rights as the number of
shares of common stock into which it can be converted. In addition, certain
corporate actions require the consent of two-thirds of the outstanding shares of
Series A and the holders of the Series A and Series C in the aggregate are
entitled to appoint all seven members of the Board of Directors.


                                                                              21


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


11. SERIES C CONVERTIBLE PREFERRED STOCK

As of December 31, 2001, the Company has authorized the issuance of up to
7,044,115 shares of Series C Convertible Preferred Stock (Series C), par value
$0.01 per share. On June 21, 2001, in connection with the acquisition of
Discourse (see Note 2), the Company issued 7,044,115 shares of Series C that was
valued at $2,042,225.

CONVERSION RIGHTS

The Series C is convertible into common stock at the option of the holder at any
time. In addition, the Series C will convert automatically into shares of common
stock upon the closing of an underwritten public offering with at least $35
million of gross proceeds to the Company, upon the change of control of the
Company, or upon the affirmative vote of two-thirds of the Series A and Series C
holders. Each share of Series C is initially convertible into one share of
common stock. This conversion ratio is subject to adjustment upon the occurrence
of certain specified dilutive events.

DIVIDENDS

The holders of Series C are entitled to receive cumulative dividends at the
annual rate of $0.0232 per share when and if declared by the Board of Directors,
and regardless of whether there are actual profits or other funds available for
dividend payment. The dividend rights of the Series C holders are superior to
those of the common stockholders. Dividends in arrears on the Series C were
$81,712 at December 31, 2001.

LIQUIDATION

Each share of Series C has a preference on liquidation equal to $0.57 per share
plus all accrued and unpaid dividends. The liquidation preference of the Series
C is subordinate to the holders of the Series A, Series B and the Series Y.

VOTING RIGHTS

Each share of Series C has substantially the same voting rights as the number of
shares of common stock into which it can be converted. In addition, the holders
of the Series A and C voting together as a class in the aggregate are entitled
to appoint all seven members of the Board of Directors.



                                                                              22

                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


12. SERIES X PREFERRED STOCK

As of December 31, 2001, the Company has authorized the issuance of up to
70,175,439 shares of Series X Preferred Stock (Series X), par value $0.01 per
share. During 2001, 1,052,632 shares of Series A automatically converted into an
equal number of shares of Series X as a result of Critical Path's default under
the initial stock purchase agreement.

The Series X is not convertible into common stock, does not accrue dividends and
the holders are not entitled to vote. Each share of Series X has a preference on
liquidation equal to $0.57 per share. The liquidation preference of the Series X
is subordinate to the holders of the Series A, Series B, Series C and Series Y.

13. STOCK OPTIONS

On October 25, 2000, the Company adopted the Mindsurf Inc. 2000 Equity Incentive
Plan. The plan allows for the grant of options to purchase common stock to
employees, officers, directors and consultants of the Company in the form of
incentive and nonqualified stock options. The aggregate number of shares of
common stock that may be issued under the plan may not exceed 15% of the total
number of shares of common stock issued and outstanding, assuming the conversion
of all convertible securities. As of December 31, 2001, options to purchase
9,158,927 shares of common stock may be granted under the plan.

All options have a 10-year term and vest over periods of up to a four years.
With the exception of the options granted to in connection with the acquisition
of HiFusion (see Note 3), all options outstanding under the plan have been
granted at prices that equal or exceed the estimated fair market value of the
stock on the date of grant. Options to purchase 2,899,250 shares of common stock
were granted to the former HiFusion option holders, many with an exercise price
that was below the market value of the stock on the date of grant. The fair
value of these options was estimated by the Company to be $1,119,300, determined
using the Black-Scholes option-pricing model with the following weighted average
assumptions: risk-free interest rate of 6%, dividend yield of 0%, volatility
factor of 0.70, and an expected life of granted options of five years.




                                                                              23


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

13. STOCK OPTIONS (CONTINUED)

The following table summarizes the stock option activity attributable to the
Company for the year ended December 31, 2001.




                                                                        WEIGHTED
                                                                        AVERAGE
                                                                        EXERCISE
                                                           OPTIONS       PRICE
                                                         ----------     --------
                                                                  
Outstanding - beginning of year                                --        $  --
   Granted                                                8,216,250       0.52
   Exercised                                                (99,093)      0.04
   Forfeited                                             (3,370,221)      0.48
                                                         ----------       -----
Outstanding - end of year                                 4,746,936       $0.56
                                                         ==========       =====
Exercisable at end of year                                1,824,850       $0.55
                                                         ==========       =====
Weighted-average fair value of options granted
  during the year                                                        $0.22
                                                                          =====


Exercise prices for options outstanding as of December 31, 2001 ranged from
$0.01 to $1.00 as follows:



                                             WEIGHTED
                              WEIGHTED        AVERAGE                       WEIGHTED
                               AVERAGE       REMAINING                       AVERAGE
                              EXERCISE      CONTRACTUAL                     EXERCISE
  RANGE OF                    PRICES OF       LIFE OF                       PRICES OF
  EXERCISE     OUTSTANDING   OUTSTANDING    OUTSTANDING   EXERCISABLE      EXERCISABLE
   PRICES       OPTIONS        OPTIONS        OPTIONS       OPTIONS          OPTIONS
- --------------------------------------------------------------------------------------
                                                            
$0.01-$0.56      157,083       $0.01        8.02 years       106,417           $0.01
$0.57-$0.61    4,553,228        0.57        9.00 years     1,681,808            0.58
$0.62-$1.00       36,625        1.00        8.69 years        36,625            1.00


                                                                              24


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

13. STOCK OPTIONS (CONTINUED)

For the year ended December 31, 2001, pro forma net loss required by Statement
123 has been determined using the minimum value method for all grants other than
the previously described grants made in connection with the acquisition of
HiFusion. The minimum value method calculates the fair value of options as the
excess of the estimated fair value of the underlying stock at the date of grant
over the present value of both the exercise price and the expected dividend
payments, each discounted at the risk-free rate, over the expected life of the
option. In determining the estimated fair value of granted stock options under
the minimum value method, the following weighted-average assumptions were used:
risk free rate of 5%; dividend yield of 0%; and, expected life of the granted
options of five years.

Because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the minimum value method and other
methods prescribed by Statement 123 do not necessarily provide a single measure
of the fair value of its employee stock options.

For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting periods. The Company's pro
forma net loss does not differ materially from the Company's historical net loss
for the year ended December 31, 2001.

14. SHARES RESERVED FOR FUTURE ISSUANCE

As of December 31, 2001 and 2000, the Company has reserved shares of common
stock for issuance as follows:



                                                                     DECEMBER 31
                                                               2001            2000
                                                             ----------     ----------
                                                                      
     Conversion of Series A                                  42,807,017     17,543,860
     Conversion of Series B                                   8,040,936      8,040,936
     Conversion of Series C                                   7,044,115           --
     Exercise of stock options granted and available for
       granting under 2000 Equity Incentive Plan
                                                              9,158,927      4,514,964
                                                             ----------     ----------
                                                             67,050,995     30,099,760
                                                             ==========     ==========



                                                                              25


                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)


15. NON-CASH INVESTING AND FINANCING ACTIVITIES




                                                                                 DECEMBER 31
                                                                           2001               2000
                                                                       ------------      ----------------
                                                                                   
 Issuance of Series B Convertible Preferred Stock in connection
   with acquisition of HiFusion, Inc.                                  $          -      $      5,500,000
 Issuance of Series Y Preferred Stock in connection with
   acquisition of HiFusion, Inc.                                                  -            16,000,000
 Conversion of notes payable assumed in acquisition of HiFusion to
   shares of Series A Convertible Preferred Stock                                 -             1,850,000
 Issuance of Series C Convertible Preferred Stock in
   connection with acquisition of Discourse Technologies, Inc.            2,042,225                     -


16. OPERATING LEASES

The Company leases office space and certain computer equipment under
noncancelable operating leases. Future minimum lease payments under
noncancelable operating leases consisted of the following at December 31, 2001:

         2002         $181,520
         2003          169,858
         2004           39,341
                      --------
                      $390,719
                      ========

Rent expense under all operating leases for the years ended December 31, 2001
and 2000 was $1,031,633 and $542,217, respectively.

17. EMPLOYEE BENEFIT PLAN

Effective October 25, 2000, the Company adopted the defined contribution
retirement plan previously established by HiFusion, Inc. The plan covers
substantially all employees of the Company. Participants may contribute from 1%
to 15% of their annual compensation to the plan. In addition, the Company may
make discretionary matching and profit-sharing contributions to the plan. For
the year ended December 31, 2001 and the period October 25, 2000 (date of
inception) through December 31, 2000, no discretionary contributions have been
made to the plan.




                                 Mindsurf, Inc.

             Notes to Consolidated Financial Statements (continued)

18. LIQUIDITY AND CAPITAL RESOURCES

For the period October 25, 2000 (date of inception) through December 31, 2001,
the Company incurred a net loss of $57.9 million and has used $34.7 million of
cash in its operations. A working capital deficit of $0.2 exists at December 31,
2001.

During 2000, the Company entered into an agreement with Sylvan, Aether and
Critical Path (the Investors) under which it agreed to sell up to 122,807,017
shares of Series A for gross proceeds of $70 million. To date, the Company has
issued 43,859,649 shares of Series A for aggregate proceeds of $25 million.
During 2001, Critical Path defaulted under this agreement and, as a result,
1,052,632 shares of previously issued Series A were converted to Series X at
which time Critical Path ceased to be eligible for future participation under
the agreement. Under the terms of agreements among the various investors and the
Company, once the Investors acquired a total of $25 million of Series A, they
were allowed to make subsequent investments in the Company in the form of debt.
During 2001, after the Company had received $25 million of gross proceeds from
the Investors, the Investors elected to make additional investments in the form
of convertible debt. During 2002, Sylvan and Aether each provided $6.6 million
of funding in the form of convertible debt (see Note 5).

 Under the terms of the agreement, in order for the Company to request that the
Investors acquire additional debt or equity securities from the Company, the
Company must meet certain milestones. As of December 31, 2001, the Company has
requested and received all of the capital that it is eligible to request based
on the milestones achieved to date. In the event the Company reaches future
milestones and requests that the Investors acquire additional securities, the
Investors have the right to decline to make an additional investment. In the
event that one of the Investors agrees to make such an investment and the other
Investor declines to do so, the Company has the right to convert all of the
securities held by the declining Investor to Series X. In the event that both of
the Investors agree not to fund, the Investors may decline to make the requested
investments without impact to the Investors previously purchased securities.

The Company's operating losses incurred since inception, in conjunction with
forecasted operating losses and limited committed funding sources raise
substantial doubt about the Company's ability to continue as a going concern.
Management is actively pursuing additional sources of financing including
negotiations with the Investors as well as other potential investors. However,
there can be no assurance that the Company will be able to generate sufficient
cash flow from operations or additional financing to meet its development and
operating needs, or that such financing would be available on terms acceptable
to the Company.

                                                                              27