Table of Contents

FORM 10-KSB

(MARK ONE)

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

For the fiscal year ended December 31, 1999

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

For the transition period from           to           

Commission File Number 0-13741

ITC LEARNING CORPORATION

(703) 713-3335

Securities registered under Section 12(b) of the Exchange Act:

Securities registered under Section 12(g) of the Exchange Act:

COMMON STOCK, $0.10 PAR VALUE

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

      Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will 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-KSB or any amendment to this Form 10-KSB.  [  ]

      Issuer’s revenues for the year ended December 31, 1999 were $16,675,565. Aggregate market value of voting stock held by non-affiliates and outstanding at February 29, 2000 was $11,733,670. Amount was computed using the average bid and ask price as of February 29, 2000, which was $2.96. As of February 29, 2000, 3,964,078 shares of common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

      The information called for by Part III is incorporated by reference to the Company’s Definitive Proxy Statement for its 2000 Annual Meeting of Stockholders.

      Transitional Small Business Disclosure Format (check one):  [  ]  Yes  [X]  No

ITC LEARNING CORPORATION

FORM 10-KSB

INDEX

Table of Contents

PART I

Item 1.  Description of Business

Overview

      ITC Learning Corporation (“ITC” or the “Company”) is a worldwide provider of education and training software to professionals in business, education and government organizations. Incorporated under the laws of the state of Maryland in 1977 the Company develops, markets and delivers specific libraries of interactive multimedia computer-based training (“CBT”) courses designed for CD-ROM, intranet and Internet delivery, thus enabling organizations to effectively and efficiently deliver training to improve individual and organizational performance.

      During 1998, the Company began to offer its customers a skill assessment service through its AdminSTAR™ learning management system (“LMS”) product. AdminSTAR™ is a software package that identifies the skills necessary to perform individual job functions within any organization, and provides an organized approach for companies to assess the proficiency of their staff to perform required job functions and manage learning. Furthermore, AdminSTAR™ identifies areas where individual job proficiency is lacking and creates individualized development plans that specify the necessary training, consisting of ITC and third-party products, required to bridge the gaps.

      During 1998, the Company expanded its CBT product library by acquiring the assets of Mentor Networks, Inc. (“Mentor”) and its wholly owned subsidiary, High Performance Group (Canada) Inc. The assets included facilities, equipment, software products developed or owned by Mentor, and the assignment of all trade names, copyrights, patents and other intellectual property of Mentor. Additionally, the Company acquired Mentor’s workforce, consisting of product development and administrative personnel, which further enhanced ITC’s product development resources. CBT products lines acquired consisted of Mentor’s Call Center and Desktop Coach (PC Skills).

      The Company is currently seeking to position itself for the paradigm shift in the education and training industry by embracing the Internet and the concept of e-Learning. E-Learning companies are defined as training providers that leverage the Internet and Web technologies to create, enable, deliver and/or facilitate life-long learning. The industry is currently categorizing e-Learning companies into four segments: Content Providers (develop, aggregate and distribute content); Learning Delivery Agents (provide core technology infrastructure, software, systems and hardware); Portals (provide training gateways on the Internet that aggregate information, services, content and applications); and Full Service Training Providers (providing all segments).

      The Company operates in four reportable business segments: United States, Canada, Australia and the United Kingdom. These business segments are managed separately due to different operating environments, customer bases, and technological capacities. The Company’s stock is traded on the NASDAQ Stock Market, Inc., National Market System, under the symbol ITCC.

ITC’s Value Proposition

      In today’s competitive marketplace, knowledge and skills fuel business innovation and success. The ability to improve organizational performance is directly tied to the successful integration of people, process, and technology. Through the dynamic interaction of technology, content, process, services, and people, ITC helps its customers facilitate learning, increase skills, maximize performance and achieve personal, professional and organizational goals. ITC fashions itself as a full-service training provider that leverages technology with a human touch.

      Over its 23-year history, the Company has endeavored to provide the highest quality training curriculum, complemented by the highest level of customer service and support. With a worldwide customer base of approximately 5,000 organizations using ITC’s products and services, ITC is currently positioned to leverage its existing customer relationships within its targeted vertical markets.

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      ITC’s learning management systems coupled with an e-Learning framework enables the Company to provide Learning Portals tailored to its customers’ industry and organization. ITC Learning Portals are delivered inside a company or in a hosted Application Service Provider (“ASP”) model, and can reach an entire enterprise to manage, administer, deliver and track training and skills development activities. Offered as one integrated solution, ITC’s customers can interact with their employees online, monitor their training development, unlock knowledge stores, streamline training activities and improve productivity, by delivering the right information at the right time.

ITC’s Strategy

      The Company is focused on four critical success factors: content, technology, process and distribution. ITC is seeking to position itself to address the paradigm shift from technology-based learning to e-Learning, and aggressively grow its existing penetration within its core vertical markets. The Company’s objective is to strengthen its position as one of the leading providers of training solutions within its core vertical markets. To achieve this goal, the Company employs the following strategies, focused on continuing to leverage its existing customer base by providing innovative and flexible training solutions and strategically expanding its existing portfolio of CBT products, within established vertical markets.

  Courseware Development

      Throughout its 23-year history, ITC has continually invested in its courseware, as changes in delivery technologies have impacted its customers and its industry. ITC intends to continue investing in its content portfolio utilizing the latest and most efficient development strategies.

      Based on current trends in the introduction and evolution of technologies, the Company also intends to continue converting its existing courseware libraries to a web-based format to further meet its customers’ expanding delivery requirements.

  Flexible Training Solutions

      The Company intends to continue its strategy of providing training solutions when, where and in a manner desired by the customer. In addition to delivering interactive CBT courseware, ITC will continue providing consulting and support services to help organizations improve employee productivity and skills.

  Build Customer Relationships

      The Company will continue its strategy of building continuing customer relationships within its core vertical markets. The Company also seeks to further expand its relationships with existing customers by integrating new product and service offerings into these accounts.

  Integrated Sales and Marketing Programs

      The Company will continue to expand its marketing efforts using both direct mail marketing and the Internet in an effort to further build brand name recognition within its core vertical markets. Distribution of the Company’s products and services will incorporate a regionalized sales force supplemented by a telemarketing sales force. Additionally, the Company will continue to utilize its indirect sales channels, composed of finders, agents, and resellers to increase market coverage and bring additional industry knowledgeable resources to increase sales.

  Leverage International Operations

      The Company maintains offices in three countries outside of the United States. In 1999, international revenues represented 29% of the Company’s total revenues. The Company intends to seek alternatives to expand its international operations, and expects that revenues derived from sources outside the United States will continue to account for a significant portion of the Company’s total revenue.

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ITC’s Product Portfolio

      The Company provides the following libraries of interactive multimedia courseware fundamental to the learning needs of industrial-based organizations worldwide. This library, which can be delivered anywhere and any time, covers multiple subject areas including:

	•	Personal Computer Skills;
	•	Business and Professional Skills;
	•	Information Technology;
	•	Safety and Regulatory Compliance;
	•	Industrial Technical Skills; and
	•	Basic Literacy Skills.

      ITC’s portfolio of CBT products combined with learning management systems and support services provides a highly effective and efficient approach to training and skills development.

Competition

      The education and training market is highly fragmented, with no single institution or company holding a dominant share. These companies include providers of traditional instructor-led training, multimedia courseware developers and sellers, textbook publishers and others. Currently, there are several developers of interactive multimedia training products, and management believes the number of these companies will continue to increase. Some of these are larger and have greater resources than ITC, while others offer only specialized training materials.

      The Company believes its expanded portfolio of products, increased delivery capabilities, and market experience, combined with its ability to effectively manage and administer an education and training environment, has positioned the Company to successfully compete in the growing education and training market. This is a forward-looking statement. See Forward-looking Statements and Risk Factors for Further Discussion.

Employees

      At December 31, 1999, the Company and its subsidiaries employed a total of 85 people. This represents a decrease of 53 employees since December 31, 1998, due primarily to a reduction in the Company’s product development and administrative resources which occurred in 1999. The Company utilizes free-lance and temporary personnel who are familiar with ITC’s development and production process to support increased personnel requirements that arise from time to time. The Company is not a party to any collective bargaining agreements, and believes that relations with its employees are good.

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Item 2.  Description of Properties

      The Company leases all its facilities. The table below sets forth certain information regarding these facilities as of December 31, 1999.

      The Company believes its facilities are suitable, adequate and well utilized. The Company’s leased premises consist of commercial office space, warehouse, and production facilities.

Item 3.  Legal Proceedings

      The Company is not a party to, nor is any of its property the subject of, any material pending legal proceedings.

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

      The Company has not submitted any matters to a vote of security holders since the May 1999 Annual Meeting of Stockholders.

PART II

Item 5.  Market for Common Equity and Related Stockholder Matters

  Market Information

      The Company’s common stock is traded on the NASDAQ Stock Market, Inc., National Market System (NMS), under the symbol ITCC.

      The following table states the high and low quotation information by quarter for the Company’s common stock based on actual trading, as reported by NASDAQ/ NMS.

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  Holders

      As of December 31, 1999, there were 965 holders of record of the Company’s common stock, the Company’s only class of stock.

  Dividends

      Stockholders of the Company’s common stock are entitled to receive ratably such dividends as may be declared by the Board of Directors out of funds legally available. There has been no declaration of dividends since 1984.

  Sales of Unregistered Securities

      On November 1, 1999, the Company issued a 5.5% $1,000,000 convertible subordinated secured debenture initially due on October 31, 2000 to New River Capital Partners, L.P. The payment date on this debenture has been extended to April 2, 2001. The principal due under this debenture is convertible at $2.00 per share. In conjunction with this debenture, the Company issued 291,500 warrants to New River Capital Partners exercisable at $2.00 per share. The initial expiration date of these warrants of October 31, 2000 has been extended to April 2, 2001.

      On December 30, 1999, the Company issued a 9.5% $1,200,000 convertible subordinated secured debenture initially due on January 1, 2000 to New River Capital Partners. The payment date on this debenture has been extended to April 2, 2001. The principal due under this debenture is convertible at the lower of $2.50 per share or the net book value per share as of December 31, 1999 unless the NASD, under the rules applicable to the Nasdaq Stock Market, approves its issuance or the Company’s shareholders consent to the issuance, in which case the conversion price will reduce to $1.75 per share. Upon conversion, the interest rate shall be retroactively reduced to 5.5% per annum. In conjunction with this debenture, the Company issued to New River Capital Partners 349,800 warrants. The exercise price of these warrants is the same as the conversion price under the debenture issued with these warrants. The number of warrants triple to 1,049,400 if NASD approval or shareholder consent to the issuance of the warrants is not obtained by May 15, 2000. The Company intends to seek an amendment to this requirement by extending the May 15 date to June 30, 2000. The initial expiration dates of these warrants of January 1, 2001 has been extended to April 2, 2002.

      The Company relied upon Section 4(2) of the Securities Act of 1933, as amended, to exempt the issuance of the debentures and warrants to New River Capital Partners from the registration requirements under this act.

RESULTS OF OPERATIONS

1999 Compared to 1998

  Revenues

      During 1999, total revenues were $16,676,000 as compared to $18,426,000 in 1998, representing a decrease of $1,750,000 or 9%. Courseware revenues, which include sales of off-the-shelf CBT products, custom CBT products, consulting services, fees, royalties and videotape training products, totaled $15,678,000, as compared to $14,134,000 in 1998, representing an increase of $1,544,000 or 11%. Revenues from the sale of hardware systems totaled $997,000 in 1999 as compared to $4,293,000 in 1998, representing a decrease of $3,296,000.

      The decrease in total revenues in 1999 as compared to 1998 was primarily attributable to decreased hardware sales. The decrease in hardware sales was the result of decreased demand for the hardware component of the Company’s training solution. As a result of decreasing margins on hardware sales and the increasing availability of computer manufacturer direct purchasing, the Company does not anticipate a significant increase in hardware sales over 1999 levels. However, the Company will continue to offer hardware

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      The increase in courseware revenues in 1999 as compared to 1998 was primarily attributable to increased sales associated with the Company’s learning management system — AdminSTAR™, offset by decreased sales of the Company’s core CBT product lines. The Company believes the decline in CBT product sales in 1999 to be the result, in part, of companies’ reduced spending on new software and hardware while working to overcome Y2K problems. Furthermore, the working capital constraints faced by the Company during 1999 limited its ability to actively market the Company’s products and services, and hindered its efforts to build, maintain and expand its sales organization. See Cash Flow, Liquidity and Capital Resources section. The Company believes recent capital infusion and its increased focus on its core CBT markets, will positively affect CBT product revenues in 2000. These are forward-looking statements. See Forward-looking Statements and Risk Factors for Further Discussion.

  Cost of Sales and Gross Margin

      Cost of sales consists of the amortized costs of developing new course titles and updating the Company’s existing libraries, product material costs, fulfillment costs, reseller discount fees, sales commissions, third party product royalties and hardware costs. Cost of sales for 1999 totaled $9,341,000 resulting in a gross margin of $7,335,000 or 44% of total revenues, as compared to cost of sales of $11,133,000 and gross margin of $7,293,000 or 40% of total revenues in 1998. The decrease in cost of sales of $1,792,000 in 1999 as compared to 1998 was the result of decreased total revenues and resulting cost of sales, offset by higher product development cost amortization of $797,000 in 1999. The increase in product development cost amortization was primarily attributable to products acquired as a result of the Company acquiring the assets of Mentor Networks, Inc. in September of 1998. The increase in gross margin of $42,000 and gross margin percentage of 4% was primarily attributable to a decrease in lower-margin hardware sales in 1999 as compared to 1998. Additionally, the Company recognized $741,000 in royalty expense, without recognizing corresponding revenues in 1999, as a result of a 1999 minimum royalty commitment with a third party courseware content provider. The Company will have access to the related third party inventory during 2000, as the obligation is paid.

  Selling, General and Administrative Expenses

      Selling, general and administrative expenses totaled $11,913,000 in 1999 as compared to $11,509,000 in 1998, representing an increase of $404,000 or 4%.

      Selling expenses consist primarily of salaries of sales personnel, travel, advertising, marketing and promotional expenses. Selling expenses in 1999 totaled $5,835,000, as compared to $6,299,000 in 1998. The $464,000 decrease in selling expenses was the result of decreased corporate marketing expenditures offset by slightly higher sales costs from each of the Company’s foreign subsidiaries. As a result of working capital constraints faced by the Company during 1999, it was unable to sustain its sales and marketing growth plan, resulting in an overall decrease in 1999 sales and marketing expenditures. The Company adjusts its sales and marketing activities to correspond with its growth goals and working capital resources. Accordingly, the Company reduced its sales and marketing expenditures in the second half of 1999. Selling expenses as a percentage of revenue in 1999 were 35% as compared to 34% in 1998. The Company anticipates gradual increases in telemarketing and field staff during 2000 as its level of working capital increases. These are forward-looking statements. See Forward-looking Statements and Risk Factors for Further Discussion.

      General and administrative expenses consist of the costs of developing new products and the costs of the Company’s executive management and support functions such as customer assurance, product fulfillment, human resources, and finance and administration. General and administrative expenses for 1999 were $6,078,000 as compared to $5,210,000 in 1998. The increase in general and administrative expenses of $868,000 or 17% was due to an increase in costs associated with the Company’s Canadian subsidiary, which was acquired in September of 1998, resulting in twelve months of activity in 1999 versus three months in 1998. General and administrative expenses as a percentage of revenue in 1999 increased to 36% from 28% in 1998,

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  Loss Before Income Taxes and Net Loss

      During 1999, the Company experienced a loss before income taxes and a net loss of $4,714,000 or $1.21 per share. This compares to a loss before income taxes of $4,026,000 and a net loss of $3,793,000 or $0.99 per share in 1998. The higher pretax and net loss in 1999 was the result of an overall decrease in revenues and an increase in general and administrative expenses as compared to 1998.

CASH FLOW, LIQUIDITY AND CAPITAL RESOURCES

      Cash and cash equivalents increased to $535,000 at December 31, 1999 from $267,000 at December 31, 1998. The change in the cash position of the Company in 1999 primarily reflects the cash provided by operations and cash used for product development and fixed asset expenditures.

      Working capital deficit at December 31, 1999 was $307,000 as compared to a surplus of $1,799,000 at December 31, 1998, a decrease of $2,106,000. The decrease was primarily due to the net loss realized during 1999, the Company’s investment in courseware development and fixed assets and an increase in short-term operating liabilities, given the Company’s current cash constraints.

      Net cash provided by operating activities totaled $1,596,000 during 1999, as compared to cash used for operating activities of $63,000 in 1998, representing an increase of $1,659,000. The increase was primarily due to an increase in profitability before depreciation and amortization and the collection of accounts receivable. Additionally, the Company incurred $1,134,000 in higher non-cash depreciation and amortization expenses during 1999 as compared to 1998. The increase in non-cash charges was primarily attributable to the acquisition of the assets of Mentor Networks, Inc. in September of 1998.

      Net cash used for investing activities during 1999 totaled $2,856,000 as compared to net cash used for investing activities of $4,883,000 in 1998. The decrease in expenditures of $2,027,000 in 1999 was due to the absence of acquisition activity, partially offset by an increase in product development costs of $1,393,000 in 1999 as compared to 1998. During 2000, the Company expects to adjust its product development and fixed asset expenditures to correspond with its working capital resources. This is a forward-looking statement. See Forward-looking Statements and Risk Factors for Further Discussion.

      Net cash provided by financing activities totaled $1,528,000 in 1999 as compared to $327,000 during 1998. The increase of $1,201,000 is principally due to proceeds generated from debt issuances totaling $2,125,000, which occurred in the fourth quarter of 1999. Additionally, the absence of a stock repurchase transaction, which occurred in 1998 in the amount of $536,000, contributed to the increase in cash flows from financing activities in 1999 as compared to 1998.

      On October 15, 1999, in response to its third quarter 1999 operating loss and its then current cash position, the Company accelerated plans to reduce its product development workforce, as the Company endeavored to make the strategic transition from merely developing its own content, to aggregating and distributing proprietary and non-proprietary content. The workforce reduction consisted of approximately 70 employees, the majority which took place in the Company’s Canadian subsidiary — ITC Canada Limited (“ITCC”).

      On October 29, 1999, the Company signed a Forbearance Agreement with its principal lender to avoid the declaration of default with respect to certain covenants and conditions in its August 11, 1999 line of credit agreement, including maximum debt to tangible net worth and minimum tangible net worth requirements. The Forbearance Agreement increased the Company’s interest rate to prime plus 3% and reduced the Company’s borrowing capacity. On January 7, 2000, the Company signed an amended Forbearance

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      On January 21, 2000, the Company satisfied its outstanding debt, and all associated fees and expenses under its line of credit agreement.

      On November 1, 1999, the Company raised $1,000,000 through the issuance of a 5.5% convertible subordinated debenture due April 2, 2001. The note is secured by the assets of the Company and is subordinated to existing and future indebtedness of the Company. Interest and principal are due in full at maturity. The note may be converted into shares of common stock of the Company at any time after February 28, 2000 up to maturity date at a price of $2.00 per share. The note was issued with warrants which grant the holders the right to acquire 291,500 shares of the Company’s common stock at a per share price of $2.00. The warrants expire on April 2, 2001.

      On December 30, 1999, the Company raised $1,200,000 through the issuance of a 9.5% convertible subordinated debenture due April 2, 2001. Proceeds of $1,125,000 were received in 1999 and $75,000 was received in January 2000. The note is secured by the assets of the Company and is subordinated to existing and future indebtedness of the Company. Interest and principal are due in full at maturity. The note may be converted into shares of common stock of the Company at any time up to maturity date at a price no lower than $1.75 per share. The note was issued with warrants which grant the holders the right to acquire 349,800 shares of the Company’s common stock at a price no lower than $1.75 per share. The warrants expire on April 1, 2002. The number of warrants can increase to 1,049,400, if certain conditions are not met.

      The Company’s financial statements have been presented on a going concern basis, which contemplates the realization of assets and settlement of liabilities and commitments in the normal course of business. The Company experienced a net loss in 1999 and 1998. Although the Company expects operating results to improve, there can be no assurances that the Company will not experience adverse results of operation in the future. The Company believes that its existing cash, the anticipated cash flows from 2000 operations, and additional planned capital fund raising activities should provide sufficient resources to fund its activities in 2000. Anticipated cash flows from 2000 operations are largely dependent upon the Company’s ability to achieve its sales and gross profit objectives for its currently existing products and new products to be launched in 2000. Achievement of these objectives is subject to various risk factors related to, among other things: incremental sales resulting from expansion of distribution capabilities; the Company’s ability to deploy its courseware over the Internet and corporate intranets; the Company’s ability to control costs in relation to future revenues and the Company’s ability to raise capital. If the Company is unable to meet these objectives, it will consider expansion of existing or development of alternative sources of bank financing; the curtailment of certain capital expenditures and discretionary expenditures (such as travel, consulting and salaries); and various other courses of action.

YEAR 2000 COMPLIANCE

      The Company completed the transition to the year 2000 with all hardware, software and current courseware products year 2000 compliant. This transition took place without incident. There have been no material reported problems with any equipment or software, nor have any disruptions with suppliers or vendors occurred. The Company will continue to monitor its systems and products in 2000 to ensure any remaining issues with year 2000 are identified and addressed.

CANADIAN OPERATIONS

      On October 15, 1999, in response to its third quarter 1999 operating loss and its then current cash position, the Company accelerated plans to reduce its product development workforce as the Company endeavored to make the strategic transition from merely developing its own content, to aggregating and distributing proprietary and non-proprietary content. The workforce reduction consisted of approximately 70 employees, the majority which took place in the Company’s Canadian subsidiary — ITC Canada Limited (“ITCC”).

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      Under Provincial employment regulations, if 10 or more employees are affected by a workforce reduction, the Company is required to provide 8 weeks notice to all affected employees. Accordingly, ITCC extended the required notice, while continuing to keep the affected employees on payroll. During the notice period, all aspects of ITCC’s business operations were negatively impacted, and consequently sales performance during that time period decreased. Although the Company sought to reestablish working relationships with unaffected personnel, it was difficult and ultimately there were voluntary terminations of certain unaffected employees, which further hindered ITCC’s ability to stabilize business operations.

      Additionally, the Toronto sales and marketing office has been closed in order to centralize ITCC business operations in the Halifax, Nova Scotia facility.

      As of March 27, 2000, the Company has made significant progress in stabilizing ITCC’s business operations and employee base, and maintains a workforce of 20 full-time employees, the majority of whom are involved in sales and product development activities. Although historically, the primary focus of the Canadian operations was product development, the Company intends to augment its worldwide sales force by expanding its existing sales and marketing organization within its Canadian subsidiary, while maintaining product development resources sufficient to meet planned courseware production requirements. These are forward-looking statements. See Forward-Looking Statements and Risk Factors for Further Discussion.

MANAGEMENT CHANGES

      On November 22, 1999, the Company announced the resignation of Carl D. Stevens, President and Chief Executive Officer, and Director. Mr. Stevens had served as ITC’s President and Chief Executive Officer since January 1998.

      On November 22, 1999, the Company’s Board of Directors appointed Christopher E. Mack President of ITC. Mr. Mack’s appointment as President was originally on an interim basis, however his appointment has been made permanent. Prior to being appointed President, Mr. Mack was serving as the Company’s Chief Financial Officer and Treasurer.

FORWARD-LOOKING STATEMENTS AND RISK FACTORS

  Forward-looking Statements

      Certain statements made by the Company’s management may be considered to be “forward-looking statements” within the meaning of the Private Securities Litigation Act of 1995. Forward-looking statements are based on various factors and assumptions that include known and unknown risks and uncertainties. The words “believe,” “expect,” “anticipate” and “project,” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. Such statements may include, but not be limited to, projections of revenues, income or loss, expenses, plans, as well as assumptions relating to the foregoing. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Future results could differ materially from those described in forward-looking statements as a result of the risks set forth in the following discussion, among others.

  Risk Factors

      The Company’s financial statements have been presented on a going concern basis, which contemplates the realization of assets and settlement of liabilities and commitments in the normal course of business. The Company experienced a net loss in 1999 and 1998. Although the Company expects operating results to improve, there can be no assurances that the Company will not experience adverse results of operation in the future. The Company believes that its existing cash, the anticipated cash flows from 2000 operations, and additional planned capital fund raising activities should provide sufficient resources to fund its activities in 2000. Anticipated cash flows from 2000 operations are largely dependent upon the Company’s ability to achieve its sales and gross profit objectives for its currently existing products and new products to be launched in 2000. Achievement of these objectives is subject to various risk factors related to, among other things: incremental sales resulting from expansion of distribution capabilities; the Company’s ability to deploy its

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      A number of factors could also contribute to significant fluctuations in operating results, which may result in volatility in the price of the Company’s common stock. These include the size and timing of orders and shipments, the mix of ITC-developed products and third party products, the mix of sales from the Company’s direct and indirect distribution channels, the introduction and acceptance of new products, and the degree to which the market understands and accepts the Company’s role as a provider of training solutions.

      In addition, the Company faces certain general business risks which could materially and adversely impact future operating results. These include, but are not limited to, changes in economic conditions, the cost of labor and raw materials, changes in technology and general competitive factors.

Item 7.  Financial Statements

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REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Stockholders
ITC Learning Corporation

      We have audited the accompanying consolidated balance sheets of ITC Learning Corporation as of December 31, 1999 and 1998, and the related consolidated statements of operations, stockholders’ equity, 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 consolidated financial position of ITC Learning Corporation at December 31, 1999 and 1998, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States.

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ITC LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements.

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ITC LEARNING CORPORATION

CONSOLIDATED BALANCE SHEETS

ASSETS

See accompanying notes to consolidated financial statements.

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ITC LEARNING CORPORATION

CONSOLIDATED BALANCE SHEETS

LIABILITIES AND STOCKHOLDERS’ EQUITY

See accompanying notes to consolidated financial statements.

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ITC LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

See accompanying notes to consolidated financial statements.

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ITC LEARNING CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying notes to consolidated financial statements.

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ITC LEARNING CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.  Summary of Significant Accounting Policies

  Basis of Presentation

      The consolidated financial statements of ITC Learning Corporation (“ITC” or the “Company”) include the accounts of its wholly owned subsidiaries Activ Training, Ltd. (“Activ”), ITC Australasia Pty. Ltd. (“ITCA”), Turn-Key Training Technologies, Inc. (“Turn-Key”), ITC Canada Limited, and ComSkill Learning Centers, Inc. (“ComSkill”). Significant intercompany accounts and transactions have been eliminated in consolidation.

      The Company is a full-service training company specializing in the development, production, marketing and sale of multimedia and technology-delivered training solutions designed to improve employee skills in business, industry, education and government. The Company operates in four reportable segments: United States, Canada, Australia and the United Kingdom.

      The Company’s financial statements have been presented on a going concern basis, which contemplates the realization of assets and settlement of liabilities and commitments in the normal course of business. The Company experienced a net loss in 1999 and 1998. Although the Company expects operating results to improve, there can be no assurances that the Company will not experience adverse results of operation in the future. The Company believes that its existing cash, the anticipated cash flows from 2000 operations, and additional planned capital fund raising activities should provide sufficient resources to fund its activities in 2000. Anticipated cash flows from 2000 operations are largely dependent upon the Company’s ability to achieve its sales and gross profit objectives for its currently existing products and new products to be launched in 2000. Achievement of these objectives is subject to various risk factors related to, among other things: incremental sales resulting from expansion of distribution capabilities; the Company’s ability to deploy its courseware over the Internet and corporate intranets; the Company’s ability to control costs in relation to future revenues and the Company’s ability to raise capital. If the Company is unable to meet these objectives, it will consider expansion of existing or development of alternative sources of bank financing; the curtailment of certain capital expenditures and discretionary expenditures (such as travel, consulting and salaries); and various other courses of action.

  Revenues and Costs

      Revenues include both off-the-shelf and custom courseware sales, courseware licenses, consulting service revenues and hardware revenues. The Company recognizes revenues from off-the-shelf product and hardware sales as units are shipped. The Company permits the customer the right to return the courseware within 30 days of purchase. In the event that sales returns are material, the Company adjusts revenue accordingly. Revenues from sales of custom training programs that are developed and produced under specific contracts with customers, including contracts with affiliated joint ventures and limited partnerships, are recognized on a percentage of completion basis as related costs are incurred during the production period. Gross revenues from sales of affiliated joint venture and limited partnership copyrighted courseware are included in the Company’s financial statements, as are related production, selling and distribution costs. Amounts due to co-owners of the affiliated venture/partnerships related to such courseware sales are reflected as royalties and included in cost of sales in the financial statements. Revenues from courseware licenses are recognized upon the delivery of the initial copy of each product licensed, and related duplication costs are accrued based on estimates. Revenues from consulting services are recognized as services are performed.

  Capitalized Program Development Costs

      Certain costs of developing and producing off-the-shelf courseware have been capitalized. Capitalized costs include direct labor, materials, product masters, subcontractors, consultants, and applicable overhead.

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These capitalized costs are amortized on a straight-line basis over the estimated useful lives of the related programs which range from three to five years. The related amortization expense is included in the cost of sales and amounts to approximately $2,616,000 and $1,819,000 in 1999 and 1998, respectively. Periodically, the Company assesses the net realizable value of program development costs by reviewing past sales performances, current and planned future marketing activities, specific sales promotions and strategic distribution arrangements. Based on this assessment, the Company determines each product’s prospects for future sales, and, if necessary, adjusts asset values to net realizable value.

  Cash and Cash Equivalents

      Cash and cash equivalents include cash and other highly liquid investments having original maturities of less than three months.

  Inventories

      Inventories consist primarily of multimedia courseware and related computer hardware, and are stated at the lower of cost or market. Cost is determined using the average cost method.

  Deferred Financing Costs

      Deferred financing costs include fees incurred to obtain debt financings and are amortized on straight-line basis, which approximates the effective interest method, over a period not to exceed the term of the related debt.

  Property and Equipment

      Property, equipment and leasehold improvements are stated at cost. Depreciation on property and equipment is computed on a straight-line basis over estimated useful lives of three to five years. Leasehold improvements are amortized on a straight-line basis over the shorter of the lease term or estimated useful lives of the related assets. Depreciation and leasehold amortization expense amounted to approximately $665,000 and $552,000 in 1999 and 1998, respectively.

  Investments in Affiliates

      Investments in affiliated joint ventures and limited partnerships are accounted for using the equity method and, accordingly, the initial cost of the investments are adjusted for the Company’s proportionate share of joint venture and partnership undistributed earnings or losses.

  Income Taxes

      The Company provides for income taxes using the liability method in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, Accounting for Income Taxes . Deferred income taxes result primarily from differences between financial statement and income tax treatment of program development costs, revenue recognition and net operating loss carry forwards.

  Net Loss Per Common Share

      Basic earnings per common share are computed based upon the weighted average number of common shares outstanding during the year. Diluted earnings per common share is computed based on common shares outstanding plus the effect of dilutive stock options and other potentially dilutive common stock equivalents. The dilutive effect of stock options and other potentially dilutive common stock equivalents is determined

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using the treasury stock method based on the Company’s average stock price. The effect on weighted average shares outstanding of securities that could potentially dilute basic earnings per share that were not included in the computation of diluted earnings per share, because to do so would have been antidilutive for the periods presented, were 65,630 and 56,127 of stock options and warrants for 1999 and 1998, respectively.

  Intangible Assets

      Intangible assets include allocations of the purchase price of acquisitions to workforce investments, leasehold premises, and goodwill. These assets are being amortized using the straight-line method over estimated useful lives of two to fifteen years. Amortization expense for 1999 and 1998 amounted to approximately $556,000 and $386,000, respectively. As part of its ongoing review, management takes into consideration any events and circumstances which might indicate an impairment to the carrying amount of intangible assets. Factors that management uses to evaluate continuing value include sales from acquired product lines, employee turnover, and development of related customer and distribution networks that were in place at the date of the acquisition.

  Research and Development

      Research and development costs consist of software-related expenditures incurred during the course of planned research and investigation aimed at developing new products or processes. The Company expenses all research and development costs as they are incurred. Research and development costs of $510,000 and $549,000 were incurred during 1999 and 1998, respectively, and are included in selling, general and administrative expenses.

  Foreign Currency Translation

      The Company owns international subsidiaries in Canada, the United Kingdom and Australia. Each of these subsidiaries perform sales and marketing activities for ITC’s portfolio of products. The Canadian subsidiary is also involved in product development activities. Under Statement of Financial Accounting Standards No. 52, Foreign Currency Translation, the subsidiaries’ financial statements are translated from their local currencies using the corresponding foreign currency exchange rate with the resulting difference recorded as a component of consolidated stockholders’ equity. Translation gains and losses incurred during 1999 were not material. The Company believes its exposure to foreign currency risk is not material.

  Stock Option Plans

      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 method provided for under SFAS 123, “Accounting for Stock Based Compensation.” Under APB 25, because the exercise price of the Company’s employee stock options generally equals the market price of the underlying stock on the date of grant, no compensation cost is recognized.

  Use of Estimates

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

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  Comprehensive Income

      Effective January 1, 1998, the Company adopted Statement 130, Reporting Comprehensive Income. Statement 130 requires foreign currency translation adjustments to be included in other comprehensive income (loss).

  New Accounting Pronouncements

      In June 1998, the Financial Accounting Standards Board issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The Company expects to adopt the new Statement effective January 1, 2000. The Company does not anticipate that the adoption of this Statement will have a significant effect on its results of operations or financial position.

Note 2.  Accounts Receivable

      Accounts receivable include the following at December 31:

Note 3.  Note Receivable

      On November 20, 1997, the Company entered into a stock purchase agreement with Anderson Holdings Inc., to sell all of the Company’s stock in its wholly owned subsidiary Anderson Soft-Teach (“AST”). Pursuant to the transaction, ITC accepted an 8% promissory note in the amount of $950,000. Under the terms of the note, interest payments are due quarterly, with the remaining principal balance due in 2001.

      Under the terms of the stock purchase agreement, ITC and AST entered into a reciprocal agreement to sell each other’s products. Royalties earned by AST for sales of their products under this agreement will be applied to the principal value of the note.

Note 4.  Investments in and Due to Affiliates

      The Company is a participant in five separate limited partnerships with Industrial Training Partners, Ltd. (the ITP partnerships) and a joint venture with DynCorp. In all of the ITP partnerships, the Company is a 5% general partner and in certain partnerships the Company has acquired a limited partnership interest as well. In the joint venture with DynCorp, the Company has a 50% ownership interest. The ITP partnerships and the DynCorp joint venture were formed to develop and produce various series of training programs. Under the contracts to market the programs for the partnerships and joint venture, ITC receives 50%-70% of the sales price for the costs of reproducing and marketing the training materials. In the case of the joint venture agreement, the Company also receives an additional 25% for its share of the joint venture profits. Sales of programs related to these affiliates were approximately $1,034,000 and $1,359,000 in 1999 and 1998, respectively.

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Note 5.  Line of Credit

      On August 11, 1999, the Company entered into a new line of credit agreement with its principal lender for a two-year term. The new agreement provided the Company with $4,000,000 of borrowing capacity. The Company collateralized the credit facility by granting the bank a security interest in the assets of the Company. The agreement required maintenance of certain financial ratios (minimum working capital and tangible net worth) and contained certain restrictive covenants, which limited borrowings and the ability to merge or dispose of assets.

      On October 29, 1999, the Company signed a Forbearance Agreement with its principal lender to avoid the declaration of default with respect to certain covenants and conditions in its August 11, 1999 line of credit agreement, including maximum debt to tangible net worth and minimum tangible net worth requirements. The Forbearance Agreement increased the Company’s interest rate to prime plus 3% and reduced the Company’s borrowing capacity. On January 7, 2000, the Company signed an amended Forbearance Agreement with its principal lender to avoid declaration of default with respect to certain covenants and conditions in its October 29, 1999 Forbearance Agreement, specifically maximum borrowing capacity requirements.

      At December 31, 1999 and December 31, 1998, the balances outstanding on the line of credit were $664,000 and $647,000, respectively.

      On January 21, 2000, the Company satisfied its outstanding debt, and all associated fees and expenses under its line of credit agreement.

Note 6.  Long-Term Debt

      Long-term debt at December 31, 1999 and 1998 consists of the following:

      The 8.5% note payable to the Company’s principal lender was due in monthly principal and interest installments of $10,258 through December 2002 and was collateralized by the assignment of interest in the shares of the Company’s common stock held by its Employee Stock Ownership Plan, accounts receivable, inventory and property and equipment. Per the Company’s line of credit agreement dated August 11, 1999, the

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Note 6.  Long-Term Debt — (Continued)

      The 8.0% note payable to Nova Scotia Business Development Corporation (“NSBDC”) is due in monthly interest installments (beginning October 31, 1998) and quarterly principal installments (beginning March 31, 1999), and matures in January 2004. The NSBDC has a subordinated interest position to the Company’s principal lender, in the receivables and inventory of ITC Canada Limited. Additionally, the NSBDC’s interest in the fixed assets and intellectual property of ITC Canada Limited ranks pari passu with the Company’s principal lender.

      On November 1, 1999, the Company raised $1,000,000 through the issuance of a 5.5% convertible subordinated debenture due April 2, 2001. The note is secured by the assets of the Company and is subordinated to existing and future indebtedness of the Company. Interest and principal are due in full at maturity. The note may be converted into shares of common stock of the Company at any time after February 28, 2000 up to maturity date at a price of $2.00 per share. The note was issued with warrants which grant the holders the right to acquire 291,500 shares of the Company’s common stock at a per share price of $2.00. The warrants expire on April 2, 2001. The warrants were determined to have a value of $245,000, which was recorded as additional capital. The resulting debt discount is being amortized over the holding period of the debenture.

      On December 30, 1999, the Company raised $1,200,000 through the issuance of a 9.5% convertible subordinated debenture due April 2, 2001. Proceeds of $1,125,000 were received in 1999 and $75,000 was received in January 2000. The note is secured by the assets of the Company and is subordinated to existing and future indebtedness of the Company. Interest and principal are due in full at maturity. The note may be converted into shares of common stock of the Company at any time up to maturity date at a price no lower than $1.75 per share. The note was issued with warrants which grant the holders the right to acquire 349,800 shares of the Company’s common stock at a price no lower than $1.75 per share. The warrants expire on April 1, 2002. The warrants were determined to have a value of $508,000, which was recorded as additional capital. The resulting debt discount is being amortized over the holding period of the debenture. The number of warrants can increase to 1,049,400 if certain conditions are not met.

Note 7.  Stock Incentive Plans and Stock Warrants

      At December 31, 1999, the Company had outstanding options to purchase common stock under three separate incentive stock option plans: the 1992 Directors’ Incentive Stock Option Plan, the 1992 Key Employee Incentive Stock Option Plan and the 1998 Incentive Stock Plan. Options granted under the 1992 Directors’ Incentive Stock Option Plan may be qualified or non-qualified. From time to time, the Company has granted other non-qualified options to certain individuals.

      On November 30, 1999, the Company repriced 255,000 of its outstanding stock options. The revised option price was $2.00 per share and was above the closing market price on the date of the repricing.

      During 1998, the Company recorded a one-time non-cash charge of $211,000 relating to a stock option grant to its then-President and Chief Executive Officer. Upon resignation in 1999, the options were forfeited and compensation expense was reduced.

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      The Company, at December 31, 1999, had the following stock-based incentive plans in effect, as outlined in the following table:

      These plans are intended to further the interests of the Company by encouraging and providing for the acquisition of an equity interest in the Company by non-employee directors, officers, and key employees through the grant of awards with respect to shares of common stock. The option exercise price of incentive stock options generally is not less than the fair market value of the common stock on the date of grant.

      The following table summarizes option activity for the years ended December 31, 1999 and 1998:

      Incentive stock options and nonqualified stock options exercisable were 81,465 and 56,457 at December 31, 1999 and 57,298 and 25,999 at December 31, 1998. The weighted average exercise price of exercisable incentive stock options and nonqualified stock options was $2.79 and $3.02 at December 31, 1999 and $4.74 and $4.88 at December 31, 1998.

      The following table summarizes information about options outstanding at December 31, 1999:

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      The Company applies APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for its plans. Accordingly, no compensation expense has been recognized other than discussed above for its stock option plans because stock options are generally granted with an exercise price equal to the fair value of the stock on the grant date. Had compensation cost for the Company’s stock option plans been determined based upon the fair value of the options at the grant date for awards under these plans consistent with the methodology prescribed under Statement 123, the Company’s 1999 net income and earnings per share would not have been materially affected. The fair value of the options granted was determined using the Black-Scholes option pricing model with the following assumptions: dividend yield of 0%, volatility of 89%, risk-free interest rate of 6.25% and an expected life of three years.

      On December 31, 1999, the Company had outstanding 641,300 warrants to purchase common stock. The following schedule summarizes the exercise price and expiration date of the warrants:

      The Company has reserved 1,827,014 shares of its common stock for future issuance relating to its convertible subordinated debentures and warrants.

Note 8.  Income Taxes

      The components of income tax expense (benefit) are as follows:

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Note 8.  Income Taxes — (Continued)

      The difference between income tax expense (benefit) and the amount determined by applying the federal statutory rate is as follows:

      The following temporary differences give rise to the provision for deferred taxes (benefit) at December 31:

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Note 8.  Income Taxes — (Continued)

      The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, are presented below.