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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-QSB

(Mark One)

For the quarterly period ended September 30, 2004

For the transition period from              to             

Commission file number 0-22405

INFORMATION ANALYSIS INCORPORATED

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

11240 Waples Mill Road, Suite 201, Fairfax, VA 22030

(Address of principal executive offices)

(703) 383-3000

(Issuer’s telephone number)

(Former name, former address and former fiscal year, if changed since last report)

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

APPLICABLE ONLY TO CORPORATE ISSUERS

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

Common Stock, par value $0.01, 10,283,515 shares as of November 9, 2004

Transitional Small Business Disclosure Format (Check one):    Yes  ¨    No  x

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INFORMATION ANALYSIS INCORPORATED

FORM 10-QSB

Index

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INFORMATION ANALYSIS INCORPORATED

CONSOLIDATED BALANCE SHEETS

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

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INFORMATION ANALYSIS INCORPORATED

CONSOLIDATED STATEMENTS OF OPERATIONS

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

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INFORMATION ANALYSIS INCORPORATED

CONSOLIDATED STATEMENTS OF OPERATIONS

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

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INFORMATION ANALYSIS INCORPORATED

CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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PART I

Item 1. Financial Statements.

INFORMATION ANALYSIS INCORPORATED

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation

The accompanying consolidated financial statements have been prepared by Information Analysis Incorporated (“IAI” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission. Financial information included herein is unaudited; however, in the opinion of management, all adjustments (which include normal recurring adjustments) considered necessary for a fair presentation have been made. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations, but the Company believes that the disclosures made are adequate to make the information presented not misleading. For more complete financial information, these financial statements should be read in conjunction with the audited financial statements and notes thereto for the year ended December 31, 2003 included in the Company’s annual report on Form 10-KSB. Results for interim periods are not necessarily indicative of the results for any other interim period or for the full fiscal year.

2. Stock-based Compensation

The Company has an incentive stock option plan, which became effective June 25, 1996. The plan provides for the granting of stock options to certain employees and directors. The maximum number of shares for which options may be granted under the plan is 3,075,000. Options expire no later than ten years from the date of grant or when employment ceases, whichever comes first, and vest over periods determined by the Board of Directors. The average vesting period for options granted in 2004 was fifteen months. The exercise price of each option equals the quoted market price of the Company’s stock on the date of grant. The stock option plan is accounted for under Accounting Principles Board (APB) Opinion No. 25. Accordingly, no compensation has been recognized for the plan. Had compensation cost for the plan been determined based on the estimated fair value of the options at the grant date consistent with the method of Statement of Financial Accounting Standards (SFAS) No. 123, the Company’s net income and earnings would have been:

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2. Stock-based Compensation (cont.)

3. Recovery of Bad Debt

During the third quarter of fiscal 2004, Information Analysis Incorporated recovered past due receivables, which had been reserved as uncollectible in 2000, in the amount of $289,902, net of attorney’s fees.

4. Net Income (Loss) Per Share

Earnings per share are presented in accordance with SFAS No. 128, “Earnings Per Share.” This statement requires dual presentation of basic and diluted earnings per share on the face of the income statement. Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, except for periods when the Company reports a net loss because the inclusion of such items would be antidilutive.

The following is a reconciliation of the amounts used in calculating basic and diluted net income per common share.

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4. Net Income (Loss) Per Share (cont.)

Item 2. Management’s Discussion and Analysis of Financial Condition or Plan of Operation

Cautionary Statement Regarding Forward-Looking Statements

This Form 10-QSB contains forward-looking statements regarding the Company’s business, customer prospects, or other factors that may affect future earnings or financial results that are subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. Such statements involve risks and uncertainties which could cause actual results to vary materially from those expressed in the forward-looking statements. Investors should read and understand the risk factors detailed in the Company’s 10-KSB for the fiscal year ended December 31, 2003 and in other filings with the Securities and Exchange Commission.

Three Months Ended September 30, 2004 Versus Three Months Ended September 30, 2003

Revenue

IAI’s revenues in the third quarter of fiscal 2004 were $2,438,440, compared to $1,483,104 in the third quarter of fiscal 2003, an increase of 64.4%. Professional services revenue was $2,255,127 versus $1,426,486, an increase of 58.1%, and product revenue was $183,313 versus $56,618, an increase of 223.8%. The increase in professional services revenue is due primarily to newer contracts on which work began during the end of fiscal 2003 and in fiscal 2004. The increase in product revenue is primarily due to non-recurring sales of licenses for Adobe forms products and an arrangement with Adobe’s government sector forms software distributor whereby a specified margin on direct sales that IAI brings to the distributer flows directly to IAI. The Company continues to have a steady pipeline of bidding opportunities for new and follow-on business. Revenues are expected to maintain their current levels or to increase in the remainder of IAI’s fiscal year 2004.

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Three Months Ended September 30, 2004 Versus Three Months Ended September 30, 2003 (cont.)

Gross Margins

Gross margin was $486,002, or 19.9% of sales, in the third quarter of fiscal 2004 versus $283,653, or 19.1% of sales, in the third quarter of fiscal 2003. Of the $486,002 in 2004, $478,555 was attributable to services and $7,447 was attributable to software sales. Gross margin, as a percentage of sales, was 21.2% for professional services and 4.1% for software sales for third quarter 2004. In the third quarter of 2003, the Company reported gross margins of 20.1% for professional services and (4.7%) for software sales. Professional services gross margin percentage is basically unchanged compared to fiscal 2003. The increase in software sales gross margin is attributed to a greater volume of sales of Adobe software during the third quarter of 2004 versus the same period in 2003, which offsets amortization of capitalized software development costs to a greater extent. Software sales gross margin has been affected traditionally by the amortization of the capitalized cost of the ICON’s suite of conversion tools. The capitalized cost of ICONS is fully amortized as of September 30, 2004, therefore IAI expects improved margins on future software sales as reported.

Other Operating Income

During the third quarter of fiscal 2004, Information Analysis Incorporated recovered past due receivables, which had been reserved as uncollectible in 2000, in the amount of $289,902, net of attorney’s fees. There were no such recoveries in the same period in 2003.

Selling, General and Administrative

Selling, general and administrative expenses (SG&A) were $416,803, or 17.1% of revenues, in the third quarter of 2004 versus $263,637, or 17.8% of revenues, in the third quarter of 2003. The increase in SG&A is partially due to non-recurring officer bonuses totaling $30,000 related to the recovery of past due receivables described above. Additional increases in SG&A are related to recruiting fees for employees with clearances and commissions on sales. The Company continues to control expenses and reduce them wherever practical, and believes that only marginal increases in SG&A will result from increases in the number of contracts under which it operates.

Profits

The Company generated income from operations of $359,101 in the third quarter of 2004 compared to income from operations of $20,016 in the third quarter of 2003. There was net income of $354,092 for the third quarter of 2004 versus net income of $10,682 for the same period in 2003. The change in profitability, excluding the effect of the recovery of the past due receivables, which added $289,902 to net income, is directly related to increased sales based largely on the addition of new contracts during the end of 2003 and in 2004. IAI believes that its current backlog of contracts, in addition to its pipeline of new opportunities, will enable it to maintain profitability in the remainder of its fiscal year 2004.

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Nine Months Ended September 30, 2004 Versus Nine Months Ended September 30, 2003

Revenue

IAI’s revenues in the first nine months of fiscal 2004 were $6,712,282, compared to $3,585,554 in the first nine months of fiscal 2003, an increase of 87.2%. Professional services revenue was $6,314,575 versus $3,338,714, an increase of 89.1%, and product revenue was $397,707 versus $246,840, an increase of 61.1%. The increase in professional services revenue is due primarily to newer contracts on which work began in the end of fiscal 2003 and in fiscal 2004. The increase in product revenue is primarily due to non-recurring sales of licenses for Adobe forms products and an arrangement with Adobe’s government sector forms software distributor whereby a specified margin on direct sales that IAI brings to the distributer flows directly to IAI. The increase in product revenue is also due to sales of IAI’s ICONS suite of conversion tools versus no sales of ICONS for the first nine months of fiscal 2003. The Company continues to have a steady pipeline of bidding opportunities for new and follow-on business. Revenues are expected to maintain their current levels in the remainder of IAI’s fiscal year 2004.

Gross Margins

Gross margin was $1,299,736, or 19.4% of sales, in the first nine months of fiscal 2004 versus $733,466, or 20.5% of sales, in the first nine months of fiscal 2003. Of the $1,299,736 in 2004, $1,216,107 was attributable to professional services and $83,629 was attributable to software sales. Gross margin, as a percentage of sales, was 19.3% for professional services and 21.0% for software sales for the first nine months of 2004. In the same period of 2003, the Company reported gross margins of 21.8% for professional services and 1.8% for software sales. The decrease in professional services gross margin as a percentage of sales is attributed to the increased use of subcontractors versus employees on contracts that were added since the third quarter of 2003. Management’s use of subcontractors has allowed IAI to utilize specialized skill sets of those employed elsewhere in order to win both broad-based and specialized contracts, and has allowed IAI to win shorter-term contracts without carrying employees on overhead after contracts expire. The increase in software sales gross margin percentage is attributed to the addition of contracts since September 30, 2003, under which the Company collects licensing fees for its ICONS suite of conversion software. There were no ICONS sales in the nine months ending September 30, 2003. Software sales gross margin has been affected traditionally by the amortization of the capitalized cost of the ICONS suite of conversion tools. The capitalized cost of ICONS is fully amortized as of September 30, 2004, so IAI expects improved margins on future software sales as reported.

Other Operating Income

During the third quarter of fiscal 2004, Information Analysis Incorporated recovered past due receivables, which had been reserved as uncollectible in 2000, in the amount of $289,902, net of attorney’s fees. There were no such recoveries in the nine months ended September 30, 2003.

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Nine Months Ended September 30, 2004 Versus Nine Months Ended September 30, 2003 (cont.)

Selling, General and Administrative

Selling, general and administrative expenses (SG&A) were $1,097,314, or 16.3% of revenues, in the first nine months of 2004 versus $966,592, or 27.0% of revenues, in the first nine months of 2003, representing an increase of $130,722, or 13.5%. The increase in SG&A is partially due to non-recurring officer bonuses totaling $30,000 related to the recovery of past due receivables described above. Additional increases in SG&A are related to recruiting fees for employees with clearances and commissions on sales. The decrease in SG&A as a percentage of revenue is attributed to a combination of higher revenue under a greater number of contracts and IAI’s continuing efforts to control expenses and reduce them wherever practicable. Management believes that only marginal increases in SG&A will result from increases in the number of contracts under which it operates.

Profits

The Company generated operating income of $492,324 in the first nine months of 2004 compared to an operating loss of $233,146 in the first nine months of 2003. There was net income of $466,440 for the first nine months of 2004 versus a net loss of $253,623 for the same period in 2003. The change in profitability, excluding the effect of the recovery of the past due receivables, which added $289,902 to the net income, is directly related to increased sales based largely on the addition of new contracts during the end of 2003 and in 2004. IAI believes that its current backlog of contracts, in addition to its pipeline of new opportunities, will enable it to maintain profitability in the remainder of its fiscal year 2004.

Liquidity and Capital Resources

Through the first nine months of 2004, the Company financed its operations from current collections and through its bank line of credit. Cash and cash equivalents at September 30, 2004 were $90,480 compared to $317,921 at December 31, 2003. As of September 30, 2004 the Company had no outstanding balance on its line of credit versus an outstanding balance of $689,017 at December 31, 2003.

The Company has a revolving line of credit with a bank providing for demand or short-term borrowings of up to $525,000. The line of credit is callable on demand, and expires on December 5, 2004. The Company was technically in default of certain financial covenants as of the periods reported herein. Management believes the line of credit will be renewed at substantially equivalent terms. Should the lender demand payment of any outstanding balance, or fail to renew the credit facility upon expiration, the Company may not be able to repay the credit facility or borrow sufficient funds from another financial institution to refinance Line of credit. The Company is in negotiations with various organizations to obtain a new line of credit or alternative sources of financing.

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Liquidity and Capital Resources (cont.)

The Company issued convertible notes in 2001 in the amount of $125,000 that came due on September 30, 2004. The Board of Directors voted to obtain agreements with the note holders, at their option, to extend the maturity dates of the notes under the current terms for an additional year, thereby enabling the note holders to retain their conversion privileges as to the amounts of their notes. All holders of the convertible notes opted to extend the maturity for one year, to September 30, 2005.

The current line of credit, or a similar new credit facility, when coupled with funds generated from operations, should be sufficient to meet the Company’s operating cash requirements. The Company, however, may periodically be required to delay timely payments of its accounts payable. Cash flow from operations may not be sufficient to provide additional working capital necessary to repay approximately $168,000 of past due payables.

The Company cannot state with certainty that it will not need additional cash resources at some point within the next year. Accordingly, the Company may from time to time consider additional equity offerings to finance business expansion. The Company is uncertain that it will be able to raise additional capital.

The Company has no material commitments for capital expenditures.

Item 3. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures. As of the end of the period covered by this report, with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer conducted an evaluation (as required by paragraph (b) of Rule 13a-15 or Rule 15d-15 under the Exchange Act) of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) or Rule 15d-15(e) under the Exchange Act). Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic SEC reports. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

(b) Changes in Internal Control over Financial Reporting. There have been no significant changes in the Company’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rule 13a-15 or Rule 15d-15 under the Exchange Act that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to affect, the Company’s internal control over financial reporting. There have been no significant changes subsequent to the date of the evaluation, nor were there any significant deficiencies or material weaknesses in the Company’s internal controls. Accordingly, no corrective actions were required or undertaken.

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PART II - OTHER INFORMATION

Item 6. Exhibits

SIGNATURES

In accordance with the requirements of the Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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Exhibit Index

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