UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A

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

For the fiscal year ended December 31, 2004

¨	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 : 0-22350

MERCURY INTERACTIVE CORPORATION

(Exact name of registrant as specified in its charter)

Delaware

77-0224776

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

379 North Whisman Road, Mountain View, California 94043-3969

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code:

(650) 603-5200

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

None

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

Common Stock, $0.002 par value

Preferred Stock Purchase Rights

(Title of class)

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 a 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 ¨ NO x

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 information statements incorporated by reference in Part III of this Form 10-K/A or any amendment to this Form 10-K/A. x

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). YES x NO ¨

The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $3,500,862,858 as of June 30, 2004, based upon the closing sale price reported for that date on the NASDAQ National Market. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive for other purposes.

The number of shares of Registrant’s Common Stock outstanding as of March 4, 2005 was 86,199,828.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for Registrant’s 2005 Annual Meeting of Stockholders held May 19, 2005 are incorporated by reference in Part III of this Annual Report on Form 10-K/A.

TABLE OF CONTENTS


		Page
	Explanatory Note	1

PART I
Item 1.	Business	3
	General	3
	Products and Services	4
	Research and Development	9
	Sales, Marketing, and Alliance Partners	10
	Licensing, Pricing, Deferred Revenue, and Seasonality	11
	Financial Information About Geographical Areas	11
	Competition	12
	Patents, Trademarks, and Licenses	12
	Personnel	13
	Available Information	13
Item 2.	Properties	14
Item 3.	Legal Proceedings	14
Item 4.	Submission of Matters to a Vote of Security Holders	14

PART II
Item 5.	Market for the Registrant’s Common Equity and Related Stockholder Matters	15
Item 6.	Selected Consolidated Financial Data	16
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	62
Item 8.	Financial Statements and Supplementary Data	65
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosures	65
Item 9A.	Controls and Procedures	65

PART III
Item 10.	Directors and Executive Officers of the Registrant	72
Item 11.	Executive Compensation	74
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	74
Item 13.	Certain Relationships and Related Transactions	74
Item 14.	Principal Accountant Fees and Services	74

PART IV
Item 15.	Exhibits and Financial Statement Schedules	75
Signatures		80

This Annual Report on Form 10-K/A contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors”. Further, except for the forward-looking statements included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement of Consolidated Financial Statements, Special Committee and Company Findings, Remedial Measures and Related Proceedings” and Item 9A, “Controls and Procedures,” all forward-looking statements contained in this amended Annual Report on Form 10-K/A, unless they are specifically otherwise stated to be made as of a different date, are made as of March 14, 2005, the original filing date of our Annual Report on Form 10-K for the year ended December 31, 2004. In addition, except for the sections of this Form 10-K/A entitled “Restatement of Consolidated Financial Statements, Special Committee and Company Findings, Remedial Measures and Related Proceedings” (included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), Item 9A, “Controls and Procedures” and Note 3 and Note 19 (unaudited) of the Notes to Consolidated Financial Statements, this Form 10-K/A does not reflect events occurring after the filing of our Annual Report on Form 10-K filed on March 14, 2005 other than the restatement, and we undertake no obligation to update the forward-looking statements in this Annual Report on Form 10-K/A.

Mercury, Mercury Interactive, the Mercury logo, LoadRunner, ProTune, QuickTest Professional, SiteScope, TestDirector, and WinRunner are trademarks of Mercury Interactive Corporation in the United States and may be registered in certain jurisdictions. The absence of a trademark from this list does not constitute a waiver of Mercury’s intellectual property rights concerning that trademark.

This Annual Report on Form 10-K/A contains references to other company, brand, and product names. These company, brand, and product names are used herein for identification purposes only and may be the trademarks of their respective owners. Mercury Interactive Corporation disclaims any responsibility for specifying which marks are owned by which companies or which organizations.

Explanatory Note

We are amending our Annual Report on Form 10-K for the year ended December 31, 2004, filed on March 14, 2005 (the Original Filing), to restate our consolidated financial statements for the years ended December 31, 2004, 2003 and 2002 and the related disclosures. This amended Annual Report on Form 10-K/A also includes the restatement of selected consolidated financial data as of and for the years ended December 31, 2004, 2003, 2002, 2001 and 2000, which is included in Item 6, and the unaudited quarterly financial data for each of the quarters in the years ended December 31, 2004 and 2003, which is included in Item 15. See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements for a detailed discussion of the effect of the restatement.

The restatement of the Original Filing reflected in this amended Annual Report on Form 10-K/A includes adjustments arising from the determinations of a Special Committee, consisting of disinterested members of the Audit Committee, which was formed in June 2005 to conduct an internal investigation into the Company’s past stock option practices, as well as our internal review relating to our historical financial statements.

For more information on these matters, please refer to Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Restatement of Consolidated Financial Statements, Special Committee and Company Findings, Remedial Measures and Related Proceedings”, Note 3 of the Notes to the Consolidated Financial Statements, and Item 9A, “Controls and Procedures”.

We have not amended and we do not intend to amend any of our other previously filed annual reports on Form 10-K for the periods affected by the restatement or adjustments other than this amended Annual Report on Form 10-K/A. As a result of the restatement of our consolidated financial statements, we will also restate the interim financial statements for the quarterly and year to date periods ended March 31, June 30, and September 30, 2004 to be included in our quarterly reports on Forms 10-Q for the periods ended March 31, June 30 and September 30, 2005. For this reason, the consolidated financial statements and related financial information contained in such previously filed reports should no longer be relied upon. Except for the sections of this Form 10-K/A entitled “Restatement of Consolidated Financial Statements, Special Committee and Company Findings, Remedial Measures and Related Proceedings” (included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”), Item 9A, “Controls and Procedures,” Note 3 and Note 19 (unaudited) of the Notes to Consolidated Financial Statements, and the “Unaudited Quarterly Financial Data,” included in Item 15 all of the information in this amended Annual Report on Form 10-K/A is as of December 31, 2004 and does not reflect events occurring after the Original Filing, other than the restatement, or modify or update disclosures (including the exhibits to the Original Filing, except for the updated Exhibits 31.1, 31.2, 32.1, and 32.2 described below) affected by subsequent events. Accordingly, this amended Annual Report on Form 10-K/A should be read in conjunction with our periodic filings made with the SEC subsequent to the date of the Original Filing, including any amendments to those filings, as well as any Current Reports filed on Form 8-K subsequent to the date of the Original Filing. In addition, in accordance with applicable SEC rules, this amended Annual Report on Form 10-K/A includes updated certifications from our Chief Executive Officer (CEO) and Chief Financial Officer (CFO) as Exhibits 31.1, 31.2, 32.1 and 32.2.

For the convenience of the reader, this amended Annual Report on Form 10-K/A sets forth the Original Filing in its entirety, as amended by, and to reflect, the restatement. The following items have been amended principally as a result of, and to reflect, the restatement, and no other information in the Original Filing is amended hereby as a result of the restatement:

Part I—Item 1—Business;

Part I—Item 3—Legal Proceedings;

Part II—Item 5—Market for the Registrant’s Common Equity and Related Stockholder Matters;

Part II—Item 6—Selected Consolidated Financial Data;

Part II—Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations;

Part II—Item 7A—Quantitative and Qualitative Disclosures about Market Risk;

Part II—Item 8—Financial Statements and Supplementary Data;

Part II—Item 9A—Controls and Procedures;

Part III—Item 10—Directors and Executive Officers of the Registrant;

Part III—Item 11—Executive Compensation;

Part III—Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters;

Part III—Item 13—Certain Relationships and Related Transactions; and

Part IV—Item 15—Exhibits and Financial Statement Schedules.

PART I

Item 1.

Business

General

Industry Overview

The importance of enterprise software applications in today’s business environment cannot be overstated. Some analysts project that up to 90-percent of business processes are automated in enterprise applications. As a result, maximizing the value of enterprise software applications is a critical factor in overall business success. Yet it is increasingly difficult for chief information officers (CIOs) to deliver business value while managing costs, risks, and compliance against a changing backdrop of increasing business and technology complexity. To address these challenges, many of our global customers are turning to business technology optimization (BTO), the industry strategy for maximizing the business value of Information Technology (IT). BTO applies business and quality management practices coupled with software to optimize the business results of IT. Global 2000 companies use the principles and practices of BTO to automate and optimize IT itself. BTO is about ensuring that every dollar invested in IT, every resource allocated, and every application in development or in production is fully aligned towards business goals. BTO helps CIOs and IT executives achieve their top priorities, which include:

•

maximize and demonstrate the business value of IT;

•

align IT strategy with business priorities;

•

reduce IT spending; and

•

control risks and improve regulatory compliance.

Company Overview

We are a leading provider of software and services for the BTO marketplace. Mercury was incorporated in 1989, and began shipping software quality testing products in 1991. Since 1991, we have introduced a variety of BTO software and service offerings, including offerings in application delivery for testing software quality and performance in pre-production, application management for monitoring and managing application availability in production, and IT governance for managing IT’s portfolio of projects, processes, priorities, and resources.

Our BTO offerings for application delivery, application management, and IT governance help customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance. The Mercury BTO offerings include:

•

Our IT governance offerings help customers govern and manage the priorities, people, and processes required to run an IT organization like a business.

•

Our application delivery offerings help customers optimize their custom and packaged business applications by improving the quality and performance of those applications, while reducing the time and costs required to deploy them.

•

Our application management offerings help customers optimize the performance and availability of applications in production and resolve problems quickly and proactively.

•

Most of our offerings are available as a managed service over the Internet. Our managed service is a “software as a service” offering that allows our customers have the flexibility of choosing which Mercury software to run themselves and which software will be outsourced to us.

•

We also provide a wide range of customer support and professional service offerings that enable our global partners and customers to implement, customize, manage, and extend our BTO offerings.

2004 Business Acquisitions and Technology License Agreement

On July 1, 2004, we acquired Appilog, Inc., a privately-held company. The acquisition of Appilog, a leading provider of auto-discovery and application mapping software, extended our capabilities in application management and BTO. Appilog’s products, now marketed and sold as Mercury Application Mapping, automatically manage the complex and dynamic relationships between enterprise applications and their supporting infrastructure. This technology helps customers to discover application dependencies on infrastructure, automatically detect and visually depict changes to applications and infrastructure, and visualize the business effect of planned and unplanned changes and infrastructure failures.

On November 16, 2004, we announced an OEM relationship with HyPerformix to enhance our capacity planning offering. The new offering, Mercury Capacity Planning (Powered by HyPerformix), allows IT teams to make the right tradeoffs between the performance and scalability of mission-critical business applications and the costs of their underlying infrastructure.

Products and Services

Our portfolio of BTO products and services is strategically organized around three product lines: IT governance, application delivery, and application management. Our BTO offerings, called Mercury Optimization Centers, consist of integrated software, services, and best practices within each center that enable companies to use a center of excellence approach to govern the priorities, processes, and people of IT, while maximizing the quality, performance, and availability of software applications. These Optimization Centers allow our existing customers to expand from tactical initiatives to an enterprise approach to BTO.

IT Governance Offerings

Our IT Governance offerings are used by CIOs and IT executives to prioritize and automate IT business processes from demand through production. These IT Governance offerings help customers optimize and align IT strategy and execution with business goals, reduce the cost of day to day operations, and improve business value and competitiveness.

Mercury IT Governance Center

Mercury IT Governance Center provides integrated capabilities for managing the strategic components of IT. It provides real-time data to consolidate key governance functions such as demand management, portfolio and project management, resource management, and a comprehensive system to help comply with regulations such as the Sarbanes-Oxley Act of 2002. It offers support for quality programs and process control frameworks such as Six-Sigma, CMMI, ITIL, ISO-9000, and COBiT. In addition, it integrates workflow, security, execution, and reporting services.

Mercury IT Governance Center core products include:

•

Mercury IT Governance Dashboard provides visibility into IT trends, status, and deliverables so that customers can make and execute real-time decisions. It provides a comprehensive real-time view of all IT initiatives and operations through a single point of access, and provides the centralized visibility and control essential to building a high-performance IT organization.

•

Mercury Demand Management is used to manage all the demand placed on IT. It allows customers to consolidate, prioritize, and fulfill both strategic projects and day-to-day activities. It also allows customers to manage service levels.

•

Mercury Portfolio Management is used to govern IT portfolios by evaluating, prioritizing, balancing, and approving both new initiatives and customers’ existing portfolio; analyzing different what-if scenarios, and ensuring alignment with business strategy and IT resource constraints. It lets business and IT stakeholders collaboratively govern their entire IT portfolio, with “apples-to-apples” comparisons and multiple levels of input, review, and approval.

•

Mercury Program Management is used to collaboratively manage IT programs from concept to completion. It allows customers to automate and align processes for managing scope, risk, quality, issues, and schedules. Customers can deliver complex programs with the highest quality and capabilities, on time and on budget.

•

Mercury Project Management enables collaborative project management for both repetitive projects, such as installing a new release of an HRMS application, and one-time projects, such as developing a new e-commerce capability. It allows customers to accelerate project delivery while reducing project costs.

•

Mercury Change Management is used to plan, package, release, and deploy changes to customers’ applications portfolios. It delivers best practice software change management processes across platforms (mainframe, UNIX, NT, Linux), types of change (code, configurations, content), environments (Java, C, COBOL), or applications (Oracle, PeopleSoft, SAP, Siebel, custom, legacy).

•

Mercury Financial Management is used to manage IT portfolios with real-time visibility into financial performance. It offers automatic real-time calculations of costs and variances, giving customers detailed comparisons of project health. It also provides real-time visibility into budgets, costs (both labor and non-labor), programs, projects, and overall IT demand—without costly integrations to multiple data sources.

•

Mercury Resource Management is used to manage resource capacity and allocation. It balances resource supply, including both staffing levels and skill base, with incoming demand, giving full visibility and control over project demand, such as deploying new web-based services, as well as day-to-day demand, such as provisioning new employees and installing vendor patches.

•

Mercury Time Management helps customers focus on value-added activities by streamlining time collection and improving accuracy across the wide range of work performed by IT.

•

Mercury Object Migrator automates the deployment of AOL (Application Object Library) setups between Oracle E-Business Suite instances—saving time, money, and reducing errors.

•

Mercury IT Governance Foundation enables customers to efficiently implement, protect, scale, and administer their Mercury IT Governance Center. It provides an integrated transaction processing architecture with shared services available across all IT Governance applications. IT Governance Foundation enables customers to minimize the total cost of ownership of their IT management applications. By sharing common services across Mercury IT Governance Center, our Foundation is less costly to administer and easier to learn and use.

Application Delivery Offerings

Our application delivery offerings help customers to optimize the quality and performance of both custom-built and pre-packaged software applications before they go into production. We offer two Mercury Optimization Centers for application delivery that automate critical delivery functions, including test management, business-process test design, functional and regression testing, load-testing, performance tuning, capacity planning, and diagnostics. These products and technologies are used to optimize the pre-production software development, customization, and integration processes. Our application delivery offerings enable customers to make informed “go live” decisions, decrease software defects, reduce the time and cost of deploying new software or software upgrades, and help ensure that software applications will produce their intended business results. In addition, certain of the capabilities of our two optimization centers are available through a managed service as application delivery services.

Mercury Quality Center

Mercury Quality Center is used by developers, quality assurance teams, and business analysts to perform automated software testing and quality assurance across a range of IT and application environments. It combines a suite of role-based applications, a business dashboard, and an application delivery foundation to optimize and

automate key quality activities, including test management, requirements and defects tracking, functional and regression testing, and business process design validation. In addition, customers can choose to have Mercury Quality Center delivered as a managed service.

Mercury Quality Center core software products include:

•

Mercury TestDirector is our global test management product that helps organizations deploy high-quality applications more quickly and effectively. Mercury TestDirector software integrates requirements management with test planning, test scheduling, test execution, and defect tracking in a single application to accelerate the quality testing process. Customers can leverage Mercury TestDirector’s core modules either as a standalone solution or integrated within a global Quality Center of Excellence.

•

Mercury QuickTest Professional is our automated testing solution for building functional and regression test suites. It provides a keyword-driven approach to structured automation, so customers can use natural language to build tests that verify user interactions and ensure business processes work as designed. Mercury QuickTest Professional supports a range of enterprise IT environments, including Web (HTML/DHTML), .NET, Java/J2EE, ERP/CRM, client/server, mainframe, and multimedia.

•

Mercury WinRunner is our standard functional testing solution for enterprise IT applications. It captures, verifies, and replays user interactions automatically, so customers can identify defects and ensure that business processes, which might span across multiple applications and databases, work as designed upon deployment and remain reliable.

•

Mercury Functional Testing combines our functional testing products, Mercury QuickTest Professional and Mercury WinRunner, to deliver a complete solution for functional test and regression test automation — with support for nearly every software application and environment.

•

Mercury Business Process Testing provides our automated functional testing capabilities to business analysts — enabling those people who are most knowledgeable about business process and application functionality to become an integral part of the quality optimization process. Mercury Business Process Testing is a web-based test automation solution designed to enable subject matter experts to build and execute test automation without any programming knowledge.

Mercury Performance Center

Mercury Performance Center is used by developers and performance testing teams to optimize application performance in pre-production. It helps to ensure applications will scale to support the right number of users, transaction volumes, and performance levels. Mercury Performance Center combines integrated software, services, best practices, and a business dashboard for key performance optimization activities, including load-testing, performance tuning, capacity planning, and diagnostics across complex, heterogeneous computing environments. In addition, customers can choose to have Mercury Performance Center delivered as a managed service.

Mercury Performance Center core software products include:

•

Mercury LoadRunner is our industry-leading load-testing solution for predicting system scalability, behavior, and performance. Mercury LoadRunner is used to obtain an accurate picture of end-to-end system performance, verify that new or upgraded applications meet specified performance requirements, and identify and eliminate performance bottlenecks during the development lifecycle. It exercises an entire application infrastructure by emulating thousands of virtual users and employs performance monitors to identify and isolate performance bottlenecks across and within each tier. By using Mercury LoadRunner, customers can minimize testing cycles, reduce defects, optimize application performance, and accelerate application deployment.

•

Mercury Tuning (formerly ProTune) helps isolate and resolve infrastructure bottlenecks. It takes customers through a structured methodology to determine where the faults might be within the system, and then provides a centralized console to look across the system configuration to resolve problems. Mercury Tuning extends Mercury LoadRunner’s capabilities through the Safe Deployment System, allowing customers to systematically identify, isolate, and resolve infrastructure performance bottlenecks by modifying the system configuration settings.

•

Mercury Capacity Planning provides simulation modeling of real-world production environments to help customers make informed decisions about the optimal infrastructure requirements from an application end-user perspective, before going live. Mercury Capacity Planning uses HyPerformix’s Integrated Performance Suite™ technology with Mercury LoadRunner, to build models of existing or future production environments and create “what-if” scenarios of infrastructure deployment alternatives. This helps customers forecast and plan the types and quantities of key IT resources required to meet cost, performance, and utilization objectives.

•

Mercury Diagnostics is our lifecycle application diagnostics solution for J2EE, .NET, and ERP/CRM environments. It can be used in both pre- and post-production environments to find deep code and configuration level issues in enterprise applications environments, including intermittent problems, memory leaks, synchronization, deadlocks, and data dependent issues. In pre-production, Mercury Diagnostics allows customers to identify, diagnose, and resolve application problems prior to deployment.

Application Management Offerings

Our application management offerings help customers optimize business availability and problem resolution. We offer one Mercury Optimization Center as well as a managed service for application management that facilitates a strategic, business-centric approach to ensuring that production software performs at the levels required to meet business goals. Additionally, our application management offerings enable customers to proactively manage and automate the repair of production problems, which reduces the business ramifications of downtime.

Mercury Business Availability Center

Mercury Business Availability Center is used by IT operations teams to maximize business availability, manage IT operations from a business perspective, minimize downtime, and ensure applications are meeting established service levels with customers. Comprised of integrated applications, a business dashboard, and an application management foundation, Mercury Business Availability Center is used to manage application performance and availability according to service levels and business priorities, automatically discover and map the dynamic relationships between applications and underlying infrastructure, quantify the business effect of application downtime, and prioritize problem resolution based on business effect and service-level compliance. In addition, customers can choose to have Mercury Business Availability Center delivered as a managed service.

Mercury Business Availability Center core software products include:

•

Mercury Application Management Dashboard (formerly Topaz Business Availability) is our interactive dashboard that provides real-time visibility into key application-enabled business processes. By monitoring application performance and availability in real time, Mercury Application Management Dashboard helps IT and business executives measure the results delivered by production applications.

•

Mercury Service Level Management (formerly Topaz for Service Level Management SLM) enables customers to proactively manage service levels from the business perspective. It provides service level reporting for enterprises and service providers to measure application service levels against business objectives. By using Mercury Service Level Management, customers can define realistic, quantifiable service level objectives that reflect business goals, and track performance both on a real-time basis and for offline planning purposes.

•

Mercury System Availability Management, in conjunction with Mercury SiteScope, enables customers to seamlessly deploy and maintain an enterprise infrastructure monitoring solution to achieve 100-percent coverage. It connects to existing Enterprise Management System (EMS) products or uses SiteScope to collect and monitor system availability and performance data from across the entire enterprise. Mercury System Availability Management, using SiteScope as its data collection engine, is based on a unique agentless architecture that enables centralized management, configuration, and management, which ultimately lowers the total cost of ownership.

•

Mercury Application Mapping provides real-time visibility into the dynamic relationships between enterprise applications and their underlying infrastructure. It continuously updates and maintains this topology map within a common relationship model, enabling customers to quickly assess business effect of IT issues. As a result, customers can reduce the costs and risks of managing new services and making changes to existing services.

•

Mercury End User Management proactively monitors application availability in real-time and from the end-user perspective, so customers can fix issues before end-users experience problems. It proactively emulates end-user business processes against applications on a 24x7 basis. Plus, it enables customers to assess business effect on real users across multiple domains and geographies, and manage end-user performance from a wide number of supported desktops, and handheld devices.

•

Mercury Diagnostics is our lifecycle application diagnostics solution for J2EE, .NET, and ERP/CRM environments. It can be used in both pre-production and production environments to find deep code and configuration level issues in enterprise applications environments, including intermittent problems, memory leaks, synchronization, deadlocks, and data dependent issues. In production, Mercury Diagnostics allows customers to manage, monitor, diagnose, and resolve critical application problems before they affect business or end-user performance.

•

Mercury Application Management Foundation (formerly Topaz Platform) offers an “agentless” monitoring architecture that includes our business process and end-user monitoring infrastructure, as well as an infrastructure monitoring solution. Key components include:

•

Mercury Business Process Monitor (formerly Topaz Business Process Monitor) proactively monitors enterprise applications in real-time and alerts IT Operations groups to performance problems before users experience them. Customers can monitor sites from various locations to accurately assess site performance from the perspective of different users.

•

Mercury Client Monitor (formerly Topaz Observer) gathers performance data directly from the client machine and measures the experience of real end-users as they utilize business processes. It provides unique client-monitoring capabilities to work through issues that affect inconsistently, and correlate them to failure points in the backend, network and all the way to the client’s “last mile” connection or even the desktop system itself, whether the user resides inside or outside the firewall.

•

Mercury Global Monitor (formerly Topaz Monitor) is the only solution that provides a monitoring infrastructure that allows a customer to gain insight into the end-user experience both inside and outside the firewall, from a single source. We maintain a network of host machines, or agents, to help our customers measure their end-user performance experience at any time, from anywhere.

•

Mercury Real User Monitor (formerly Topaz Prism) is a central solution for measuring the online experience of every user, from every location, all the time. With Real User Monitor, customers can quantify the business effect of performance problems and effectively prioritize resolution efforts. By providing visibility outside of the datacenter into all users, it enables customers to isolate inconsistent issues which affect individuals or groups of users.

Mercury BTO Services

Mercury Services provides a wide range of professional and educational services as well as customer support offerings that enable global partners and customers to implement, customize, manage, and extend our BTO offerings. Many of our software offerings are available as a managed service over the Internet—giving customers the flexibility of choosing to deploy Mercury software in-house, and/or outsourced to us.

Mercury Professional and Educational Services

Our professional services organization offers the expertise, knowledge, and practices to help the customer implement an enterprise-wide BTO strategy. We help the customer measure the quality of their applications and automated business processes from a business perspective, maximize technology and business performance at each stage of the application lifecycle, and use effective governance strategies to manage IT operations for continuous improvement. Post-sales support is provided by our professional services organization through training and consulting engagements. Our educational services provide a comprehensive curriculum for all our products, using different methods of delivery at multiple locations in the U.S. and worldwide. Customers must take rigorous certifications to obtain “Mercury Certified Product Consultant” and “Mercury Certified Instructor” titles. As of December 31, 2004, our professional and educational services organization consisted of 244 employees.

Mercury Customer Support

Our customer support organization provides post-sales support through renewable maintenance contracts. These contracts provide for technical support as well as software upgrades on an “if and when available” basis. Our customer support organization offers different customer support programs to suit varying needs of our global customers. Our development teams in Israel serve as an extension of our customer support organization to assist when local support centers are unable to solve a problem. We believe that a strong customer support organization is integral to both the initial marketing of our products and maintenance of customer satisfaction, which in turn enhances our brand and improves opportunity for repeat orders. In addition, the customer feedback received through our ongoing support function provides us with information on market trends and customer requirements that are strategic to ongoing product development efforts. As of December 31, 2004, our customer support organization consisted of 262 employees.

Mercury Managed Services

Our managed services offerings are a critical part of our strategy to deliver rapid time to value for our customers. These services offer customers the choice to run our software in-house or have us provide them with an outsourced offering. By deploying our software as a service over the Internet, our managed services help our customers rapidly derive more value from their IT investments while minimizing costs and risks. Our managed services provide an infrastructure that consists of server farms, a robust infrastructure for managing data, and more than 300 agent machines located in more than 80 cities around the world. In addition, to help customers be successful in implementing our BTO products, our managed services can be augmented with on-going knowledge transfer from our professional services. We believe that offering our customers the choice of whether to run our software internally or have us provide it as a managed service is a significant competitive advantage over vendors who only offer one or the other option. As of December 31, 2004, our managed services organization consisted of 111 employees.

Research and Development

Since our inception in 1989, we have made significant investments in research and product development. We believe that our success will depend in large part on our ability to maintain and enhance our current product lines, develop new products and solutions, maintain technological competitiveness, extend our technological leadership, and meet changing customer requirements. Our research and development organization maintains relationships with third-party software vendors and with many major hardware vendors on whose platforms our products operate.

Our primary research and development facility is located near Tel Aviv, Israel. Performing research and development in Israel offers a lower cost structure than in the U.S. Operating in Israel has also allowed us to receive tax incentives from the government of Israel (see Note 13 to the consolidated financial statements for additional information regarding our income tax provision).

We also have engineering facilities in Boulder, Colorado; Bellevue, Washington; and Mountain View, California that were acquired in conjunction with our acquisitions of Freshwater in May 2001, Performant in May 2003, and Kintana in August 2003, respectively.

For the years ended December 31, 2004, 2003, and 2002, we incurred $82.1 million, $73.1 million, and $51.2 million in research and development expenses, including stock-based compensation expense of $8.2 million, $16.4 million, and $9.9 million, respectively. As discussed in Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements, previously reported stock-based compensation expense was adjusted as part of our restatement. As of December 31, 2004, our research and development organization consisted of 602 employees.

Sales, Marketing, and Alliance Partners

Sales

We employ highly skilled enterprise sales professionals and systems engineers to understand our customers’ needs and to explain and demonstrate the value of our products and services. We sell our products primarily through our direct sales organization, which is supported by our pre-sales systems engineers. Our sales organization also includes our inside corporate sales professionals, who are primarily responsible for smaller transactions with existing customers. As of December 31, 2004, our sales organization consisted of 945 employees.

Our subsidiaries and branches operate sales and support offices in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, Poland, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore.

Marketing

Our marketing organization is primarily responsible for aligning the needs of our customers and partners with our BTO strategy, building the value of the Mercury brand, marketing our product and service offerings, differentiating us from competitors, and enabling our global channel to sell and service our customers. Our marketing activities include integrated marketing campaigns, BTO executive summits, business and trade press tours, industry analyst briefings, global advertising, and lead generation campaigns targeted at senior IT executives. Marketing activities included direct mailings to customers and prospects, as well as attendance and sponsorship at strategic industry events and tradeshows. We also share BTO best practices with partners, existing customers and prospects through a series of events, publications, and hosting a series of Internet seminars. These activities are designed to familiarize the market with the capabilities of BTO and Mercury Optimization Center offerings. As of December 31, 2004, our marketing organization consisted of 149 employees.

Alliance Partners

We work with a wide range of partners around the globe. Our strategy is to partner with global software vendors, systems integrators, and hardware and software vendors to provide our customers with a wide breadth and depth of leading software and services to get the most value out of their initiatives. These companies include:

•

global software vendors that provide enterprise applications, such as Oracle, SAP AG, and Siebel Systems; and

•

major systems integrators, including Accenture and BearingPoint.

We derive a portion of our business from sales of our products through our alliance partners. We normally pay our alliance partners through our channel business in the form of a discount or a fee for the referral of business, which is netted against the revenue we recognize.

Licensing, Pricing, Deferred Revenue, and Seasonality

We license our software to customers under non-exclusive license agreements on either subscription, perpetual, or multiple year term bases that generally restrict use of the products to internal purposes at a specified site. We typically license software products to either allow up to a set number of users to access the software on a network at any one time, using any workstation attached to that network, or to allow use of the software on designated computers or workstations. In addition, our managed services, our application management products, and some of our application delivery and IT governance products are licensed and priced based on usage, such as the number of transactions monitored, number of virtual users emulated per day, or period of usage.

We believe that offering customers the option to license our software using term and subscription contracts provides us with a unique differentiator. Term and subscription licensing enable our customers to license the software they need for the time period they use it, while providing us with the opportunity to earn renewals and expand contracts over time.

Our products are priced to encourage customers to purchase multiple products and licenses and expand the usage of our technology. License fees depend on the product licensed, the term of the license, the number of users for the product licensed, and the locations in which such licenses are sold, as international prices tend to be higher than U.S. prices. Sales to our indirect sales channels, which are intended for resale to end-users, are made at discounts from our list prices based on the sales volume of the indirect sales channels. Original purchases of maintenance and renewal maintenance sales are priced at specified percentages of the related license fees. Training and consulting revenues are generally generated on a time and expense basis.

We recognize revenue ratably for subscription contracts whose terms generally range from a period of one to three years. Recognized revenue from these contracts was $152.2 million, $98.8 million, and $53.0 million for the years ended December 31, 2004, 2003, and 2002, respectively.

Our total deferred revenue balance was $413.8 million at December 31, 2004. This includes deferred revenue associated with (a) license fees that have been billed but were not recognizable as revenue at that time; (b) subscription contracts; and (c) maintenance contracts for which revenue is recognized ratably over the term of the maintenance period. We expect $102.2 million of this balance to be recognized as revenue in periods after 2005.

We do not have any sales contracts that obligate our customers to buy any material products or services over future periods other than those sales recorded as either revenues or deferred revenues.

Financial Information About Geographical Areas

Financial information about geographical areas is included in Note 18 to the consolidated financial statements.

Competition

We believe that we compete favorably in each of the key components of BTO. However, the market for our business technology optimization products and services is extremely competitive, dynamic, and subject to frequent technological change. There are few substantial barriers of entry in our market. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in our markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of current and potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.

In the market for application delivery solutions, our principal competitors include Compuware, Empirix, IBM Software Group, Parasoft, Worksoft, and Segue Software. In the new and rapidly changing market for application management solutions, our principal competitors include BMC Software, Computer Associates, Compuware, HP OpenView (a division of Hewlett-Packard), Keynote Systems, Segue Software, Tivoli (a division of IBM), Wily Technologies, and Veritas. In the market for IT governance solutions, our principal competitors include enterprise application vendors such as SAP AG, Oracle, Lawson, and Compuware (with its acquisition of Changepoint), as well as point tool vendors such as Niku and Primavera.

We believe that the principal competitive factors affecting our market are:

•

price and cost effectiveness;

•

product functionality;

•

product performance, including scalability and reliability;

•

quality of support and service;

•

company reputation;

•

depth and breadth of BTO offerings;

•

research and development leadership;

•

financial stability; and

•

global capabilities.

Although we believe that our products and services currently compete favorably with respect to these factors, the markets for application management, application delivery, and IT governance are new and rapidly evolving. We may not be able to maintain our competitive position, which could lead to a decrease in our revenues and adversely affect our operating results. The software industry is increasingly experiencing consolidation and this could increase the resources available to our competitors and the scope of their product offerings. For example, our former IT governance competitor, PeopleSoft, was acquired by Oracle, which has substantially greater financial and other resources than we have. Our competitors and potential competitors may develop more advanced technology, undertake more extensive marketing campaigns, adopt more aggressive pricing policies, or make more attractive offers to distribution partners and to employees. We anticipate the market for our software and services to become increasingly more competitive over time.

Patents, Trademarks, and Licenses

We rely on a combination of patents, copyrights, trademarks, service marks, trade secret laws, and contractual restrictions to establish and protect proprietary rights in our products and services. The source code for our products is protected both as a trade secret and as an unpublished copyrighted work. Despite our precautions, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization. In addition, the laws of various countries in which our products may be sold may not protect our products and intellectual property rights to the same extent as the laws of the U.S. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology.

We rely on software that we license from third parties for certain components of our products and services including the technology we licensed from HyPerformix. In the future, we may license other third party technologies to enhance our products and services and meet evolving customer needs. The failure to license any necessary technology, or to maintain our existing licenses, could result in reduced demand for our products.

Because the software industry is characterized by rapid technological change, we believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition, and reliable product maintenance are more important to establishing and maintaining a technology leadership position than the various legal protections of our technology.

As of February 1, 2005, we have been granted or own by assignment 27 patents issued in the United States and have 10 patent applications on file with the United States Patent and Trademark Office (including continuation and divisional applications) for elements contained in our products and services. Once granted, we expect the duration of each patent will be up to 20 years from the effective date of filing of the applications. Our earliest issued patents can remain effective until April 23, 2013. In addition, we have three patents issued in Australia. We intend to continue to file patent applications as appropriate in the future. We cannot be sure, however, that any of our pending patent applications will be allowed, that any issued patents will protect our intellectual property or will not be challenged by third parties, or that the patents of others will not seriously harm our ability to do business. In addition, others may independently develop similar or competing technologies or design around any of our patents. We do not believe we are significantly dependent on any of our patents as we do not generally license our patents to other companies and do not receive any revenue as a direct result of our patents.

Although we believe that our products and services and other proprietary rights do not infringe upon the proprietary rights of third parties, third parties may assert intellectual property infringement claims against us in the future. Any such claims may result in costly, time-consuming litigation and may require us to enter into royalty or cross-license arrangements.

Personnel

As of December 31, 2004, we had a total of 2,659 employees, of which 1,307 were based in the Americas and 1,352 were based outside the Americas. Of the total, 1,094 were engaged in marketing and selling, 617 were in services and support, 602 were in research and development, and 346 were in general and administrative functions. Our success depends in significant part upon the performance of our senior management and certain key employees. Competition for highly skilled employees, including sales, technical, and management personnel, is strong in the software and technology industry. We may not be able to recruit and retain key sales, technical, and managerial employees. Our failure to attract, assimilate, or retain highly qualified sales, technical, and managerial personnel could seriously harm our business. Additionally, during 2004 we had changes in the roles, responsibilities, and personnel in our executive management. Any failures of our executive team to adopt and change to these new roles and responsibilities could have an adverse affect on our business. None of our employees are represented by a labor union, we have never experienced any work stoppages, and we believe that our employee relations are in good standing.

Available Information

We are subject to the informational requirements of the Securities Exchange Act of 1934 (the Exchange Act). Therefore, we file periodic reports, proxy statements, and other information with the SEC. Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet website at http://www.sec.gov that contains reports, proxy, and information statements and other information regarding issuers that file electronically.

You can access financial and other information on our website at www.mercury.com/us/company/ir/. We have made all reports and amendments to reports from December 31, 2002 to December 31, 2004 (other than the

original filing of the Annual Report on Form 10-K for the year ended December 31, 2004 being amended by this amended Annual Report on Form 10-K/A) available on our website. We also make available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC.

Item 2.

Properties

In the second quarter of 2004, we moved into four buildings in Mountain View, California that we leased in October 2003. The four leased buildings, with a total square footage of approximately 253,000, became our new headquarters. Prior to the move, we were headquartered in Sunnyvale, California in four buildings that we owned with a total square footage of approximately 156,000. In January 2004, we sold two of the three vacant buildings in Sunnyvale, California with a total square footage of approximately 50,000. As of December 31, 2004, we owned two buildings with a total square footage of approximately 106,000. On January 7, 2005, we sold one of the two buildings in Sunnyvale, California that was vacant since April 2004 with a total square footage of approximately 55,000. In addition, we lease office buildings in other locations within the Americas. As of December 31, 2004, we leased approximately 171,000 square feet of office buildings in other locations within the Americas.

Our primary research and development activities are conducted by our subsidiary in Israel in two buildings that we own with a total square footage of 255,000. We also lease two other buildings, one of which is used for research and development activities and the other of which is used for manufacturing activities. In February 2004, we purchased approximately 30,000 square feet of land near our existing offices in Israel to accommodate future expansion in research and development activities.

As of December 31, 2004, we had a total of 72 sales and support offices throughout the world, of which 38 were in the Americas, 23 were in EMEA, 9 were in APAC, and 2 were in Japan.

As of December 31, 2004, we leased office buildings in EMEA, APAC, and Japan with a total square footage of approximately 180,000, 36,000, and 7,000, respectively.

We believe that our existing facilities are adequate for our current needs.

Item 3.

Legal Proceedings

As of December 31, 2004, there were no material legal proceedings pending, other than routine litigation incidental to our business, to which we were a party or to which any of our properties was subject. It is common in our industry to experience legal disputes with customers, shareholders, partners, and/or employees. This type of legal action could significantly harm our business.

See Note 19, “Subsequent Events—Events Related to the Special Committee and Company Investigations and the Restatement,” (unaudited) of the Notes to Consolidated Financial Statements for more information about legal proceedings.

Item 4.

Submission of Matters to a Vote of Security Holders

No matters were submitted during the fourth quarter of 2004 to a vote of the holders of our common stock through the solicitation of proxies or otherwise.

PART II

Item 5.

Market for the Registrant’s Common Equity and Related Stockholder Matters

(a) Market for Common Stock

As described in Note 19, “Subsequent Events (unaudited),” of the Notes to Consolidated Financial Statements, on January 3, 2006, we announced that our common stock was delisted from the NASDAQ National Market for noncompliance with the NASDAQ listing requirements and that our common stock would be traded on the Pink Sheets effective as of January 4, 2006.

As of December 31, 2004, our common stock was traded publicly on the NASDAQ National Market under the trading symbol “MERQ”. The following table presents, for the periods indicated, the high and low intra-day sale price per share of our common stock as reported on the NASDAQ National Market.


	High		Low
Year Ended December 31, 2003:
First Quarter	$	38.63	$	29.28
Second Quarter	$	44.20	$	29.24
Third Quarter	$	52.16	$	37.25
Fourth Quarter	$	52.43	$	42.01
Year Ended December 31, 2004:
First Quarter	$	54.25	$	41.21
Second Quarter	$	50.94	$	42.53
Third Quarter	$	50.08	$	31.05
Fourth Quarter	$	47.44	$	35.55

Holders of Record

As of March 4, 2005, there were approximately 301 holders of record of our common stock.

Dividends

We have never declared or paid any cash dividends on our common stock. We currently intend to retain earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future.

(b) None.

(c) None.

Item 6.

Selected Consolidated Financial Data

The following selected consolidated financial data has been restated and is derived from our consolidated financial statements and should be read in conjunction with the consolidated financial statements and notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial data included elsewhere in this report. Our historical results of operations are not necessarily indicative of results of operations to be expected for any future period.

See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements for more detailed information regarding the restatement of our consolidated financial statements for the years ended December 31, 2004, 2003 and 2002 and our selected consolidated financial data as of and for the years ended December 31, 2004, 2003, 2002, 2001 and 2000.


	Year ended December 31,							Year ended December 31,
	2004		2003		2002			2001								2000
	(in thousands, except per share amounts)							(in thousands, except per share amounts)

	As restated (1)		As restated (1)		As restated (1)			As previously reported		Adjustments			As restated (1)			As previously reported		Adjustments			As restated (1)
Consolidated Statements of Operations Data:
Revenues:
License fees	$	261,382	$	200,839	$	192,214		$	203,817	$	(189	)	$	203,628		$	206,835	$	(5	)	$	206,830
Subscription fees		152,199		98,824		52,970			32,783		50			32,833			9,265		4			9,269

Total product revenues		413,581		299,663		245,184			236,600		(139	)		236,461			216,100		(1	)		216,099
Maintenance fees		196,215		159,023		122,262			98,536		27			98,563			64,250		13			64,263
Professional service fees		76,275		47,519		32,507			25,864		43			25,907			26,650		(1	)		26,649

Total revenues		686,071		506,205		399,953			361,000		(69	)		360,931			307,000		11			307,011

Costs and expenses:
Cost of license and subscription (including stock-based compensation*)		41,799		34,432		27,327			23,915		(3,864	)		20,051			15,626		8,873			24,499
Cost of maintenance (including stock-based compensation*)		17,898		17,731		14,597			10,712		2,378			13,090			4,969		8,893			13,862
Cost of professional services (including stock-based compensation*)		63,737		40,321		25,510			20,396		839			21,235			21,359		3,150			24,509
Cost of revenue—amortization of intangible assets		10,019		5,189		1,833			1,118		—			1,118			—		—			—
Marketing and selling (including stock-based compensation*)		335,867		303,865		216,546			183,680		(64,393	)		119,287			147,077		133,024			280,101
Research and development (including stock-based compensation*)		82,122		73,096		51,197			41,276		5,433			46,709			35,282		12,584			47,866
General and administrative (including stock-based compensation*)		63,802		55,904		30,914			25,257		(127,082	)		(101,825	)		19,274		145,333			164,607
Acquisition-related expenses		900		11,968		—			—		—			—			—		—			—
Restructuring, integration, and other related expenses		3,088		3,389		(537	)		5,361		—			5,361			—		—			—
Amortization of intangible assets		5,544		2,281		542			29,007		407			29,414			—		—			—
Excess facilities expense		8,943		16,882		—			—		—			—			—		—			—

Total costs and expenses		633,719		565,058		367,929			340,722		(186,282	)		154,440			243,587		311,857			555,444


	Year ended December 31,									Year ended December 31,
	2004			2003			2002			2001									2000
	(in thousands, except per share amounts)									(in thousands, except per share amounts)

	As restated (1)			As restated (1)			As restated (1)			As previously reported			Adjustments			As restated (1)			As previously reported			Adjustments			As restated (1)
Income (loss) from operations		52,352			(58,853	)		32,024			20,278			186,213			206,491			63,413			(311,846	)		(248,433	)
Interest income		38,210			34,399			34,941			36,981			(173	)		36,808			30,526			(81	)		30,445
Interest expense		(24,627	)		(22,824	)		(24,994	)		(23,636	)		(2,131	)		(25,767	)		(11,775	)		(1,077	)		(12,852	)
Other income (expense), net		(1,261	)		(4,907	)		4,308			17,113			2,100			19,213			(1,289	)		1,382			93

Income (loss) before provision for income taxes		64,674			(52,185	)		46,279			50,736			186,009			236,745			80,875			(311,622	)		(230,747	)
Provision for income taxes		10,898			10,401			9,219			16,582			(5,226	)		11,356			16,175			(10,578	)		5,597

Net income (loss)	$	53,776		$	(62,586	)	$	37,060		$	34,154		$	191,235		$	225,389		$	64,700		$	(301,044	)	$	(236,344	)

Net income (loss) per share—basic	$	0.61		$	(0.72	)	$	0.45		$	0.41		$	2.36		$	2.77		$	0.81		$	(3.80	)	$	(2.99	)

Net income (loss) per share—diluted (2)	$	0.53		$	(0.72	)	$	0.42		$	0.39		$	2.18		$	2.57		$	0.73		$	(3.72	)	$	(2.99	)

Weighted average common shares—basic		87,668			86,609			82,712			82,559			(1,159	)		81,400			79,927			(865	)		79,062

Weighted average common shares and equivalents—diluted (2)		103,237			86,609			87,214			88,567			(912	)		87,655			88,745			(9,683	)		79,062


* Stock-based compensation:
Cost of license and subscription	$	1,201		$	5,073		$	2,517		$	—		$	(3,864	)	$	(3,864	)	$	—		$	8,873		$	8,873
Cost of maintenance		1,725			5,433			2,926			—			2,378			2,378			—			8,893			8,893
Cost of professional services		798			3,180			1,174			—			838			838			—			3,143			3,143
Marketing and selling		16,305			60,425			22,736			998			(64,629	)		(63,631	)		—			132,602			132,602
Research and development		8,199			16,404			9,906			550			5,433			5,983			—			12,584			12,584
General and administrative		6,232			15,148			(850	)		451			(127,659	)		(127,208	)		—			144,964			144,964

Consolidated Balance Sheet Data:
Cash, cash equivalents, and short-term investments	$	630,321		$	717,360		$	527,246		$	427,781		$	—		$	427,781		$	628,743		$	—		$	628,743
Working capital		389,660			515,739			370,113			342,724			(4,090	)		338,634			556,821			(10,572	)		546,249
Total assets		2,013,481			1,983,720			1,081,457			927,625			(1,711	)		925,914			976,375			(168	)		976,207
Convertible notes		804,483			811,159			316,972			377,480			—			377,480			500,000			—			500,000
Stockholders’ equity		563,892			697,715			453,637			354,345			(1,081	)		353,264			303,032			(792	)		302,240

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

(2)

Diluted net income per share and diluted common shares and equivalents for 2004 include the effect of common stock issuable upon the conversion of the Zero Coupon Senior Convertible Notes due 2008 issued in 2003. The 2003 diluted net income per share has been retroactively adjusted to reflect the adoption of Emerging Issue Task Force No. 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. In the event of a loss, EITF 04-08 is not applicable as the shares would be considered anti-dilutive. See Note 1, “Our Significant Accounting Policies,” of the Notes to the Consolidated Financial Statements for the computations of basic and diluted net income per share for these periods.

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors”. Our business and the associated risks may have changed since the date this report was originally filed with the SEC, and we undertake no obligation to update these forward-looking statements. Further, except for the forward-looking statements included in Item 9A, “Controls and Procedures” and under the heading “Restatement of Consolidated Financial Statements, Special Committee and Company Findings, Remedial Measures and Related Proceedings” under this Item 7, all forward-looking statements contained in this amended Annual Report on Form 10-K/A, unless they are specifically otherwise stated to be made as of a different date, are made as of March 14, 2005, the original filing date of our Annual Report on Form 10-K for the year ended December 31, 2004. In addition, except for the sections of this Form 10-K/A entitled “Restatement of Consolidated Financial Statements, Special Committee and Company Findings, Remedial Measures and Related Proceedings” (included in this Item 7), Item 9A, “Controls and Procedures,” and Note 3 and Note 19 (unaudited) of the Notes to Consolidated Financial Statements, this Form 10-K/A does not reflect events occurring after the filing of our Annual Report on Form 10-K filed on March 14, 2005 other than the restatement, and we undertake no obligation to update the forward-looking statements in this Annual Report on Form 10-K/A.

The discussion and analysis set forth below in this Item 7 has been amended to reflect the restatement as described above in the Explanatory Note to this amended Annual Report on Form 10-K/A and in Note 3, “Restatement of Consolidated Financial Statements,” to the Notes to Consolidated Financial Statements. For this reason, the data set forth in this section may not be comparable to discussions and data in our previously filed Annual Reports.

Restatement of Consolidated Financial Statements, Special Committee and Company Findings, Remedial Measures and Related Proceedings

Restatement of Consolidated Financial Statements

In November 2004, the Company was contacted by the Securities and Exchange Commission (“SEC”) as part of an informal inquiry entitled In the Matter of Certain Option Grants (SEC File No. MHO-9858). The Company voluntarily produced documents in response to this request, which was followed by an additional document request by the SEC in April 2005. In June 2005, in the course of responding to the SEC’s inquiry, we determined that there were potential problems with the dating and pricing of stock option grants and with the accounting for these option grants.

Our Board of Directors promptly formed a Special Committee of disinterested directors with broad authority to investigate and address the Company’s past stock option practices. The Special Committee was composed of two disinterested members of our Board of Directors and Audit Committee, Clyde Ostler and Brad Boston. The Special Committee retained the law firm of O’Melveny & Myers LLP as its independent outside counsel. O’Melveny & Myers LLP hired Ernst & Young LLP as independent accounting experts to aid in its investigation. In August 2005, the Special Committee concluded that the actual dates of determination for certain past stock option grants differed from the originally stated grant dates for such awards. Because the prices at the originally stated grant dates were lower than the prices on the actual dates of the determination, we determined we should have recognized material amounts of stock-based compensation expense which were not previously accounted for in our previously issued financial statements. Therefore, we concluded that our previously filed

unaudited interim and audited annual consolidated financial statements for the years ended December 31, 2004, 2003 and 2002, as well as the unaudited interim financial statements for the first quarter ended March 31, 2005, should no longer be relied upon because these financial statements contained misstatements and would need to be restated. In October 2005, we disclosed that the SEC inquiry had been converted to a formal investigation.

On November 2, 2005, we announced that the Special Committee had made certain determinations as a result of its review, and that our Board of Directors had accepted the resignations of our then CEO, CFO and General Counsel (“Prior Management”). As a result of the Special Committee’s investigation, as well as our internal review of our historical financial statements, we have recorded additional stock-based compensation expense for the vast majority of our stock option grants made from January 1996 through April 2002, and have accounted for stock options exercisable or exercised with promissory notes as variable rather than fixed awards. We have restated our consolidated financial statements for the years ended December 31, 2004, 2003 and 2002 and the selected consolidated financial data as of and for the years ended December 31, 2004, 2003, 2002, 2001 and 2000, to correctly account for: (a) stock option grants and exercises for which the Special Committee determined that the actual grant or exercise date for accounting purposes was different from the stated grant or exercise date; (b) stock option grants that were made to persons before they became employees; (c) modifications of stock options for employees in transition or advisory roles; (d) modifications to stock options resulting from administrative or processing errors, primarily relating to active employment status; and (e) stock options exercised or exercisable with promissory notes deemed to be non-recourse for accounting purposes, including options issued to certain executive officers. We also have restated previously reported interest receivable and interest income from such promissory notes to reflect such amounts as components of stockholders’ equity, as opposed to assets and income.

In connection with the restatement, we and the Special Committee conducted certain recertification procedures as part of the process of determining if there was evidence which would prevent current management from relying upon the work performed by the accounting, finance and legal personnel, excluding Prior Management, as it relates to fiscal years 2004, 2003 and 2002 and the extent to which the Company’s prior accounting and controls for non-stock option related matters can be relied upon for purposes of the preparation and certification of the restated consolidated financial statements. In this process, and our internal review of other accounting items relating to transactions occurring in fiscal years 2004, 2003 and 2002, we identified certain other errors in accounting determinations and judgments which, although immaterial, have been reflected in the restated consolidated financial statements. These include: an error in an overstatement of the amount of sales commissions that should be recorded as deferred commissions in our consolidated balance sheets, several specific instances of incomplete sales order documentation, subsequent modification to terms, conditions and product deliverables of previously recorded revenue transactions and instances of expense timing and expense accrual adjustments.

We have also recorded tax-related adjustments. We recorded a tax liability in connection with the disqualification of ISO tax treatment for certain stock options. We have increased withholding tax liabilities due to an ESPP administrative error. We also determined that we failed to properly withhold the appropriate employment taxes associated with Canadian employee ESPP purchases and stock option exercises and have recorded a tax liability as a result. We were unable to record additional deferred tax assets related to stock-based compensation in accordance with limits required under section 162(m) of the Internal Revenue Code on certain executive compensation and reduced our available tax net operating loss carry-forwards arising from certain exercised stock options for periods through December 31, 2004 because of this section 162(m) limitation.

As a result of the findings described above, our restated consolidated financial statements reflect a decrease in income before provision for taxes of approximately $566.7 million for the periods 1992 through December 31, 2004, consisting principally of non-cash adjustments to stock-based compensation expense resulting from the stock option grant and exercise practices discussed above. These expenses are reflected as a decrease to retained earnings (net of income tax effects) in the opening balance sheet for 2002 of approximately $362.3 million reflecting adjustments from 1992 to 2001. Adjustments are also reported in our consolidated statements of

operations in subsequent periods based on the accounting treatment for exercises, modifications, loan repayments and expenses recognized over the remaining option vesting periods. These accounting adjustments relating to stock options are not based on the benefits realized by individuals on exercise of stock options.

We have increased (decreased) previously reported net income by an aggregate amount of $(30.8) million, $(104.1) million, $(28.1) million, $191.2 million and $(301.0) million for the years ended December 31, 2004, 2003, 2002, 2001 and 2000, respectively. The adjustments increased (reduced) previously reported diluted earnings per common share by $(0.30), $(1.13), $(0.32), $2.18 and $(3.72) for the years ended December 31, 2004, 2003, 2002, 2001 and 2000, respectively. The cumulative effect of the restatement adjustments on our consolidated balance sheet at December 31, 2004 resulted in an increase in the accumulated deficit offset by a corresponding increase in additional paid-in capital and unearned stock-based compensation which results in a net decrease in total stockholders’ equity of $17.1 million. The adjustments reduced retained earnings as of December 31, 2001 from $155.7 million to an accumulated deficit of $206.6 million, and reduced retained earnings as of December 31, 2004 from $347.1 million to an accumulated deficit of $178.3 million.

Special Committee and Company Findings

As disclosed above, our Board of Directors appointed a Special Committee, consisting of disinterested members of the Audit Committee to review the Company’s past stock option practices. As a result of the Special Committee’s investigation, as well as our internal review of our historical financial statements, we have determined the following:

•

We did not maintain controls adequate to prevent or detect instances of intentional override of or intervention with our controls or intentional misconduct by certain former members of senior management. This lack of an effective control environment permitted certain former members of senior management (including Prior Management) to deliberately override certain controls between 1992 through March 31, 2005 resulting in certain transactions not being properly accounted for in the Company’s consolidated financial statements and the need to restate certain of our previously issued financial statements. Each of these former members of our senior management appears to have also personally benefited from these practices. In addition, a $1.0 million loan to our former CEO in 1999 (which has since been repaid) lacked documentation supporting its approval by the Board of Directors and was referred to in some of our public filings, but was not clearly disclosed. Our former CEO, CFO and General Counsel are no longer employed by us.

•

From 1994 through the quarter ended March 31, 2005, there were fifty-four instances (including twenty-four grants approved by the Board or the Compensation Committee) in which the exercise price of stock options was established based on a stated grant date that differed from the date on which the option appeared to have been actually granted. In almost every such instance, the price of our common stock on the actual approval date for the grant was higher than the price of our common stock on the stated grant date. The misdating occurred with respect to grants to all levels of employees, and these instances represent the vast majority of grants between January 1996 and April 2002. Intentional selection of a favorable price for stock option grants appears to have largely ended in or about April 2002, at which time we began to follow enhanced compliance processes for grants, including a consistent monthly schedule for grants to newly hired employees.

•

The members of Prior Management were each aware of and, to varying degrees, participated in the practices described above. The Special Committee also found that questions should have been raised in the minds of the Compensation Committee members from 1998 to 2002 (who included present directors Igal Kohavi, Yair Shamir and Giora Yaron) as to whether grants they approved were properly dated. The Special Committee also concluded that it appears that the Compensation Committee members reasonably, but mistakenly, relied on certain former members of senior management to prepare the proper documentation for the option grants and to account for the options properly.

•

From 1998 through the quarter ended March 31, 2005, we had not consistently adhered to the terms of legal documentation for stock options exercisable or exercised with promissory notes, including

exercises by certain executive officers. These included instances in which interest and/or principal was forgiven, the term of and collateral for the notes were subsequently modified, and additional principal was added to the note without requiring additional collateral. Additionally, these notes were secured only by the stock issued without any evidence that the Company would exercise its rights to enforce collection of amounts due under the note against other assets of the borrowers. The accumulation, over time, of substantive lack of adherence to the legal terms of these notes that we identified in our review led us to determine that the notes should be deemed non-recourse in nature for accounting purposes.

•

From 1997 through the quarter ended March 31, 2005, we had not maintained accurate documentation, and had not properly accounted for stock-based compensation expense, for stock options issued to or modified for certain individuals who held consulting, transition or advisory roles with us either preceding or following their full-time employment with us. These included instances of continued vesting after an individual was no longer required to provide substantive services, or after an individual converted from an employee to a consultant or advisory role, continued vesting during an extended leave of absence, as well as individual extensions of option termination dates.

•

On several occasions between 1998 and 2001, exercise dates for options exercised by certain executives appear to have been incorrectly reported. In each case, the price of our common stock was substantially lower on the reported exercise date than on the date the option was actually exercised. The reporting of such incorrect dates ordinarily would have had the effect of significantly reducing the individuals’ taxable income, resulting in underreported liabilities for withholding taxes and exposing us to possible penalties for failure to pay such withholding taxes.

In connection with the restatement, we and the Special Committee also conducted certain investigative procedures to determine whether current management could continue to rely upon the work performed by the accounting, finance and legal personnel, excluding Prior Management, as it relates to fiscal years 2004, 2003 and 2002, and the extent to which the Company’s prior accounting and controls for non-stock option related matters could be relied upon for purposes of the preparation and certification of the restated consolidated financial statements. The investigation included a search of the e-mail records of current and former employees who previously provided representations that formed the basis of our prior financial reporting or have held key positions in our management structure, using over 175 search terms chosen to identify potential issues (other than stock option issues) that might affect the Company’s prior financial statements. The search process yielded over two million documents which were reviewed to identify potential issues. E-mails that raised concerns were subject to further investigation and resolution by the Company and the Special Committee. In addition, current and former employees were interviewed by the Special Committee’s outside counsel to determine whether there were additional issues relating to the integrity of the restated consolidated financial statements not captured in the e-mail review.

These recertification procedures identified several instances in which other established controls appear to have been deliberately overridden between 1997 and early 2002 to permit certain former members of senior management (including our then CEO Amnon Landan and then CFO Sharlene Abrams) at times to manage or influence the timing of quarter-end shipments and influence the timing and level at which certain expense items and accruals were recorded to achieve a desired consistency of reported financial results. While the practice of influencing quarter-end shipments did not result in any misstatements of reported financial results or the need for any accounting adjustment, the lack of public disclosure of this practice was improper. In addition, the recertification procedures identified what appears to have been several instances of efforts to influence the timing and level at which certain expense items and accruals were recorded. These activities did not result in additional adjustments to the restated consolidated financial statements contained within this Form 10-K/A because they occurred in periods prior to the year ended December 31, 2002 and related principally to the timing of transactions.

As discussed above, our Special Committee determined that a $1.0 million loan made in 1999 to our former CEO (which has since been repaid) lacked appropriate documentation including approval by the Board of

Directors. This loan was referred to in several of our periodic public filings but not all of its significant terms were clearly and completely disclosed. In addition, we identified certain inappropriate expense reimbursements that were made to our former CEO.

In addition, through our recertification efforts, we also identified certain other errors in accounting determinations and judgments relating to transactions occurring in years 2004, 2003 and 2002 which, although immaterial, have been reflected in the restated consolidated financial statements.

Remedial Measures

It is important to note that based on the additional procedures performed as part of the Company’s restatement of its financial statements, current management has concluded that important improvements were made to the control environment commencing in mid-2002, including: (i) an improved commitment to competency manifested by the hiring of more experienced and senior finance and legal personnel, (ii) the implementation of additional financial controls that enhanced independent judgment and review, including as appropriate segregation of duties and increased employee responsibility and accountability for the completeness of the Company’s disclosures, (iii) the establishment of processes and procedures to increase communications between the financial reporting and accounting functions and senior management, including our Audit Committee, and (iv) instituting a formal code of conduct and whistle-blower policy. While we believe that the improvements made to our control environment after mid-2002, if viewed on a stand-alone basis, would be sufficient for an adequate control environment in areas other than stock-based compensation and the intentional override of controls by Prior Management, the fact that the Prior Management continued in their respective roles and in some instances exercised the ability to override stock option controls and proper accounting treatment during 2004, leads us to conclude that the material weaknesses described in Item 9A, “Controls and Procedures” existed as of December 31, 2004.

Management is committed to remediating the material weaknesses identified above by implementing changes to the Company’s internal control over financial reporting. Management along with our Board of Directors has implemented, or is in the process of implementing, the following changes to the Company’s internal control systems and procedures:

•

After reviewing the results of the investigation to date, our Board of Directors determined that it would be appropriate to accept the resignations of our then CEO, CFO and General Counsel. Our Board of Directors has since appointed a new Chief Executive Officer, a new Chief Financial Officer and a new General Counsel, who together with other members of our senior management are committed to achieving transparency through effective corporate governance, a strong control environment, the business standards reflected in our Code of Business Conduct and Ethics, and financial reporting and disclosure completeness and integrity.

•

We have established an Internal Audit function, which reports to our Audit Committee, and created the role of the Chief Compliance Officer. Through these functions we will implement enhancements to our independent monitoring of controls and expanded education, compliance training and review programs to strengthen employees’ competency, independent judgment and intolerance for questionable practices and emphasize the importance of improved communication among the Company’s various internal departments and regional operations - focused initially on the identified control weaknesses, but over time with a commitment to make efforts to continuously improve our broader control environment.

•

We have changed our stock-based compensation transaction procedures and approval policies to require additional and more systematic authorization to ensure that all stock option transactions adhere to the Company’s approved plans and stated policies, and that all such transactions are reflected in the Company’s stock administration systems and have appropriate supporting documentation. In addition, we have modified the CEO expense reimbursement and other CEO payment procedures to be consistent with our standard control practices and subject to periodic review by our Internal Audit function.

•

Our Board of Directors has adopted certain further enhancements to our corporate governance and oversight, including a formal separation of the roles of Chairman and CEO, strengthening the independence of our Board of Directors by adding two additional independent members to provide additional expertise and independence, reconstituting the membership of our Board Committees and making available additional advisory resources available to our Board of Directors and its committees, including the Compensation Committee.

Additionally, management is investing in ongoing efforts to continuously improve the control environment and has committed considerable resources to the continuous improvement of the design, implementation, documentation, testing and monitoring of our internal controls.

Related Proceedings

Regulatory Inquiries. We announced on October 4, 2005 that the informal inquiry initiated by the SEC in November 2004 had been converted to a formal investigation. We continue to fully cooperate with the SEC, and have provided the staff with extensive documentation relating to the Special Committee’s and our findings discussed above. The SEC inquiry is ongoing. We do not know the remedial or monetary terms which the SEC may seek.

On June 23, 2006, the SEC Staff, as part of the “Wells” process by which the SEC Staff affords individuals and companies the opportunity to present their views regarding potential action by the SEC, advised counsel for directors Igal Kohavi, Yair Shamir and Giora Yaron that the SEC Staff is considering recommending that the Commission file a civil enforcement proceeding against each of these directors under applicable provisions of the federal securities laws. If charges are brought, the SEC may seek a permanent injunction against further violations of the securities laws, an order permanently barring these directors from serving as officers or directors of any SEC registered company, and civil monetary penalties. The charges under consideration would allege that each of these directors knew or should have known about the manipulation of grant dates and that each knew, or was reckless in not knowing, the impact that option backdating would have on our financial results. The directors have advised the SEC Staff that they intend to file a Wells submission arguing that they did not violate the federal securities laws, that they did not participate in or know of option backdating, and that the charges under consideration are legally and factually without basis. Former officers are likely to receive or have received similar Wells notices. As described above, the formal SEC investigation of the Company is continuing. In light of the Wells notice, the aforementioned directors have offered to withdraw from their respective positions on the applicable committees of the Company’s Board of Directors, and the Board has accepted that offer.

We have been responding to inquiries and providing information and documents relating to stock option matters to the Internal Revenue Service and the United States Department of Justice. We have provided information relating to findings with tax implications to the Internal Revenue Service, and are presently discussing possible settlement terms. We are also cooperating fully with the Department of Justice and intend to continue to do so.

There is no assurance that other regulatory inquiries will not be commenced by other U.S. federal, state or foreign regulatory agencies.

Class Action Lawsuits. As a result of the Special Committee investigation, we announced in August 2005 that we would be required to restate certain financial statements. Beginning on or about August 19, 2005, several securities class action complaints were filed against us and certain of our current and former officers and directors, on behalf of purchasers of our stock from October 2003 to November 2005. These class action lawsuits are consolidated in the U.S. District Court for the Northern District of California as In re Mercury Interactive Corporation Securities Litigation, Case No. C05-3395. The original actions were Archdiocese of Milwaukee Supporting Fund, Inc. v. Mercury Interactive, et al. (Case No. C05-3395), Johnson v. Mercury Interactive, et al. (Case No. 05-3864), Munao v. Mercury Interactive, et al. (Case No. C05-4031), and Public Employees’ Retirement System of Mississippi v. Mercury Interactive, et al. (Case No. 05-5157). The securities class action

complaints allege, among other things, violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaints generally allege that we and the individual defendants made false or misleading public statements regarding our business and operations, and seek unspecified monetary damages and other relief against the defendants. On May 5, 2006, the Court appointed the Mercury Pension Fund Group, represented by Labaton Sucharow & Rudoff LLP and Glancy Binkow & Goldberg LLP, as lead plaintiff and counsel. The parties stipulated, and the Court approved, a briefing schedule by which the consolidated amended complaint will be filed between August 7, 2006 and September 5, 2006.

Derivative Lawsuits. Beginning on or about October 14, 2005, several derivative actions were also filed against certain current and former directors and officers. These derivative lawsuits were filed in: (1) the U.S. District Court for the Northern District of California, as In re Mercury Interactive Corporation Derivative Litigation, Lead Case No. 05-3395, which consolidates Korhely v. Boston, et al. (Case No. 05-4642), Gupta v. Boston, et al. (Case No. 05-4685), Casey v. Landan, et al. (Case No. 05-4690), Selig v. Landan, et al. (Case No. 05-4703) and City of New Orleans Employees’ Retirement System v. Landan, et al. (Case No. 05-4704); (2) California Superior Court, Santa Clara County, as In re Mercury Interactive Corporation Shareholder Derivative Litigation, Lead Case No. 1-05-CV-050710, which consolidates Conrardy v. Landan, et al. (Case No. 1-05-CV-050710), and Morillo v. Landan, et al. (Case No. 1-05-CV-051923); and (3) the Delaware Court of Chancery, as Schwartz v. Landan, et al. (Case No. Civ A 1755-N), and Cropper v. Landan, et al. (Case No. Civ A. 1938-N). The complaints allege that certain of our current and former directors and officers breached their fiduciary duties to us by engaging in alleged wrongful conduct complained of in the securities class action litigation described above. The Company is named solely as a nominal defendant against whom the plaintiffs seek no recovery.

In February 2006, our Board of Directors appointed a Special Litigation Committee, consisting of two independent Board members, authorized to conduct an independent review and investigation of issues relating to these derivative matters, take any action, including the filing and prosecution of litigation on our behalf, that the Special Litigation Committee deems in our interests, and recommend to our Board any other appropriate action that we should take with respect to the derivative matters.

On June 7, 2006, we announced that the Special Litigation Committee issued a report which made the following determinations: (i) the claims against Amnon Landan should be pursued by the Company using counsel retained by the Company; (ii) recommended that the Special Committee declare void Mr. Landan’s vested and unexercised options to the extent such options are found by the Special Committee to have been dated improperly; (iii) the derivative claims asserted against former Chief Operating Officer Ken Klein, former Chief Financial Officer Doug Smith and former General Counsel Susan Skaer should be pursued by a shareholder plaintiff in the context of the derivative action in the Santa Clara County Superior Court, rather than in the Delaware Chancery Court or the Northern District of California; (iv) the derivative claims against non- management directors Giora Yaron, Igal Kohavi and Yair Shamir should be dismissed because the Special Litigation Committee determined that the derivative claims against Dr. Yaron, Dr. Kohavi and Mr. Shamir will fail in the face of the provisions of the Company’s Certificate of Incorporation and the Delaware General Corporation Law which would permit damages claims against them only for breach of their duty of loyalty or for actions taken in bad faith; (v) the derivative claims against current CEO and director Tony Zingale, outside directors Clyde Ostler and Brad Boston, and former principal accounting officer Bryan LeBlanc should be dismissed because none of these individuals was affiliated with us at the time of the principal events at issue; and (vi) the derivative claims against our independent registered public accounting firm, PricewaterhouseCoopers LLP, should be stayed at least six additional months. Also on June 7, 2006, we announced that the Special Committee determined to follow the Special Litigation Committee’s recommendation and declared void and cancelled an aggregate of 2,625,416 vested and unexercised options granted to Mr. Landan between 1997 and 2002.

On June 8, 2006 we filed a motion in the Santa Clara Superior Court seeking to implement the Special Litigation Committee’s conclusions. The motion is set for hearing on July 14, 2006. We also filed motions seeking to dismiss or stay the derivative actions pending in the Delaware Chancery Court in favor of the California state court derivative litigation. The Delaware motions are likely to be set for hearing in early

September 2006. Pursuant to a stipulation of the parties, which was approved by the Court, the derivative action pending in the Northern District of California was stayed pending resolution of the California state court derivative litigation.

Section 16(b) Litigation: On May 5, 2006, a shareholder derivative lawsuit was filed against certain current and former officers and directors in the U.S. District Court for the Northern District of California, Klein v. Landan, et al., No. 06-2971 (JF). This action alleges that defendants violated Section 16(b) (the short-swing profits provision) of the Securities Exchange Act of 1934. The Company is named solely as a nominal defendant against whom the plaintiffs seek no recovery. The individual defendants must respond to the complaint by July 21, 2006.

On June 9, 2006, our Board of Directors received a shareholder letter demanding that the Company bring suit for alleged Section 16(b) violations against a different group of current and former officers. If the Board does not comply with the demand letter by August 8, the shareholder may initiate an action on Mercury’s behalf.

NASDAQ Delisting. In August 2005, we failed to timely file our Form 10-Q for the period ended June 30, 2005 as a result of the ongoing Special Committee investigation. This failure to file caused us to violate a NASDAQ listing requirement. On January 3, 2006, we announced that our common stock was delisted from The NASDAQ National Market as a result of our noncompliance with the NASDAQ listing requirements; effective as of January 4, 2006, our common stock has been traded on the Pink Sheets. We can provide no assurance that we will be successful in re-listing the Company’s securities on a national securities market or exchange.

Amendments to Terms of Our 2000 Notes and Our 2003 Notes. As a result of our failure to file our Form 10-Q for the period ended June 30, 2005, we violated provisions of the indentures related to our 4.75% Convertible Subordinated Notes due July 1, 2007 issued in 2000 (2000 Notes) and our Zero Coupon Senior Convertible Notes due 2008 issued in 2003 (2003 Notes; and, together with the 2000 Notes, the Notes) that require us to furnish such information promptly to the trustee for the Notes. On August 26, 2005 we received from the trustee a notice of default on the Notes. On October 26, 2005, we announced that holders of a majority of each series of the Notes had submitted consents which waived, until March 31, 2006, any default or events of default under the indentures arising out of our failure to timely file with the SEC and provide to the trustee those reports required to be filed under the Exchange Act (Report Defaults). In consideration for the waiver, we (1) paid to the consenting holders of the 2000 Notes a consent fee of $25.00 for each $1,000 principal amount of 2000 Notes, resulting in a $7.1 million payment, and (2) entered into a supplement to the indenture governing the 2003 Notes, pursuant to which we will be required to repurchase the 2003 Notes, at the option of the holder, on November 30, 2006 at a repurchase price equal to 107.25% of the principal amount. If this put option is exercised by all holders, we will be required to pay the face value and an additional $36.3 million to the 2003 Note holders on that date.

Because we failed to file our SEC reports by March 31, 2006, as required by the waivers we obtained in October 2005, on April 21, 2006 we solicited additional consents from the holders of the Notes requesting a waiver until the stated maturity of the 2000 Notes and the 2003 Notes, as applicable, of any Report Defaults. On May 4, 2006, we announced that, as of May 3, 2006, holders of a majority of each series of the Notes had submitted consents and therefore the Report Defaults were waived for all holders. In consideration for the waiver, we entered into (1) a supplement to the Indenture governing the 2000 Notes requiring us to repurchase the 2000 Notes at the option of the holder on March 1, 2007 at a repurchase price equal to 101.3% of the principal amount of the 2000 Notes, together with accrued and unpaid interest, if any, and providing that any 2000 Notes redeemed pursuant to Article XI of the Indenture during the period from July 1, 2006 through March 5, 2007 shall be at a redemption price of 101.3% of the principal amount of the 2000 Notes, together with accrued and unpaid interest, if any, to the redemption date; and (2) a supplement to the Indenture governing the 2003 Notes requiring us to repurchase the 2003 Notes at the option of the holder on October 31, 2006 (in addition to the existing optional put date of November 30, 2006) at a repurchase price equal to 107.25% of the principal amount of the 2003 Notes. If these put options are exercised by all holders of both series of Notes, we will be required to pay the face value of the Notes and an additional $36.3 million to the holders of the 2003 Notes on October 31, 2006 or November 30, 2006 and $3.9 million to the holders of the 2000 Notes on March 1, 2007.

Costs of Restatement and Legal Activities. We have incurred substantial expenses for legal, accounting, tax and other professional services in connection with the Special Committee investigation, our internal review of our historical financial statements, the preparation of the restated financial statements, the SEC investigation and inquiries from other government agencies, the related class action and derivative litigation, and the amendments to the terms of our Notes as a result of our failure to timely file our Exchange Act reports with the SEC and the trustee for the Notes. Excluding the $40.2 million that we will be required to pay to the holders of both series of Notes in addition to the face value of the Notes in the event all holders of both series of Notes exercise their put options, we estimate these expenses to date to be in excess of $70 million in aggregate through the quarter ended March 31, 2006. We expect to continue to incur significant expense in connection with these matters.

Overview

We are the leading provider of software and services for the Business Technology Optimization (BTO) marketplace. BTO is a business strategy for aligning information technology (IT) and business goals while optimizing the quality, performance, and business availability of strategic software applications and systems. Our BTO offerings for application delivery, application management, and IT governance products and services, and the Mercury Optimization Centers are designed to help our customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance.

We have aligned our enterprise software business model with the way we believe customers want to license and deploy enterprise software today. We believe our customers value a choice between perpetual software licenses and flexible term or subscription based contracts. Customers have the choice between running our software in-house or having software delivered as a hosted or managed service. Our enterprise software business model enables our customers to license the right software, for the right period of time, and have it deployed the right way—while giving us the right financial incentives to expand and/or renew our relationships with customers.

We believe that the success of our model can be seen in our financial results which include significant growth in revenue and deferred revenue. To understand our financial results, it is important to understand our business model and its effect on the consolidated statements of operations and the consolidated balance sheets. We continue to offer many of our products, including a majority of our IT governance products and our application delivery products, on a perpetual license basis. We have in the past expanded the number of offerings structured as subscription based contracts. The majority of these subscription contracts are required to be recorded initially as deferred revenue in the consolidated balance sheets and then recognized in subsequent periods over the term of the contract as subscription revenue in our consolidated statements of operations (see below under Business Model). Therefore, to understand the full growth of our business, one must look at both revenue and the change in deferred revenue.

Business Model

Revenue consists of fees for the license and subscription of our software products, maintenance fees, and professional service fees. License revenue consists of license fees charged for the use of our products under perpetual or multiple-year arrangements in which the license fee is separately determinable from undelivered items such as maintenance and/or professional services. Subscription revenue, including managed service revenue, consists of license fees to use one or more software products, and to receive maintenance support (such as customer support and product updates) for a limited period of time. Since subscription licenses include bundled products and services, which are sold as a combined offering and for which the value of the license fee is not separately determinable from maintenance, both product and service revenue is generally recognized ratably over the term of the subscription. Maintenance revenue consists of fees charged for post-contract customer support, which are determinable based upon substantive renewal rates quoted in the contracts and, in the absence of stated renewal rates, upon the fair market value established by separate sales of renewals to other customers. Professional service revenue consists of fees charged for product training and consulting services, the fair value of which is determinable based upon separate sales of these services to other customers without the bundling of other elements.

Due to the different treatment of subscription and perpetual licenses under applicable accounting rules, each type of license has a different effect on our consolidated financial statements. When a customer purchases a subscription license, the majority of the revenue will be recorded as deferred revenue in our consolidated balance sheets. The amount recorded as deferred revenue is equal to the portion of the license fee that has been invoiced or paid but not recognized as revenue. Deferred revenue is reduced as revenue is recognized. Under perpetual licenses (and some multiple-year arrangements for which separate vendor specific objective evidence of fair value exists for undelivered elements), all license revenue is recognized in the quarter that the product is delivered, with only the remaining term of maintenance revenue recorded as deferred revenue. Vendor specific objective evidence of fair value is established by the price charged when that element is sold separately. Therefore, an order for a subscription license, or a perpetual license bundled with a subscription license, will result in significantly lower current-period revenue than an equal-sized order under a perpetual license. Conversely, an order for a subscription license will result in higher revenues recognized in future periods than an equal-sized order for a perpetual license. Furthermore, if a perpetual license is sold at the same time as a subscription-based license to the same customer, then generally the two become bundled together and the related revenue is recognized ratably over the term of the contract.

Our product revenues in any given quarter are dependent upon the volume of perpetual license orders delivered during the current quarter and the amount of subscription revenue amortized from deferred revenue from prior quarters and, to a small degree, revenue recognized on subscription orders received during the current quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of perpetual licenses and subscription licenses. The mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets. Conversely, if our overall level of orders is below the target level but our license mix is above our targets (if we deliver more-than-expected perpetual licenses), our revenues may still meet or even exceed our revenue targets. Our ability to achieve our revenue targets is also affected by the mix of domestic and international sales, together with fluctuations in foreign exchange rates. If there is an increase in value of other currencies relative to the U.S. dollar, our revenues from international sales may be positively affected. On the other hand, if there is a decrease in value of other currencies relative to the U.S. dollar, our revenues from international sales may be negatively affected.

Cost of license and subscription includes direct costs to produce and distribute our products, such as costs of materials, product packaging and shipping, equipment depreciation, production personnel, and outsourcing services. It also includes costs associated with our managed services business, including personnel-related costs, fees to providers of internet bandwidth and the related infrastructure, and depreciation expense of managed services equipment. We have not separately presented the costs associated with license and subscription because these costs cannot be reasonably allocated between license and subscription cost of revenue. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel-related costs, and the cost of providing upgrades to our customers. Cost of professional services includes direct costs of providing product training and consulting, largely consisting of personnel-related costs and costs of outsourcing service. License and subscription, maintenance, and professional services costs also include allocated facility expenses and allocated IT infrastructure expenses. Cost of revenue also includes a portion of amortization expenses for intangible assets that are associated with our current products. These amortization expenses have been recorded as “Cost of revenue—amortization of intangible assets” in our consolidated statements of operations.

Costs associated with subscription licenses, which include the cost of products and services, are expensed as incurred over the subscription term. In addition, we defer a portion of our commission expense related to subscription licenses and maintenance contracts and amortize the expense over the term of the subscription or maintenance contract. See “Critical Accounting Policies and Estimates” for a full description of our estimation process for valuation allowances, accrued liabilities and deferred commissions.

Results of Operations

The following table presents, as a percentage of total revenues, certain consolidated statements of operations data for the periods indicated. These operating results are not necessarily indicative of operating results for any future period.


	Year ended December 31,
	2004		2003		2002
	(as restated) (1)		(as restated) (1)		(as restated) (1)
Revenues:
License fees	38	%	40	%	48	%
Subscription fees	22		20		13

Total product revenues	60		60		61
Maintenance fees	29		31		31
Professional service fees	11		9		8

Total revenues	100		100		100

Costs and expenses:
Cost of license and subscription (including stock-based compensation)	6		7		7
Cost of maintenance (including stock-based compensation)	3		4		4
Cost of professional services (including stock-based compensation)	9		8		6
Cost of revenue—amortization of intangible assets	2		1		—
Marketing and selling (including stock-based compensation)	49		60		54
Research and development (including stock-based compensation)	12		14		13
General and administrative (including stock-based compensation)	9		11		8
Acquisition-related expenses	—		2		—
Restructuring, integration, and other related expenses	—		1		—
Amortization of intangible assets	1		1		—
Excess facilities expense	1		3		—

Total costs and expenses	92		112		92

Income (loss) from operations	8		(12	)	8
Interest income	6		7		8
Interest expense	(4	)	(4	)	(6	)
Other income (expense), net	—		(1	)	1

Income (loss) before provision for income taxes	10		(10	)	11
Provision for income taxes	2		2		2

Net income (loss)	8		(12	)	9

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

Revenues

The following table presents license fees, subscription fees, maintenance fees and professional service fees for the periods indicated (in thousands, except percentages):


	Year ended December 31,				Increase				Year ended December 31,				Increase
	2004		2003		in Dollars		in Percentage		2003		2002		in Dollars		in Percentage
	(as restated) (1)		(as restated) (1)						(as restated) (1)		(as restated) (1)
Revenues:
License fees	$	261,382	$	200,839	$	60,543	30	%	$	200,839	$	192,214	$	8,625	4	%
Subscription fees		152,199		98,824		53,375	54	%		98,824		52,970		45,854	87	%
Maintenance fees		196,215		159,023		37,192	23	%		159,023		122,262		36,761	30	%
Professional service fees		76,275		47,519		28,756	61	%		47,519		32,507		15,012	46	%

Total revenues	$	686,071	$	506,205	$	179,866	36	%	$	506,205	$	399,953	$	106,252	27	%

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

License fees

The increase in license fees for the year ended December 31, 2004 was primarily due to an increase in license sales of application delivery products of $29.0 million, as well as an increase in IT governance license sales of $19.4 million and an increase in application management license sales of $12.1 million. We expect our license fees to increase in absolute dollars for fiscal year 2005.

The increase in license fees for the year ended December 31, 2003 was primarily attributable to the sale of IT governance products acquired through our acquisition of Kintana in 2003 and an increase of $2.7 million in application management license fees. IT governance license fees were $7.6 million in 2003. The increase in license fees was partially offset by a decrease of $1.7 million in application delivery license fees due to more customers licensing these products on a subscription basis.

Subscription fees

The increase in subscription fees for the year ended December 31, 2004 was primarily due to a continuous growth in subscription license sales of application delivery products and an increase over the past two years in subscription license sales of our application management products. Our application management products are mainly offered on a subscription basis. The increase in subscription license sales of application delivery products was $30.7 million and in application management products was $20.9 million. The increase was also attributable to an increase in IT governance subscription license sales of $1.8 million. In the event that more customers license our products on a subscription basis, we expect our subscription fees to increase in absolute dollars for fiscal year 2005.

The increase in subscription fees for the year ended December 31, 2003 was primarily attributable to an increase in subscription license sales of $22.9 million in application management subscription products and an increase of $22.9 million in application delivery subscription license sales due to more products being offered and more customers licensing our products on a subscription basis.

Maintenance fees

The increase in maintenance fees for the year ended December 31, 2004 was primarily attributable to renewals of existing maintenance contracts and sales of first year maintenance contracts for application delivery products and IT governance products. The increase in maintenance fees related to application delivery products, IT governance products and application management products was $24.7 million, $10.1 million, and $2.4 million, respectively. We expect our maintenance fees to increase in absolute dollars for fiscal year 2005.

The increase in maintenance fees for the year ended December 31, 2003 was primarily attributable to an increase of $32.9 million in application delivery maintenance fees due to renewals of existing maintenance contracts, an increase of $2.2 million in application management maintenance fees due to renewals of maintenance contracts for products including those acquired through the acquisition of Freshwater in 2001, and $1.7 million in maintenance fees for the sale of IT governance products acquired through the acquisition of Kintana in 2003.

Professional service fees

The increase in professional service fees for the year ended December 31, 2004 was primarily attributable to an increase of $12.8 million for service engagements related to IT governance products and an increase in professional service fees of $9.7 million and $6.2 million associated with application management products and application delivery products, respectively. Professional service fees increased as a result of our continuous effort to offer more training and consulting services to customers who license our products. We expect our professional service fees to increase in absolute dollars for fiscal year 2005.

The increase in professional service fees for the year ended December 31, 2003 was attributable to $6.6 million in consulting fees related to the sale of IT governance products acquired through the acquisition of Kintana. The increase was also attributable to an increase of $5.5 million in professional service fees associated with application delivery products and an increase of $2.9 million in professional service fees associated with application management products due to a continuous growth in both of our application delivery and application management product offerings and an effort to increase our professional service offerings to our customers.

International revenues

International revenues include sales from countries in Europe, the Middle East and Africa (EMEA), Asia Pacific (APAC) and Japan. International revenues also include sales from Brazil, Canada and Mexico, which are included in the Americas geographic segment. (See Note 1 to the consolidated financial statements for the countries included in each geographic segment.) International revenues for the year ended December 31, 2004, compared to the year ended December 31, 2003, were affected favorably by a weakening of the U.S. dollar relative to other currencies, primarily the Euro and the British Pound. International revenues for the year ended December 31, 2004 were $273.5 million, an increase of $78.2 million, or 40%, compared to $195.3 million for the year ended December 31, 2003. The increase was primarily attributable to increased sales in EMEA of $40.0 million and APAC and Japan of $15.7 million, as well as fluctuations in foreign exchange rates of $23.0 million. International revenues represented 40% and 39% of our total revenues for the years ended December 31, 2004 and 2003, respectively.

International revenues for the year ended December 31, 2003, compared to the year ended December 31, 2002, were affected favorably by a weakening of the U.S. dollar relative to other currencies, primarily the Euro and the British Pound. Total international revenues for the year ended December 31, 2003 were $195.3 million, an increase of $46.1 million, or 31%, compared to $149.2 million for the year ended December 31, 2002. The increase was primarily attributable to increased sales in EMEA of $18.2 million and APAC and Japan of $6.5 million, as well as fluctuations in foreign exchange rates of $22.7 million. International revenues represented 39% and 37% of our total revenues for the years ended December 31, 2003 and 2002, respectively.

Costs and expenses

Cost of revenues

The following tables present costs of revenues for the periods indicated (in thousands, except percentages):


	Year ended December 31,						Increase			Year ended December 31,						Increase
	2004			2003			in Dollars		in Percentage	2003			2002			in Dollars		in Percentage
	(as restated) (1)			(as restated) (1)						(as restated) (1)			(as restated) (1)
Costs of revenues:
Cost of license and subscription	$	41,799		$	34,432		$	7,367	21%	$	34,432		$	27,327		$	7,105	26%
Cost of maintenance		17,898			17,731			167	1%		17,731			14,597			3,134	21%
Cost of professional services		63,737			40,321			23,416	58%		40,321			25,510			14,811	58%
Cost of revenue—amortization of intangible assets		10,019			5,189			4,830	93%		5,189			1,833			3,356	183%

Total costs of revenues	$	133,453		$	97,673		$	35,780	37%	$	97,673		$	69,267		$	28,406	41%

Percentage of total revenues		19	%		19	%					19	%		17	%


	Year Ended 2004						Year Ended 2003						Year Ended 2002
	Stock-based compensation		All Other Costs		Total		Stock-based compensation		All Other Costs		Total		Stock-based compensation		All Other Costs		Total
	(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)
Costs of revenues:
Cost of license and subscription	$	1,201	$	40,598	$	41,799	$	5,073	$	29,359	$	34,432	$	2,517	$	24,810	$	27,327
Cost of maintenance		1,725		16,173		17,898		5,433		12,298		17,731		2,926		11,671		14,597
Cost of professional services		798		62,939		63,737		3,180		37,141		40,321		1,174		24,336		25,510
Cost of revenue—amortization of intangible assets		—		10,019		10,019		—		5,189		5,189		—		1,833		1,833

Total costs of revenues	$	3,724	$	129,729	$	133,453	$	13,686	$	83,987	$	97,673	$	6,617	$	62,650	$	69,267

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

Cost of license and subscription

The increase in cost of license and subscription for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs, an increase in outsourcing expense, and an increase in royalty expense. Personnel-related costs increased by $6.9 million as a result of growth in headcount. Outsourcing expense related to delivery of one of our application delivery offerings increased by $1.3 million and royalty expense primarily associated with license agreements signed in 2004 for current products increased by $1.2 million. Allocated IT infrastructure expenses increased by $0.6 million primarily due to the lease of our new headquarters. These increases in costs were partially offset by a net decrease in stock-based compensation expense of $3.9 million, resulting from a decrease in the number of outstanding stock options subject to variable accounting due to exercises and cancellations, and changes in the market value of our common stock. Excluding stock-based compensation expense, portions of which will fluctuate based on changes in the market price of our common stock and the number of stock options outstanding which are subject to variable accounting, we expect cost of license and subscription to increase in absolute dollars for fiscal year 2005, consistent with our expected revenue growth as discussed in “Revenues”.

The increase in cost of license and subscription for the year ended December 31, 2003 was primarily attributable to an increase of $5.5 million in personnel-related costs due to growth in headcount and higher stock-based compensation expense of $2.6 million primarily due to an increase in the market value of our common stock, partially offset by a decrease in the number of outstanding stock options subject to variable accounting due to exercises and cancellations. Professional service costs related to outsourcing expense also increased by $0.7 million due to outsourcing expense related to delivery of our application delivery offerings. The increase was partially offset by a decrease of $0.9 million in allocated facility expenses.

Cost of maintenance

The increase in cost of maintenance for the year ended December 31, 2004 was due to higher personnel-related costs due to growth in headcount to support our overall growth in business, higher consulting fees for our global expansion assessment project, higher allocated facility expenses and higher allocated IT infrastructure expenses. Personnel-related costs, allocated facility expenses, allocated IT infrastructure expenses and consulting fees increased by $1.2 million, $0.9 million, $0.8 million and $0.5 million, respectively. Facility expenses and IT infrastructure expenses increased primarily due to the lease of our new headquarters. These increases in costs were partially offset by a net reduction in stock-based compensation expense of $3.7 million, resulting from a decrease in the number of outstanding stock options subject to variable accounting due to exercises and cancellations, and changes in the market value of our common stock. Excluding stock-based compensation expense, portions of which will fluctuate based on changes in the market price of our common stock and the

number of stock options outstanding which are subject to variable accounting, we expect cost of maintenance to increase in absolute dollars for fiscal year 2005, consistent with our expected revenue growth as discussed in “Revenues”.

The increase in cost of maintenance for the year ended December 31, 2003 was primarily due to higher stock-based compensation expense of $2.5 million resulting primarily from changes in the market value of our common stock, partially offset by a decrease in the number of outstanding stock options subject to variable accounting due to exercises and cancellations.

Cost of professional services

The increase in cost of professional services for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs due to growth in headcount, an increase in outsourcing expense, higher allocated facility expenses and higher allocated IT infrastructure expenses. Personnel-related costs increased by $13.3 million, of which $7.7 million was related to Kintana employees who joined us as part of that acquisition in 2003. The increase in outsourcing expense of $10.1 million was primarily due to the growth in professional services and our continuous efforts to offer more training and consulting services to customers who license our products. The increase was also attributable to higher allocated facility expenses of $1.6 million and higher allocated IT infrastructure expenses of $1.0 million. Facility expenses and IT infrastructure expenses increased primarily due to the lease of our new headquarters. These increases in costs were partially offset by a net decrease in stock-based compensation expense of $2.4 million, resulting from a decrease in the number of outstanding stock options subject to variable accounting due to exercises and cancellations, and changes in the market value of our common stock. Excluding stock-based compensation expense, portions of which will fluctuate based on changes in the market price of our common stock and the number of stock options outstanding which are subject to variable accounting, we expect cost of professional services to increase in absolute dollars for fiscal year 2005, consistent with our expected revenue growth as discussed in “Revenues”.

The increase in cost of professional service for the year ended December 31, 2003 was due to higher personnel-related costs due to growth in headcount of $11.2 million of which $3.5 million was related to Kintana employees who joined us as part of that acquisition in 2003, an increase of $0.9 million in allocated facility expenses, an increase of $0.9 million in allocated IT infrastructure expenses and an increase of $2.0 million in net stock-based compensation expense resulting primarily from changes in the market value of our common stock, partially offset by a decrease in number of outstanding stock options subject to variable accounting due to exercises and cancellations. These increases were partially offset by a decrease of $0.6 million in outsourcing expense due to a higher utilization of our internal professional services group, resulting in less outsourcing activities.

Cost of revenue—amortization of intangible assets

Cost of revenue—amortization of intangible assets includes amortization expenses for intangible assets that are associated with our current products. See “Amortization of intangible assets” in Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 7 of the Notes to Consolidated Financial Statements for detailed information.

The following table presents amortization of intangible assets recorded as cost of revenue for the periods indicated (in thousands):


	Year ended December 31,
	2004		2003		2002
Cost of license and subscription	$	8,882	$	4,808	$	1,833
Cost of maintenance		1,137		381		—

	$	10,019	$	5,189	$	1,833

Operating expenses

The following tables present operating expenses for the periods indicated (in thousands, except percentages):


	Year ended December 31,				Increase/(Decrease)			Year ended December 31,				Increase/(Decrease)
	2004		2003		in Dollars		in Percentage	2003		2002		in Dollars		in Percentage
	(as restated) (1)		(as restated) (1)					(as restated) (1)		(as restated) (1)
Operating expenses:
Marketing and selling	$	335,867	$	303,865	$	32,002	11 %	$	303,865	$	216,546	$	87,319	40%
Research and development		82,122		73,096		9,026	12 %		73,096		51,197		21,899	43%
General and administrative		63,802		55,904		7,898	14 %		55,904		30,914		24,990	81%
Acquisition-related expenses		900		11,968		(11,068)	(92)%		11,968		—		11,968	*%
Restructuring, integration, and other related expenses		3,088		3,389		(301)	(9)%		3,389		(537)		3,926	*%
Amortization of intangible assets		5,544		2,281		3,263	143 %		2,281		542		1,739	321%
Excess facilities expense		8,943		16,882		(7,939)	(47)%		16,882		—		16,882	*%

Total operating expenses	$	500,266	$	467,385	$	32,881	7 %	$	467,385	$	298,662	$	168,723	56%

Percentage of total revenues		73%		92%					92%		75%

*	Percentage is not applicable


	Year Ended 2004						Year Ended 2003						Year Ended 2002
	Stock-based compensation		All Other Expenses		Total		Stock-based compensation		All Other Expenses		Total		Stock-based compensation			All Other Expenses			Total
	(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)		(as restated) (1)			(as restated) (1)			(as restated) (1)
Operating expenses:
Marketing and selling	$	16,305	$	319,562	$	335,867	$	60,425	$	243,440	$	303,865	$	22,736		$	193,810		$	216,546
Research and development		8,199		73,923		82,122		16,404		56,692		73,096		9,906			41,291			51,197
General and administrative		6,232		57,570		63,802		15,148		40,756		55,904		(850	)		31,764			30,914
Acquisition-related expenses		—		900		900		—		11,968		11,968		—			—			—
Restructuring, integration, and other related expenses		—		3,088		3,088		—		3,389		3,389		—			(537	)		(537	)
Amortization of intangible assets		—		5,544		5,544		—		2,281		2,281		—			542			542
Excess facilities expense		—		8,943		8,943		—		16,882		16,882		—			—			—

Total operating expenses	$	30,736	$	469,530	$	500,266	$	91,977	$	375,408	$	467,385	$	31,792		$	266,870		$	298,662

⁽¹⁾	SeeNote 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

Marketing and selling

Marketing and selling expense consists of employee salaries and related costs, sales commissions, marketing programs, sales training, campaigns, allocated facility expenses, allocated IT infrastructure expenses and stock-based compensation expense.

The increase in marketing and selling expense for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs due to growth in headcount, higher commission expense as a result of increased revenue and growth in headcount and an increase in consulting fees for recruiting activities and other business development activities. The increase was also attributable to an increase in allocated facility

expenses, allocated IT infrastructure expenses, spending on marketing programs and sales training. Facility expenses and IT infrastructure expenses increased primarily due to the lease of our new headquarters. The increase in spending on marketing programs was primarily related to additional marketing research and brand building campaigns. Personnel-related costs and commission expense increased by $35.5 million and $21.6 million, respectively, of which personnel-related costs of $8.8 million and commission expense of $3.9 million were related to Kintana employees who joined us as part of that acquisition in 2003. In addition, consulting fees, spending on marketing programs and sales training fees increased by $3.7 million, $2.8 million and $1.0 million, respectively. Allocated IT infrastructure expenses and allocated facility expenses increased by $4.9 million and $3.5 million, respectively. These increases in costs were partially offset by a net decrease in stock-based compensation expense of $44.1 million, resulting from a decrease in the number of outstanding stock options subject to variable accounting due to exercises, cancellations and repayments of notes receivable as well as changes in the market value of our common stock. Further, the decrease in stock-based compensation was also attributable to a decrease in the number of outstanding fixed awards due to cancellations and certain awards becoming fully expensed in 2003 and early 2004, and $5.1 million of stock-based compensation expense associated with the modification of stock options for a former executive officer in connection with a severance agreement we entered into in December 2003. Excluding stock-based compensation expense, portions of which will fluctuate based on changes in the market price of our common stock and the number of stock options outstanding which are subject to variable accounting, we expect marketing and selling expense to increase in absolute dollars for fiscal year 2005.

The increase in marketing and selling expense for the year ended December 31, 2003 was primarily due to higher stock-based compensation expense of $37.7 million, resulting primarily from changes in the market value of our common stock, partially offset by a decrease in number of outstanding stock options subject to variable accounting due to exercises and cancellations. Further, the increase in stock-based compensation was also attributable to an increase of $4.7 million in stock-based compensation expense resulted from the issuance of compensatory shares under our 1998 Employee Stock Purchase Plan (ESPP) priced at a discount greater than 15% from the applicable closing price of our common stock and a $5.1 million additional stock-based compensation expense associated with the modification of stock options for a former executive officer in connection with a severance agreement we entered into in December 2003. The increase in marketing and selling expense was also due to a $34.4 million increase in personnel-related costs due to growth in headcount and an increase of $4.5 million in commission expense due to higher revenue and growth in headcount. This increase included personnel-related costs of $4.2 million and commission expense of $1.0 million related to Kintana employees who joined us as part of that acquisition in 2003. The increase was also attributable to additional spending of $5.5 million in marketing programs to promote our BTO initiative through a number of campaigns, an increase of $2.9 million in allocated IT infrastructure expenses, a severance expense of $1.5 million for the former executive officer related to accrued salary and bonus amounts which he is entitled to receive through October 3, 2005 in accordance with the severance agreement and an increase of $1.0 million in professional services. The increase in marketing and selling expense was partially offset by $0.9 million decrease in facilities expenses.

Research and development

Research and development expense associated with the development of new products, enhancements of existing products and quality assurance procedures consists of employee salaries and related costs, consulting costs, equipment depreciation, allocated facility expenses, allocated IT infrastructure expenses and stock-based compensation expense.

The increase in research and development expense for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs of $10.7 million due to growth in headcount, of which $5.8 million was related to Kintana employees who joined us as part of that acquisition in 2003. The increase was also attributable to higher allocated IT infrastructure expenses of $2.2 million, higher allocated facility expenses of $2.0 million and higher consulting fees for research and development projects of $0.7 million. Facility expenses

and IT infrastructure expenses increased primarily due to the lease of our new headquarters. The increase was also attributable to a $1.0 million devaluation of the U.S. dollar to the Israeli Shekel as a substantial portion of our research and development expense was in Israeli Shekel. These increases in costs were partially offset by a net decrease in stock-based compensation expense of $8.2 million, resulting from a decrease in the number of outstanding stock options subject to variable accounting due to exercises and cancellations, and changes in the market value of our common stock, somewhat offset by additional stock-based compensation expense due to modifications of stock options for employees in transition or advisory roles upon their termination of employment with us. Excluding stock-based compensation expense, portions of which will fluctuate based on changes in the market price of our common stock and number of stock options outstanding which are subject to variable accounting, based on our product development plan, we expect research and development expense to increase in absolute dollars for fiscal year 2005.

The increase in research and development expense for the year ended December 31, 2003 was primarily attributable to a $10.0 million increase in personnel-related costs due to growth in headcount, of which $3.0 million was related to Kintana employees who joined us as part of that acquisition in 2003, an increase of $1.5 million in allocated facility expenses, $2.0 million in allocated IT infrastructure expenses and $1.8 million in devaluation of the U.S. dollar to the Israeli Shekel as a substantial portion of our research and development expense was in Israeli Shekel. The increase was also attributable to a net increase in stock-based compensation expense of $6.5 million, resulting primarily from changes in the market value of our common stock, partially offset by a decrease in number of stock options outstanding which are subject to variable accounting due to exercises and cancellation. The increase in stock-based compensation expense also resulted from the issuance of compensatory shares under our 1998 ESPP priced at a discount greater than 15% from the applicable closing price of our common stock.

General and administrative

General and administrative expense consists of employee salaries and related costs, allocated facility expenses, allocated IT infrastructure expenses and stock-based compensation expense. It also consists of fees for audit, tax, legal and consulting services primarily for compliance with Section 404 of the Sarbanes-Oxley Act of 2002.

The increase in general and administrative expense for the year ended December 31, 2004 was primarily attributable to higher personnel-related costs of $5.8 million due to growth in headcount and additional fees for audit, tax and other consulting services of $6.9 million, of which $3.3 million was related to projects for compliance with Section 404 of the Sarbanes-Oxley Act of 2002. The increase was also attributable to higher allocated facility expenses of $0.8 million, higher allocated IT infrastructure expenses of $0.6 million and an increase in loss on disposal of assets of $0.5 million. Facility expenses and IT infrastructure expenses increased primarily due to the lease of our new headquarters. These increases in costs were partially offset by a net decrease in stock-based compensation expense of $8.9 million, resulting from a decrease in the number of outstanding stock options subject to variable accounting due to exercises and cancellations, and changes in the market value of our common stock. The decrease in stock-based compensation expense was also associated with a decrease in the number of outstanding fixed awards due to cancellations and certain awards becoming fully expensed in 2003 and early 2004. The decrease was further offset by additional stock-based compensation expense due to modifications of stock options for employees in transition or advisory roles upon their termination of employment with us. Excluding stock-based compensation expense, portions of which will fluctuate based on changes in the market price of our common stock and the number of stock options outstanding which are subject to variable accounting, we expect general and administrative expenses to increase in absolute dollars for fiscal year 2005 due to a projected growth in headcount and the implementation of a new operational and financial reporting system.

The increase in general and administrative expense for the year ended December 31, 2003 was primarily due to a $16.0 million net increase in stock-based compensation expense resulting primarily from changes in the market value of our common stock, partially offset by a decrease in number of outstanding stock options subject to variable accounting due to exercises and cancellations. The increase in stock-based compensation expense also

resulted from the issuance of compensatory shares under our 1998 ESPP priced at a discount greater than 15% from the applicable market value of our common stock. The increase was also attributable to a $6.7 million increase in personnel-related costs due to growth in headcount, an increase of $1.2 million in professional services due to increased audit, tax and other consulting fees, and an increase of $0.9 million in allocated IT infrastructure expenses.

Acquisition-related expenses

Acquisition-related expenses for the year ended December 31, 2004 of $0.9 million were related to acquired in-process research and development (IPR&D) from the acquisition of Appilog in July 2004.

Acquisition related expenses of $12.0 million for the year ended December 31, 2003, were related to acquired in-process research and development from acquisitions of Performant in May 2003 and Kintana in August 2003. We recorded acquired in-process research and development because technological feasibility of Performant’s and Kintana’s in-process technology had not been established and no future alternative uses existed upon the acquisitions. No in-process research and development was recorded in 2002.

The fair value of in-process research and development was determined through the discounted cash flow approach using key assumptions for percentage of completion, future market demand, and product life cycle. Acquired IPR&D projects from the Appilog, Kintana, and Performant acquisitions had been completed as of December 31, 2004.

Also, see Notes 6 and 7 to the consolidated financial statements for additional information regarding the acquisitions completed in 2003 and 2004 and the acquired in-process research and development recorded in each acquisition.

Restructuring, integration, and other related expenses

Integration and other related expenses for the year ended December 31, 2004 were primarily attributable to a milestone bonus plan associated with certain research and development activities that was signed in conjunction with the acquisition of Performant in 2003. The plan entitles each eligible employee to receive bonuses, in the form of cash payments, based on the achievement of certain performance milestones by applicable target dates. The commitment will be earned over time as milestones are achieved and recorded as an expense in the consolidated statements of operations as earned. The maximum total payment under the plan is $5.5 million, of which $5.2 million has been paid through December 31, 2004. We did not record any restructuring expenses in 2004 and 2003.

Integration and other related expenses for the year ended December 31, 2003 were primarily due to an expense of $2.8 million related to the milestone bonus plan signed in conjunction with the acquisition of Performant and integration costs of $0.6 million associated with the Kintana acquisition, primarily for employee severance and consulting services.

We did not record any integration costs for the year ended December 31, 2002. We recognized a benefit of $0.5 million for a reversal of cash expenses associated with the cancellation of a marketing event for which we were able to use the deposit toward another event during 2002. The expense was originally recorded as part of the restructuring expense in 2001.

Amortization of intangible assets

The increase in amortization of intangible assets for the year ended December 31, 2004 was primarily due to the full year amortization of intangible assets related to the acquisitions of Performant in May 2003 and Kintana in August 2003, the purchase of existing technology in the third quarter of 2003, and the acquisition of a domain name in the fourth quarter of 2003. The increase was also attributable to amortization of expenses associated with intangible assets of $8.9 million acquired from the Appilog acquisition in July 2004.

The increase in amortization of intangible assets for the year ended December 31, 2003 was primarily due to the amortization of intangible assets related to the acquisitions of Performant in May 2003 and Kintana in August 2003, purchase of existing technology in the third quarter of 2003, and the acquisition of a domain name in the fourth quarter of 2003.

We amortize intangible assets on a straight-line basis over their useful lives, which best represents the distribution of the economic value of the intangible assets.

For the years ended December 31, 2004, 2003 and 2002, $10.0 million, $5.2 million, and $1.8 million, respectively, of intangible assets related to our current products were amortized to expense.

Future amortization of intangible assets at December 31, 2004 is as follows (in thousands):


Year Ending December 31,
2005	$	15,436
2006		11,764
2007		5,516
2008		4,253
Thereafter		1,483

	$	38,452

Also see Notes 6 and 7 to the consolidated financial statements for additional information regarding the acquisitions completed in 2004 and 2003 and the intangible assets acquired in each acquisition.

Excess facilities expense

Excess facilities expense for the years ended December 31, 2004 and 2003, was $8.9 million and $16.9 million, respectively, and was primarily related to the write-down of three vacant buildings we owned in our Sunnyvale headquarters that had been placed for sale. In July 2003, the Board of Directors approved a plan to lease a new headquarters facility and to sell the existing buildings we owned in our Sunnyvale headquarters. In September 2003, as a result of our decision to move to a new headquarters facility and to sell two vacant buildings, we performed an impairment analysis of the vacant buildings. In the third quarter of 2003, we recognized a non-cash expense of $16.9 million to write down the net book value of the two vacant buildings that were held for sale to their appraised market value. We considered the cost to maintain the facilities until sold and sales commissions related to the sale of the buildings when we calculated the expense. On January 30, 2004, we sold the two vacant buildings in Sunnyvale, California at carrying value to a third party for $2.5 million in cash, net of $0.2 million in transaction fees.

In April 2004, we completed the move from one of the two remaining buildings we owned and we placed the vacant building for sale. We recognized a non-cash expense to write down the net book value of the vacant building that was held for sale to its appraised market value. We included the cost to maintain the facility until sold and sales commissions related to the sale of the building when we calculated the expense. On January 7, 2005, we completed the sale of the third vacant building at carrying value to a third party for $4.9 million in cash, net of $0.3 million in transaction fees. As such, we will not record any additional impairment expense on this vacant building.

Excess facilities expense for the year ended December 31, 2004 was also related to the remaining lease payments for two leased facilities from the Kintana acquisition. In connection with our move into our consolidated headquarters, we also vacated two leased facilities from the Kintana acquisition. We recognized a non-cash expense for the remaining lease payments, as well as the associated costs to protect and maintain the leased facilities prior to returning these leased facilities to the lessor. One of these lease agreements expired in September 2004 and the other expires in December 2005. Due to the short duration of the remaining lease terms, it is not likely that we can sublease the facilities; as such, no sublease income was included in the facilities lease

costs calculation. The excess facilities expense also included the write-off of leasehold improvements and the disposal of fixed assets, net of cash proceeds, associated with these facilities.

Non-operating income (expense)

The following table presents non-operating income (expense) for the periods indicated (in thousands, except percentages):


	Year ended December 31,						Change				Year ended December 31,						Change
	2004			2003			in Dollars			in Percentage	2003			2002			in Dollars			in Percentage
	(as restated) (1)			(as restated) (1)							(as restated) (1)			(as restated) (1)
Non-operating income (expense):
Interest income	$	38,210		$	34,399		$	3,811		11%	$	34,399		$	34,941		$	(542	)	(2)%
Interest expense		(24,627	)		(22,824	)		(1,803	)	(8)%		(22,824	)		(24,994	)		2,170		9%
Other income (expense), net		(1,261	)		(4,907	)		3,646		74%		(4,907	)		4,308			(9,215	)	*

Total non-operating income, net	$	12,322		$	6,668		$	5,654		85%	$	6,668		$	14,255		$	(7,587	)	(53)%

Percentage of total revenues		2%			1%							1%			4%

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

*	Percentage is not applicable

Interest income

The increase in interest income for the year ended December 31, 2004 was attributable to an improvement in the average yields of our cash and investments during 2004 compared to 2003, partially offset by a decrease in our average cash and investments balances in 2004. The decrease in interest income for the year ended December 31, 2003 was primarily attributable to a decline in interest rates in 2003 and a reduction of interest income associated with our February 2002 interest rate swap, which was included in interest income until the January and February 2002 swaps were merged into one in November 2002.

Interest expense

Interest expense for the years ended December 31, 2004 and 2003 primarily consisted of interest expense associated with the interest rate swap, the 4.75% Convertible Subordinated Notes due 2007 (2000 Notes) which we issued in July 2000 and the amortization of debt issuance costs associated with the issuance of our Zero Coupon Convertible Notes due 2008 (2003 Notes) and 2000 Notes. The increase in interest expense in 2004 was due to an increase in the London Interbank Offering Rate (LIBOR) associated with our interest rate swap agreement and the full year amortization of debt issuance costs associated with our 2003 Notes issued in April 2003. The decrease in interest expense in 2003 was primarily attributable to a decrease of $2.6 million in interest expense associated with our interest rate swap as a result of a lower LIBOR rate, a change in the interest rate spread between the January 2002 swap and the November 2002 swap, and a decrease of $1.2 million associated with the portion of our 2000 Notes that were retired early in 2002, partially offset by an increase of $1.5 million in amortization of debt issuance costs associated with the issuance of our 2003 Notes.

In 2002, we entered into an interest rate swap arrangement with Goldman Sachs Capital Markets, L.P. (GSCM). The interest rate swap is designated as an effective hedge of the change in the fair value attributed to the LIBOR with respect to $300.0 million of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on our 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The interest rate swap qualifies for hedge accounting treatment in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, and the related amendment.

Also, see Notes 8, 14 and 19 (unaudited) to the consolidated financial statements for additional information regarding our 2000 Notes and the related interest rate swap activities.

Other income (expense), net

Other income (expense), net primarily consists of net gains or losses on investments in non-consolidated companies, a warrant to purchase common stock of Motive, and currency gains or losses. The change in other expense, net for the year ended December 31, 2004 was primarily attributable to a decrease of $2.9 million in losses on our investments in privately-held companies and a private equity fund and a realized gain of $0.3 million on the sale of available-for-sale securities.

The change in other income (expense), net for the year ended December 31, 2003 was primarily attributable to a recognized gain of $11.6 million on early retirement of our 2000 Notes during 2002. Since we did not retire any portion of our 2000 or 2003 Notes during 2003, there was no gain associated with early retirement of our Notes to reduce other expense in 2003. The increase in other expense, net was partially offset by a decrease of $1.7 million in foreign exchange losses due to a devaluation of the U.S. dollar and a decrease of $1.4 million in losses on our investments in privately-held companies and a private equity fund and an unrealized gain of $0.4 million for the initial fair value of the Motive warrant.

The fair value of the Motive warrant was calculated using the Black-Scholes option-pricing model, which requires subjective assumptions including expected stock price volatility. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. A decline in the U.S. stock market and the market price of Motive’s common stock could contribute to volatility in our reported results of operations. In calculating the loss to be recorded on our investments in privately-held companies and private equity funds, we consider the most recent valuation of each of the companies based on recent sales of equity securities to unrelated third party investors and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

Also, see Notes 8, 14 and 19 (unaudited) to the consolidated financial statements for additional information regarding our 2000 Notes and 2003 Notes and the related interest rate swap activities.

Provision for income taxes

Historically, our operations have generated a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investments. The tax holidays and rate reductions, which we will be able to realize under programs currently in effect, expire in 2005 through 2013. Future provisions for taxes will depend upon the mix of worldwide pre-tax income and the tax rates in effect for various tax jurisdictions. The effective tax rates for the years ended December 31, 2004, 2003 and 2002 differ from statutory tax rates principally because of our participation in taxation programs in Israel. We intend to continue to increase our investment in our Israeli operations consistent with our overall tax strategy. Other factors that cause the effective tax rates and statutory tax rates to differ include the difference between book and tax treatment of expenses for amortization of intangible assets, stock-based compensation and in-process research and development. U.S. income taxes and foreign withholding taxes were not provided for on undistributed earnings for certain non-U.S. subsidiaries. We intend to invest these earnings indefinitely in operations outside the U.S.

In 2002, we sold the economic rights of Freshwater’s intellectual property to our Israeli subsidiary. As a result of this intellectual property sale, we have recorded a current income taxes payable and a prepaid asset in the amount of $25.5 million, to be amortized to income tax expense in our consolidated statements of operations on a straight-line basis over eight years, which approximates the period over which the benefit is expected to be realized. At December 31, 2004 and 2003, the prepaid asset balance was $15.9 million and $19.1 million, respectively. We are evaluating the migration of the economic ownership of technology acquired from Performant and Kintana to our Israeli subsidiary. This migration may lead to an increase in our effective tax rate.

In the event that we do not migrate the technology, our effective tax rate may also increase due to a greater portion of U.S. source income associated with the technology acquired from Performant and Kintana.

Liquidity and Capital Resources

At December 31, 2004, our principal source of liquidity consisted of $1,138.4 million of cash and investments, compared to $1,233.7 million and $665.2 million at December 31, 2003 and 2002, respectively. The December 31, 2004 balance included $447.5 million of short-term and $508.1 million of long-term investments, compared to $589.4 million and $422.6 million of short-term and $516.3 million and $138.0 million of long-term investments in the December 31, 2003 and 2002 balances, respectively. We invested in high quality financial, government, corporate securities, and auction rate securities in 2004, 2003, and 2002. The overall decrease in cash and investments from December 31, 2003 was primarily due to cash used to repurchase shares of our common stock in the open market and for capital expenditures, partially offset by positive cash generated from operating activities and cash received from issuances of common stock under our stock option and employee stock purchase plans. During the year ended December 31, 2004, we generated $212.4 million of cash from operating activities, compared to $180.9 million and $131.7 million during the years ended December 31, 2003 and 2002, respectively. The increase in cash from operations in each year was due primarily to an overall growth in our business.

During the year ended December 31, 2004, cash provided by our investing activities was $71.3 million, compared to a use of $724.0 million of cash in investing activities during the year ended December 31, 2003. Cash proceeds from investing activities in 2004 consisted of net proceeds of $152.1 million from transactions related to our marketable securities, the sale of assets and vacant facilities of $2.7 million, and return on investment in one of the privately-held companies of $1.5 million. Cash used for investing activities during the year ended December 31, 2004 primarily consisted of net cash paid for the Appilog acquisition of $49.5 million, including $50.8 million paid in accordance with the acquisition agreement, $0.7 million paid for direct acquisition costs, less $2.0 million in cash acquired from Appilog. Cash was also used for the acquisition of property and equipment of $32.7 million and an additional investment in a private equity fund of $2.6 million. Cash used for the acquisition of property and equipment was primarily attributable to leasehold improvements and IT infrastructure for our new headquarters in Mountain View, California and new foreign offices, as well as $2.2 million to purchase land in Israel in February 2004.

During the year ended December 31, 2004, our financing activities primary consisted of $332.2 million in cash used to repurchase 9,675,000 shares of our common stock at an average price of $34.33 per share under the stock repurchase program approved by our Board of Directors on July 27, 2004. In addition, we received $104.0 million in cash proceeds from common stock issued under our employee stock option and stock purchase plans.

In June 2003, we entered into a non-exclusive agreement (amended in February 2004) to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out, or other transfer of all or substantially all of the business, stock or assets to which the agreement relates. The licensed technology will be combined with our other existing products, which should be generally available in early 2006. The agreement is in effect until December 31, 2006 with the right to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. Under the original agreement, we had committed to royalty payments totaling $15.4 million, of which $8.0 million had been paid as of December 31, 2003. In accordance with the addendum, $7.0 million of the royalty balance was accelerated and was paid in February 2004 with the remaining $0.4 million due and payable on December 31, 2005 for continued maintenance and support services through fiscal year 2006. We recorded such payments as prepaid royalties.

As of December 31, 2004, we were committed to make additional capital contributions of $6.0 million to a private equity fund.

We have entered into four irrevocable letters of credit agreements totaling $1.4 million with Wells Fargo & Company (Wells Fargo). Three agreements, totaling $1.2 million, remained outstanding at December 31, 2004.

Two of the agreements were related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003. One of these agreements remains intact and has an automatic annual renewal provision under which the expiration date cannot be extended beyond March 1, 2006 and the other agreement expired in September 2004. A third agreement is related to a facility lease agreement assumed by us in conjunction with the acquisition of Freshwater in 2001. This agreement has an automatic annual renewal provision under which the expiration dates cannot be extended beyond August 31, 2006. The fourth agreement is related to the facility lease agreement for our new headquarters in Mountain View, California. This agreement is automatically extended after January 1, 2005 unless we provide a termination notice to Wells Fargo. At December 31, 2004, no amounts had been drawn on the letters of credit. Wells Fargo is a related party to us as one of the members of Board of Directors is an executive officer of Wells Fargo.

We lease our headquarters facility and facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. In addition, we lease certain equipment under various lease agreements with lease terms ranging from month-to-month up to one year. In April 2004, we moved from the two Kintana facilities to our new headquarters in Mountain View, California. Future payments for leases with non-cancelable terms, including leases of the two vacant facilities from the Kintana acquisition, are included in the following table.

Future payments due under debt, lease, royalty, and license agreements at December 31, 2004 were as follows (in thousands):


	Due in
	2005		2006			2007			2008			2009		Thereafter		Total
Zero Coupon Senior Convertible Notes due 2008 (2003 Notes)	$	—	$	—	(2)	$	—		$	500,000	(2)	$	—	$	—	$	500,000	(2)
4.75% Convertible Subordinated Notes due 2007 (2000 Notes) (1)		—		—			300,000	(2)		—			—		—		300,000	(2)
Non-cancelable operating leases		20,532		14,178			10,330			6,700			5,876		21,186		78,802
Royalty and license agreements		2,335		1,615			1,615			160			10		90		5,825

	$	22,867	$	15,793		$	311,945		$	506,860		$	5,886	$	21,276	$	884,627

(1)

The above table does not include contractual interest payments on the 2000 Notes. Assuming we do not retire additional 2000 Notes during 2005 and interest rates stay constant, we estimate that we will make interest payments, net of our interest rate swap, of approximately $9.8 million during each of 2005 and 2006 and approximately $4.9 million during 2007. The face value of our 2000 Notes differs from our book value. See Note 8 to the consolidated financial statements for a full description of our long-term debt activities and related accounting policy.

(2)

If the put options are exercised by the holders of each of the 2000 Notes and the 2003 Notes, we will be required to pay $303.9 million on March 1, 2007 and $536.3 million on October 31, 2006, respectively, to the holders of these Notes. See Note 19, “Subsequent Events (unaudited),” of the Notes to Consolidated Financial Statements.

As of December 31, 2004, we did not have any purchase commitments other than obligations incurred in the normal course of business. These amounts are accrued when services or goods are received.

In July 2000, we issued $500.0 million in 4.75% Subordinated Convertible Notes due July 1, 2007. The 2000 Notes bear interest at a rate of 4.75% per annum and are payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. From December 2001 through December 31, 2004, we retired $200.0 million face value of the 2000 Notes. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. If we redeem the 2000 Notes, we will pay accrued interest up to the redemption date. We have not redeemed any portion of the 2000 Notes since the original issuance through December 31, 2004.

In 2002, we entered into an interest rate swap agreement of $300.0 million with Goldman Sachs Capital Markets, L.P. (GSCM) to hedge the change in the fair value attributable to the London Interbank Offering Rate

(LIBOR) of our 2000 Notes. The interest rate swap matures in July 2007. The value of the interest rate swap is determined using various inputs, including forward interest rates, and time to maturity. Under the terms of the swap, we provided initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (regardless of movements in the value of the swap) and from time to time additional collateral can change hands between us and GSCM as swap rates and equity prices fluctuate. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of December 31, 2004 and 2003, but will decrease in value if interest rates rise. If market changes continue to negatively affect the value of the swap, the swap may become a liability in our consolidated balance sheets. In the event we chose to terminate the swap before maturity, and the swap value was a liability due to an unfavorable value, we would be obligated to pay to our counterparty the market value of the swap at the termination date.

In April 2003, we issued $500.0 million of Zero Coupon Senior Convertible Notes due 2008 in a private offering. The 2003 Notes mature on May 1, 2008, do not bear interest, have a zero yield to maturity and may be converted into our common stock.

Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only if the sale price of our common stock reaches specified thresholds or if specified corporate transactions have occurred. Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity. See Note 8 to the consolidated financial statements for further details on the conversion provisions for the 2003 Notes.

As a result of our failure to file our Form 10-Q for the period ended June 30, 2005, we violated provisions of the indentures related to our 2000 Notes and our 2003 Notes (together, the “Notes”) that require us to furnish such information promptly to the trustee for the Notes. On August 26, 2005 we received from the trustee a notice of default on the Notes. On October 26, 2005, we announced that holders of a majority of each series of the Notes had submitted consents which waived, until March 31, 2006, any default or events of default under the indentures arising out of our failure to timely file with the SEC and provide to the trustee those reports required to be filed under the Exchange Act (Report Defaults). In consideration for the waiver, we (1) paid to the consenting holders of the 2000 Notes a consent fee of $25.00 for each $1,000 principal amount of 2000 Notes, resulting in a $7.1 million payment, and (2) entered into a supplement to the indenture governing the 2003 Notes, pursuant to which we will be required to repurchase the 2003 Notes, at the option of the holder, on November 30, 2006 at a repurchase price equal to 107.25% of the principal amount. If this put option is exercised by all holders, we will be required to pay the face value and an additional $36.3 million to the 2003 Note holders on that date.

Because we failed to file our SEC reports by March 31, 2006, as required by the waivers we obtained in October 2005, on April 21, 2006 we solicited additional consents from the holders of the Notes requesting a waiver until the stated maturity of the 2000 Notes and the 2003 Notes, as applicable, of any Report Defaults. On May 4, 2006, we announced that, as of May 3, 2006, holders of a majority of each series of the Notes had submitted consents and therefore the Report Defaults were waived for all holders. In consideration for the waiver, we entered into (1) a supplement to the indenture governing the 2000 Notes requiring us to repurchase the 2000 Notes at the option of the holder on March 1, 2007 at a repurchase price equal to 101.3% of the principal amount of the 2000 Notes, together with accrued and unpaid interest, if any, and providing that any 2000 Notes redeemed pursuant to Article XI of the Indenture during the period from July 1, 2006 through March 5, 2007 shall be at a redemption price of 101.3% of the principal amount of the 2000 Notes, together with accrued and unpaid interest, if any, to the redemption date; and (2) a supplement to the indenture governing the 2003 Notes requiring us to repurchase the 2003 Notes at the option of the holder on October 31, 2006 (in addition to the existing optional put date of November 30, 2006) at a repurchase price equal to 107.25% of the principal amount of the 2003 Notes. If these put options are exercised by the holders of both series of Notes, we will be required to pay the face value of the Notes and an additional $36.3 million to the holders of the 2003 Notes on October 31, 2006 or November 30, 2006 and $3.9 million to the holders of the 2000 Notes on March 1, 2007.

We have incurred substantial expenses with third parties for legal, accounting, tax and other professional services in connection with the Special Committee investigation, our internal review of our historical financial statements, the preparation of the restated financial statements, the SEC investigation and inquiries from other government agencies, the related class action and derivative litigation, and the amendments to the terms of our Notes as a result of our failure to timely file our Exchange Act reports with the SEC and the trustee for the Notes. Excluding the $40.2 million that we will be required to pay to the holders of both series of Notes in addition to the face value of the Notes in the event the holders of both series of Notes exercise their put options, we estimate these expenses were in excess of $70 million in aggregate for the quarter ended June 30, 2005 through the quarter ended March 31, 2006. We expect to continue to incur significant expense in connection with these matters in 2006 and thereafter.

In addition, we have acquired several companies and certain technology assets in 2005 and the first half of 2006. In connection with these acquisitions, we have incurred, or will be required to incur, a cash outlay of approximately $133.1 million.

During December 2005, we repatriated $500.0 million from our Israeli subsidiary under The American Jobs Creation Act of 2004. Significant tax payments will be required as a result of this repatriation.

Historically, a significant amount of our income and cash flow was generated in Israel where tax rate incentives have been extended to encourage foreign investment. We may have to pay significantly more income taxes if these tax rate incentives are not renewed upon expiration, tax rates applicable to us are increased, or if we choose to repatriate cash balances from Israel to other tax jurisdictions. In addition, our future tax provisions will depend on the mix of our worldwide pre-tax income and the tax rates in effect for various tax jurisdictions. Please note that the information in this amended Annual Report on Form 10-K/A, including the descriptions of the taxes in Israel, is as of December 31, 2004 and, therefore, does not reflect any Israeli taxes incurred subsequent to December 31, 2004, which are described in Note 19, “Subsequent Events (unaudited),” of the Notes to Consolidated Financial Statements.

For the years ended December 31, 2004, 2003, and 2002, our source of funding was mainly from cash generated by our operations and, in 2003, from the issuance of convertible notes. A decrease in customer demand or a decrease in the acceptance of our future products and services may affect our ability to generate positive cash flow from operations.

A shift in the mix of license types does not affect our collections cycle as we typically invoice customers up front for the full license amount and cash is generally received within 30-60 days from the invoice date. Our quarterly operating results are affected by the mix of license types entered into in connection with the sale of products. As revenue associated with our subscription licenses is generally recognized ratably over the term of the license, any increase in our subscription business will also result in deferred revenue becoming a larger component of our cash provided by operations. Furthermore, if a perpetual license is sold at the same time as a subscription-based license to the same customer, then the two generally become bundled together and are recognized over the term of the contract. If our business was to shift to a greater percentage of revenue generated from a subscription revenue model, we may experience a decrease or a lower rate of growth in recognized revenue in a given period, as a continued growth in deferred revenue. Deferred revenue at December 31, 2004 was $413.8 million compared to $281.1 million as of December 31, 2003. Of this increase, $55.7 million was attributable to an increase in subscription fees and $50.7 million was attributable to an increase in maintenance fees. We expect the mix of license to continue to fluctuate.

In the future, we expect cash will continue to be generated from our operations. For the year ending December 31, 2005, we expect to spend approximately $5.0 to $8.0 million on our customer management database and $3.2 million for a license and the related first year maintenance service of a new operational and financial reporting system that we purchased in December 2004. We expect to spend an additional $12.0 to $17.0 million in 2005 for the implementation of this new operational and financial reporting system. Excluding the cost of our customer management database, the license and the related maintenance of the new operational and

financial reporting system, we do not expect the level of cash used to acquire property and equipment in 2005 to change significantly from 2004. We currently plan to reinvest our cash generated from operations in new short and long-term investments in high quality financial, government, and corporate securities or other investments, consistent with past investment practices, and therefore net cash used in investing activities may increase. Cash could be used in the future for acquisitions or strategic investments. Cash could also be used to repurchase additional shares of our common stock or retire or redeem additional debt. For example, since the inception of the stock repurchase program on July 27, 2004 and through March 4, 2005, cash used to repurchase our common stock was $332.2 million. There are no transactions, arrangements, or other relationships with non-consolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of our requirements for capital resources.

Assuming there is no significant change in our business, we believe that our current cash and investment balances and cash flow from operations will be sufficient to fund our cash needs for at least the next twelve months.

Subsequent Events

For more information regarding events occurring after December 31, 2004, please refer to Note 19, “Subsequent Events (unaudited),” of the Notes to Consolidated Financial Statements.

Critical Accounting Policies and Estimates

The methods, estimates, and judgments we use in applying our most critical accounting policies have a significant effect on the financial condition and results of operations we report in our consolidated financial statements. The U.S. Securities and Exchange Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of our financial condition and results of operations, and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain.

Our critical accounting policies are as follows:

•

revenue recognition;

•

estimating valuation allowances and accrued liabilities;

•

accounting for sales commissions and deferred commissions;

•

accounting for stock-based compensation;

•

valuation of long-lived assets and other intangible assets;

•

valuation of goodwill;

•

accounting for income taxes; and

•

accounting for investments in non-consolidated companies.

We further discuss these policies, as well as the estimates and judgments involved, below. In addition, we also have other significant accounting policies. We believe that these other policies either do not generally require us to make estimates and judgments that are as difficult or as subjective, or it is less likely that they would have a material effect on our reported financial condition or results of operations for a given period. See Note 1 to the consolidated financial statements for the significant accounting policies used in the preparation of our consolidated financial statements.

Revenue recognition

Our revenue recognition policy is detailed in Note 1 to the consolidated financial statements. We have made significant judgments related to revenue recognition; specifically, in connection with each transaction involving

our arrangements, we must evaluate whether our fee is “fixed or determinable” and we must assess whether “collectibility is probable”. These judgments are discussed below.

Fee is fixed or determinable

With respect to each arrangement, we must determine whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, and all other revenue recognition criteria have been met, revenue is recognized upon delivery of software or over the period of arrangements with our customers. If the fee is not fixed or determinable, the revenue recognized in each quarter, subject to application of other revenue recognition criteria, will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees had been fixed or determinable based on our revenue recognition policy.

A determination of whether an arrangement fee is fixed or determinable depends, in part, upon the payment terms relating to such an arrangement. Extended payment terms may indicate that future concessions are likely to occur. Our customary payment terms are generally within 30-60 days of the invoice date. Arrangements with payment terms extending beyond the customary payment terms are generally considered not to be fixed or determinable. Additionally, provisions for rebates, price protection and similar items may result in arrangement fees that are not fixed or determinable. A determination of whether the arrangement fee is fixed or determinable is particularly relevant to revenue recognition on perpetual licenses. The amount and timing of our revenue recognized in any period may differ materially if we make different judgments.

Collectibility is probable

In order to recognize revenue, we must make a judgment regarding the collectibility of the arrangement fee. Our judgment of collectibility is applied on a customer-by-customer basis. We generally sell to customers for which we have a history of successful collection. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. The amount and timing of revenue recognized in any period may differ materially if we make different judgments.

Estimating valuation allowances and accrued liabilities

The preparation of financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Use of estimates and assumptions include, but are not limited to, the sales reserve.

We are required to make significant judgments and estimates in conjunction with recording deferred commissions, specifically as it relates to associated revenues that will be recognized in future periods. The future revenues and timing of revenue recognition may vary significantly from period to period based on the application of the appropriate revenue recognition criteria. As a result, we are required to use estimates that include, but are not limited to, the composition of future revenues and timing of revenue recognition, which if changed could affect the timing and recognition of sales commissions. Sales commissions are paid to employees in the month after we receive an order. Sales commissions are calculated as a percentage of the sales value of a signed contract or a customer signed purchase order. The deferred commissions are realizable through the future revenue streams under the customer contracts. Material differences may result in the amount and timing of our sales commissions expense recognized for any period if we make different estimates related to future revenue and timing of revenue recognition.

We must make estimates of potential future credits, warranty cost of product and services, and write-off of bad debts related to current period product revenues. We analyze historical returns, historical bad debts, current economic trends, average deal size, and changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserve. Revenue for the period is reduced to reflect the sales reserve

provision. As a percentage of current period revenues, charges against the sales reserve were insignificant for the years ended December 31, 2004, 2003, and 2002. Significant management judgments and estimates are made and used in connection with establishing the sales reserve in any reporting period. Material differences may result in the amount and timing of our revenues for any period if we make different judgments or use different estimates. At December 31, 2004 and 2003, the provision for sales reserve was $5.2 million and $6.1 million, respectively.

Accounting for sales commissions and deferred commissions

Sales commissions are paid to employees in the month after we receive an order. We sell our products under non-cancelable perpetual, subscription or term contracts. Sales commissions are calculated as a percentage of the sales value of a signed contract or a customer signed purchase order. Sales commission rates vary by position, title and the extent to which employees achieve rate accelerators by exceeding their quotas. Our policy is that sales commissions paid to employees are refundable to us when we are required to write off a customer accounts receivable because management has determined it has become uncollectible or in instances in which the revenue may no longer be recognized.

Deferred commissions are the incremental costs that are directly associated with non-cancelable subscription and term contracts with customers and consist of sales commissions paid to our sales employees. The deferred commissions are recognized over the term of the related customer contracts. The deferred commissions are realizable through the future revenue streams under the customer contracts. Recognition of deferred commissions is included in marketing and selling expense in the consolidated statements of operations. Deferred commissions are included in other current assets and non-current deferred commissions are included in other non-current assets on the consolidated balance sheets.

As of December 31, 2004 and 2003, restated deferred commissions were $31.8 million and $22.2 million, respectively.

Accounting for stock-based compensation

We account for stock-based compensation for options granted to our employees and members of our Board of Directors using Accounting Principles Board (APB) Statement No. 25, Accounting for Stock Issued to Employees, and related interpretations, including Financial Accounting Standard Board Interpretation (FIN) No. 44, Accounting for Certain Transactions Involving Stock Compensation, An Interpretation of APB Opinion No. 25, and comply with the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure Amendment of SFAS No. 123.

Under APB No. 25, compensation expense is measured as of the date on which the number of shares and exercise price become fixed. Generally, this occurs on the grant date, in which case the stock option is accounted for as a fixed award as of the date of grant. If the number of shares or exercise price is not fixed as of the grant date, the stock option is accounted for as a variable award until such time as the number of shares and/or exercise price becomes fixed, or the stock option is exercised, is cancelled or expires.

Compensation expense associated with fixed awards is measured as the difference between the fair market value of our stock on the date of grant and the grant recipient’s exercise price, which is the intrinsic value of the award on that date. No compensation expense is recognized if the grant recipient’s exercise price equals the fair market value of our common stock on the date of grant. Stock compensation expense will be recognized over the vesting period using the ratable method, whereby an equal amount of expense is recognized for each year of vesting.

We have determined that promissory notes used in the past to exercise stock options are non-recourse in nature, and therefore account for such transactions in accordance with Emerging Issues Task Force Consensus

No. 95-16, “Accounting for Stock Compensation Arrangements with Employer Loan Features Under APB Opinion No. 25” (EITF 95-16) and FIN No. 44. Our determination was based on a series of factors that, when assessed collectively, indicated the promissory note holders were not at risk, despite the recourse provisions of the notes. These factors included, among other things; such loans were secured by the stock issued, loan interest in numerous circumstances was forgiven, and repurchase of shares by us in instances in which the value of the stock pledged as security for the loan was less than the loan amount upon maturity of the note or the note holder’s termination of employment. Since interest associated with non-recourse promissory notes is considered part of the option’s exercise price, and our promissory notes were subject to prepayment, the exercise prices of the awards were not fixed. Accordingly, stock options exercisable or exercised with non-recourse promissory notes are subject to variable accounting under APB No. 25. Additionally, certain stock options for which evidence of authorization could not be located are being accounted for as variable awards.

For variable awards, the intrinsic value of our stock options is remeasured each period based on the difference between the fair market value of our stock as of the end of the reporting period and the grant recipient’s exercise price. As a result, the amount of compensation expense or benefit to be recognized each period fluctuates based on changes in our closing stock price from the end of the previous reporting period to the end of the current reporting period. Compensation expense in any given period is calculated as the difference between total earned compensation at the end of the period, less total earned compensation at the beginning of the period. Compensation expense for these awards is recognized over the vesting period using an accelerated method of recognition in accordance with FIN No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan, An Interpretation of APB Opinions No. 15 and 25. Variable accounting is applied until there is a measurement date, the award is exercised, forfeited or expires, or the related note is repaid.

We account for modifications to stock options under FIN No. 44, which was effective July 1, 2000. Modifications include, but are not limited to, acceleration of vesting, extension of the exercise period following termination of employment and/or continued vesting while not providing substantive services. Compensation expense is recorded in the period of modification for the intrinsic value of the vested portion of the award, including vesting that occurs while not providing substantive services, on the date of modification. The intrinsic value of the award is the difference between the fair market value of our common stock on the date of modification and the optionee’s exercise price.

We account for stock options issued to non-employees in accordance with the provisions of SFAS No. 123 and EITF No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. In accordance with these accounting standards, the fair value of stock options issued to non-employees is determined on the date of grant using the Black-Scholes option pricing model. If a performance commitment exists, the fair value of the award is amortized to compensation expense over the service period using the ratable method. A performance commitment exists if performance by the counterparty to earn the equity instruments is probable because of sufficiently large disincentives for nonperformance, provided the Company has no history of not enforcing such terms. If a performance commitment does not exist, a measurement date does not occur until performance is complete. In these instances, the fair value of the award is remeasured each period and compensation expense is recognized over the service period using the accelerated method of amortization in accordance with FIN No. 28.

We value stock options assumed in conjunction with business combinations accounted for using the purchase method at fair value on the date of acquisition using the Black-Scholes option-pricing model, in accordance with FIN No. 44. The fair value of assumed options is included as a component of the purchase price. The intrinsic value of unvested stock options is recorded as unearned stock-based compensation and amortized to expense over the remaining vesting period of the stock options using the straight-line method.

SFAS No. 123 established a fair value based method of accounting for stock-based plans. Companies that elect to account for stock-based compensation plans in accordance with APB No. 25 are required to disclose the pro forma net income (loss) that would have resulted from the use of the fair value based method under SFAS No. 123.

We account for our Employee Stock Purchase Plan (ESPP) in accordance with APB No. 25, SFAS No. 123 and FASB Technical Bulletin No. 97-1 (FTB 97-1), Accounting Under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option. We calculate stock-based compensation expense under the fair value based method for shares issued pursuant to our 1998 ESPP based on an estimate of shares to be issued using estimated employee contributions.

Valuation of long-lived assets and other intangible assets (other than goodwill)

We assess the impairment of long-lived assets and certain identifiable intangible assets to be held and used whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

•

a significant decrease in the market price of a long-lived asset (asset group);

•

a significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;

•

a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;

•

an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group);

•

a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group); and

•

a current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

We determine the recoverability of long-lived assets and certain identifiable intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Such estimation process is highly subjective and involves significant management judgment. Determination of impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. During the year ended December 31, 2004, we recorded an impairment expense of $6.7 million associated with the remaining vacant building we owned that had been placed for sale. During the year ended December 31, 2003, we recorded an impairment expense of $16.9 million associated with our two vacant buildings we owned. During the year ended December 31, 2002, we did not record any impairment expenses on long-lived assets or certain intangible assets. If our estimates or the related assumptions change in the future, we may be required to record an impairment expense on long-lived assets and certain intangible assets to reduce the carrying amount of these assets. Net intangible assets and property and equipment were $116.7 million and $118.3 million at December 31, 2004 and 2003, respectively.

Valuation of goodwill

We assess the impairment of goodwill on an annual basis, and potentially more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

•

significant underperformance relative to expected historical or projected future operating results;

•

significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

•

significant negative industry or economic trends;

•

significant decline in our stock price for a sustained period; and

•

our market capitalization relative to net book value.

When we determine that the carrying value of goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we further determine if an impairment exists based on a projected discounted cash flow in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. We performed an annual impairment review in the fourth quarter of 2004, 2003, and 2002. We did not record an impairment expense based on our reviews. If our estimates or the related assumptions change in the future, we may be required to record impairment expense on goodwill to reduce its carrying amount to its estimated fair value.

Accounting for income taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax expense in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are recorded in our consolidated balance sheets and presented in the related notes thereto. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future. Our taxes could increase if these tax rate incentives are not renewed upon expiration, tax rates applicable to us are increased, authorities challenge our tax strategy, or our tax strategy is affected by new laws or rulings. To the extent that we are able to continue to reinvest a substantial portion of our profits in lower tax jurisdictions, our tax rate may decrease in the future.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance for the entire portion of our net operating losses related to the income tax benefits arising from the exercise of employees’ stock options. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could materially affect our financial position and results of operations.

Accounting for investments in non-consolidated companies

From time to time, we hold equity investments in publicly traded companies, privately-held companies, and private equity funds for business and strategic purposes. These investments are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We periodically monitor our equity investments for impairment and will record reductions in carrying values if and when necessary. For equity investments in privately-held companies and private equity funds, the evaluation process is based on information that we request from these companies and funds. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies and funds. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above fair value, or if a company has completed a financing with unrelated third party investors based on a valuation significantly lower than the carrying value of our investment and the decline is other-than-temporary, it is our policy to record an investment loss in our consolidated statements of operations. Estimating the fair value of non-marketable equity investments in companies is inherently subjective and may contribute to significant volatility in our reported results of operations.

For equity investments in publicly traded companies, we record a loss on investment in our consolidated statements of operations when we determine the decline in fair value below the carrying value is other-than-temporary. The ultimate value realized on these equity investments is subject to market price volatility until they are sold. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, earnings/revenue outlook, operational performance, management/ownership changes, competition, and stock price performance. Our on-going review may result in additional impairment expenses in the future which could significantly affect our results of operations.

At December 31, 2004, our equity investments in non-consolidated companies consisted of investments in privately-held companies of $4.1 million, a private equity fund of $8.0 million, and a warrant to purchase of common stock of Motive of $0.9 million. At December 31, 2004, our total capital contributions to this private equity fund were $9.0 million. We have committed to make additional capital contributions to this private equity fund up to $6.0 million in the future. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. A decline in the U.S. stock market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on many of these investments. For the year ended December 31, 2004, we recorded losses of $0.5 million on one of our investments in privately-held companies and a loss of $0.6 million on our investment in the private equity fund. The losses for the year ended December 31, 2004 were partially offset by unrealized gains of $0.5 million related to a change in fair value of the Motive warrant. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in privately-held companies and a loss of $0.4 million on our investment in the private equity fund. The losses on our investments in privately-held companies and private equity fund for the year ended December 31, 2003 were partially offset by an unrealized gain of $0.4 million for the initial value of the Motive warrant. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million, and $0.4 million on three of our investments in privately-held companies. In calculating the loss to be recorded, we took into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to unrelated third party investors and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

The Motive warrant is treated as a derivative instrument due to a net settlement provision and is recorded at its fair value on each reporting period. We calculate the fair value of the Motive warrant using the Black-Scholes option-pricing model. The option-pricing model requires the input of highly subjective assumptions such as the expected stock price volatility. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. A decline in the U.S. stock market and the market price of Motive’s common stock could contribute to volatility in our reported results of operations.

Recent Accounting Pronouncements

In March 2004, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF No. 03-1. The consensus clarified the meaning of other-than-temporary impairment and its application to debt and equity investments accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and other investments accounted for under the cost method. The recognition and measurement guidance for which the consensus was reached in March 2004 is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. In September 2004, the FASB issued a final FASB Staff Position that delays the effective date for the measurement and recognition guidance for all investments within the scope of EITF No. 03-1. We will evaluate the effect of adopting the recognition and measurement guidance when the final consensus is reached. The consensus reached in March 2004 also provided for certain annual disclosure requirements associated with cost method investments that were effective for fiscal years ending after June 15, 2004. We adopted the annual disclosure requirements in 2004.

In June 2004, the EITF reached a consensus on EITF No. 02-14, Whether an Investor Should Apply Equity Method of Accounting to Investments Other Than Common Stock. EITF No. 02-14 states that an investor should

only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. EITF No. 02-14 was effective for periods beginning after September 15, 2004. The adoption of EITF No. 02-14 does not have an effect on our consolidated financial position, results of operations or cash flows.

In September 2004, the EITF reached a consensus on EITF No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. In accordance with EITF No. 04-8, potential shares issuable under contingently convertible securities with a market price trigger should be accounted for the same way as other convertible securities and included in the diluted earnings per share computation, regardless of whether the market price trigger has been met. Potential shares should be calculated using the if-converted method or the net share settlement method. EITF No. 04-8 was effective for periods ending after December 15, 2004 and should be applied by retroactively adjusting previously reported diluted earnings per share. We adopted EITF No. 04-8 in the fourth quarter of 2004 and have included 9,673,050 shares issuable upon the conversion of our 2003 Notes in the diluted earnings per share computation, unless these shares are deemed to be anti-dilutive. Diluted earnings per share for the years ended December 31, 2003 has been retroactively adjusted to conform to the methodology used for the current period. See Note 8 to the consolidated financial statements for additional information regarding our 2000 and 2003 Notes.

In December 2004, the Financial Accounting Standard Board issued Statement No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment, that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. The standard requires public companies to value employee stock options and stock issued under employee stock purchase plans using the fair value based method on the grant date and record stock-based compensation expense over the service period or the vesting period. The standard also requires public companies to initially measure the cost of liability based service awards based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. We are required to adopt the new standard for interim or annual periods beginning after June 15, 2005. Upon the adoption of SFAS No. 123R, we can elect to recognize stock-based compensation related to employees equity awards in our consolidated statements of operations using fair value based method on a modified prospective basis and disclose the pro forma effect on net income or loss assuming the use of fair value based method in the Notes to Consolidated Financial Statements for periods prior to the adoption. We expect the adoption of SFAS No. 123R to have a significant effect on our results of operations.

Risk Factors

In addition to the other information included in this amended Annual Report on Form 10-K/A, you should carefully consider the risks described below before deciding to invest in us or maintain or increase your investment. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem not significant may also affect our business operations. If any of these risks actually occur, our business, financial condition, or results of operations could be seriously harmed. In that event, the market price of our common stock could decline and you may lose all or part of your investment. These risk factors are as disclosed in our originally filed Form 10-K and have not been updated as part of our amended filing.

Our future success may be impaired and our operating results will suffer if we cannot respond to rapid market and technological changes by introducing new products and services and continually improving the performance, features, and reliability of our existing products and services and responding to competitive offerings. The market for our software products and services is characterized by:

•

rapidly changing technology;

•

consolidation of the software industry;

•

frequent introduction of new products and services and enhancements to existing products and services by our competitors;

•

increasing complexity and interdependence of our applications;

•

changes in industry standards and practices;

•

ability to attract and retain key personnel; and

•

changes in customer requirements and demands.

To maintain our competitive position, we must continue to enhance our existing products, including our software products and services for our application management and application delivery, and IT governance solutions. We must also continue to develop new products and services, functionality, and technology that address the increasingly sophisticated and varied needs of our customers and prospective customers. The development of new products and services, and enhancement of existing products and services, entail significant technical and business risks and require substantial lead-time and significant investments in product development. In addition, many of the markets in which we operate are seasonal. If we fail to anticipate new technology developments, customer requirements, industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements, and standards in a timely manner, our products and services may become obsolete, our ability to compete may be impaired, our revenue could decline, and our operating results may suffer.

We expect our quarterly revenue and operating results to fluctuate, and it is difficult to predict our future revenue and operating results. Our revenue and operating results have varied in the past and are likely to vary significantly from quarter to quarter in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including:

•

fluctuations in demand for, and sales of, our products and services;

•

fluctuations in the number of large orders in a quarter, including changes in the length of term and subscription licenses;

•

changes in the mix of perpetual, term, or subscription licenses sold in a quarter;

•

changes in the mix of products or services sold in a quarter;

•

our success in developing and introducing new products and services and the timing of new product and service introductions, and order realization;

•

our ability to keep a sales force organization with adequate number of sales and services personnel;

•

our ability to introduce enhancements to our existing products and services in a timely manner;

•

changes in economic conditions affecting our customers or our industry;

•

uncertainties related to the integration of products, services, employees, and operations of acquired companies;

•

the introduction of new or enhanced products and services by our competitors and changes in the pricing policies of these competitors;

•

the discretionary nature of our customers’ purchase and budget cycles and changes in their budgets for software and related purchases;

•

the amount and timing of operating costs and capital expenditures relating to the expansion of our business;

•

deferrals by our customers of orders in anticipation of new products or services or product enhancements;

•

the continuing relationships with alliance partners; and

•

the mix of our domestic and international sales, together with fluctuations in foreign currency exchange rates.

In addition, the timing of our software product revenues is difficult to predict and can vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. The timing of larger orders and customer buying patterns are difficult to forecast, therefore, we may not learn of shortfalls in revenue or earnings or other failures to meet market expectations until late in a particular quarter. As a result, if total revenues for a particular quarter are below our expectations, we would not be able to proportionately reduce operating expenses for that quarter.

We have experienced seasonality in our orders and revenues which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth quarters, from our application management and application delivery businesses being typically strongest in the fourth quarter and weakest in the first quarter, however, and to a lesser extent, from the structure of our sales commission program. In addition, the tendency of some of our customers to wait until the end of a fiscal quarter to finalize orders has resulted in higher order volumes towards the end of the quarter. We expect this seasonality to continue in the future. In the first quarter of 2004, we experienced higher orders and revenues than the fourth quarter of 2003. We do not believe that these results are indicative of a shift in the future seasonality trends that we have typically experienced in the past.

Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. If our operating results are below the expectations of investors or securities analysts, the trading prices of our securities could decline.

Our revenue targets are dependent on a projected mix of orders in a particular quarter and any failure to achieve revenue targets because of a shift in the mix of orders could adversely affect our quarterly revenue and operating results. Our license revenue in any given quarter is dependent upon the volume of perpetual orders shipped during the quarter and the amount of subscription revenue amortized from deferred revenue and, to a small degree, the amount recognized on subscription orders received during the quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain license mix of perpetual licenses and subscription licenses. The mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). In addition, if we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets which may adversely affect our operating results. Conversely, if our overall level of orders is below the target level but our license mix is above our targets (if we deliver more-than-expected perpetual licenses), our revenues may still meet or even exceed our revenue targets. In 2002, we began to effect a change in the mix of software license types to a higher percentage of subscription licenses in our application management and application delivery products. We believe that this shift may continue in the future in the event that more of our customers license our products on a subscription basis. Furthermore, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two generally become bundled together and are recognized over the term of the contract. This shift may cause us to experience a decrease in recognized revenue

in a given period, as well as continued growth of deferred revenue. In addition, while subscription and term based licenses represent a potential source of renewable license revenue, there is also the risk that customers will not renew their licenses at the end of a term.

We expect to face increasing competition in the future, which could cause reduced sales levels and result in price reductions, reduced gross margins, or loss of market share. The market for our business technology optimization products and services is extremely competitive, dynamic, and subject to frequent technological change. There are few substantial barriers of entry in our market. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in our markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of current and potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.

We believe that the principal competitive factors affecting our market are:

•

price and cost effectiveness;

•

product functionality;

•

product performance, including scalability and reliability;

•

quality of support and service;

•

company reputation;

•

depth and breadth of BTO offerings;

•

research and development leadership;

•

financial stability; and

•

global capabilities.

If we fail to maintain our existing distribution channels and develop additional channels in the future, our revenue could decline. We derive a portion of our business from sales of our products and services through distribution channels, such as global software vendors, systems integrators, or value-added resellers. We generally expect that sales of our products through these channels will continue to account for a substantial portion of our revenue for the foreseeable future. We may not experience increased revenue from new channels and may see a decrease from our existing channels, which could harm our business.

The loss of one or more of our systems integrators or value-added resellers, or any reduction or delay in their sales of our products and services could result in reductions in our revenue in future periods. In addition, our ability to increase our revenue in the future depends on our ability to expand our indirect distribution channels.

Our dependence on indirect distribution channels presents a number of risks, including:

•

each of our global software vendors, systems integrators, or value-added resellers can cease marketing our products and services with limited or no notice and with little or no penalty;

•

our existing global software vendors, systems integrators, or value-added resellers may not be able to effectively sell any new products and services that we may introduce;

•

we may not be able to replace existing or recruit additional global software vendors, systems integrators, or value-added resellers, if we lose any of our existing ones;

•

our global software vendors, systems integrators, or value-added resellers may also offer competitive products and services;

•

we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities; and

•

our global software vendors, systems integrators, or value-added resellers may not give priority to the marketing of our products and services as compared to our competitors’ products.

The continued growth of our business may be adversely affected if we fail to form and maintain strategic relationships and business alliances. Our development, marketing, and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals, and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.

If we do not adequately manage and evolve our financial reporting and managerial systems and processes, our ability to manage and grow our business may be harmed. Our ability to successfully implement our business plan and comply with regulations, including Sarbanes-Oxley Act of 2002, requires an effective planning and management system and process. We will need to continue to improve existing, and implement new operational and financial systems, procedures and controls to manage our business effectively in the future. As a result, we have licensed software from SAP AG and have begun a process to expand and upgrade our operational and financial systems. Any delay in the implementation of, or disruption in the transition to, our new or enhanced systems, procedures or controls, could harm our ability to accurately forecast sales demand, manage our supply chain, achieve accuracy in the conversion of electronic data and record and report financial and management information on a timely and accurate basis. In addition, as we add additional functionality, new problems could arise that we have not foreseen. Such problems could adversely affect our ability to do the following in a timely manner: provide quotes; take customer orders; ship products; provide services and support to our customers; bill and track our customers; fulfill contractual obligations; and otherwise run our business. Failure to properly or adequately address these issues could result in the diversion of management’s attention and resources, affect our ability to manage our business and our results of operations, cash flows, and stock price could be negatively affected.

Our increasing efforts to sell enterprise-wide software products and services could expose us to revenue variations and higher operating costs. We increasingly focus our efforts on sales of enterprise-wide solutions, which consist of our entire Mercury Optimization Centers product suite and related professional services, and managed services, in addition to the sale of component products. As a result, each sale requires substantial time and effort from our sales and support staff as well as involvement by our professional services and managed services organizations and our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and adversely affect our results of operations for a particular period. The timing of large orders is usually difficult to predict and, like many software and services companies, many of our customers typically complete transactions in the last month of a quarter and even in the last few days of a quarter.

If we are unable to manage rapid changes, our operating results could be adversely affected. We have, in the past, experienced significant growth in revenue, employees, and number of product and service offerings and we believe this growth may continue. This growth has placed a significant strain on our management and our financial, operational, marketing, and sales systems. We are implementing and plan to implement in the future a variety of new or expanded business and financial systems, procedures, and controls, including the improvement of our sales and customer support systems. The implementation of these systems, procedures, and controls may not be completed successfully, or may disrupt our operations or our data may not be transitioned properly. Any failure by us to properly manage these transitions could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan.

We have also in the past experienced reductions in revenue that required us to rapidly reduce costs. If we fail to reduce staffing levels when necessary, our costs would be excessive and our business and operating results could be adversely affected.

The success of our business depends on the efforts and abilities of our senior management and other key personnel. We depend on the continued services and performance of our senior management and other key personnel. We do not have long-term employment agreements with any of our key personnel. The loss of any of our executive officers or other key employees could hurt our business. The loss of senior personnel can result in significant disruption to our ongoing operations and new senior personnel must spend a significant amount of time learning our business and our systems in addition to performing their regular duties. Additionally, our inability to attract new senior executives and key personnel could significantly affect our business results.

Our international sales and operations subject us to risks that can adversely affect our revenue and operating results. International sales have historically accounted for a significant percentage of our revenue and we anticipate that such sales will continue to be a significant percentage of our revenue. As a percentage of our total revenues, international revenues were 40%, 39%, and 37% for the years ended December 31, 2004, 2003, and 2002, respectively. We face risks associated with our international operations, including:

•

changes in tax laws and regulatory requirements;

•

difficulties in staffing and managing foreign operations;

•

reduced protection for intellectual property rights in some countries;

•

the need to localize products for sale in international markets;

•

longer payment cycles to collect accounts receivable in some countries;

•

seasonal reductions in business activity in other parts of the world in which we operate;

•

changes in foreign currency exchange rates;

•

geographical turmoil, including terrorism and wars;

•

country or regional political and economic instability; and

•

economic downturns in international markets.

Any of these risks could harm our international operations and reduce our international sales. For example, some countries in Europe, the Middle East, and Africa already have laws and regulations related to technologies used on the Internet that are more strict than those currently in force in the U.S. Any or all of these factors could cause our business and operating results to be harmed.

Because our research and development operations are primarily located in Israel, we may be affected by volatile political, economic, and military conditions in that country and by restrictions imposed by that country on the transfer of technology. Our operations depend on the availability of highly skilled scientific and technical personnel in Israel. Our business also depends on trading relationships between Israel and other countries. In addition to the risks associated with international sales and operations generally, our operations could be adversely affected if major hostilities involving Israel should occur or if trade between Israel and its current trading partners were interrupted or curtailed.

These risks are compounded due to the restrictions on our ability to manufacture or transfer outside of Israel any technology developed under research and development grants from the government of Israel without the prior written consent of the government of Israel. If we are unable to obtain the consent of the government of Israel, we may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel.

We are subject to the risk of increased taxes if tax rate incentives in Israel are altered or if there are other changes in tax laws or rulings. Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investment. Our taxes could increase if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased. Tax authorities could challenge the manner in which profits are allocated between our subsidiaries and us, and we may not prevail in any such challenge. If the profits recognized by our subsidiaries in jurisdictions where taxes are lower became subject to income taxes in other jurisdictions, our worldwide effective tax rate would increase. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future.

Other factors that could increase our effective tax rate include the effect of changing economic conditions, business opportunities, and changes in tax laws and rulings. We have in the past and may continue in the future to retire amounts outstanding under our 2000 Notes. To the extent that these repurchases are completed below the par value of the 2000 Notes, we may generate a taxable gain from these repurchases. These gains may result in an increase in our effective tax rate. Merger and acquisition activities, if any, could result in nondeductible expenses, which may increase our effective tax rate. In addition, we are currently evaluating the migration of the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary. The migration may lead to an increase in our effective tax rate. In the event that we do not migrate the technology, our effective tax rate may also increase due to a greater portion of U.S. source income associated with the technology acquired from Performant and Kintana.

Our financial results may be positively or negatively affected by foreign currency fluctuations. A substantial portion of our research and development activities are performed in Israel. In addition, our foreign operations are generally transacted through our international sales subsidiaries and offices in the Americas; Europe, the Middle East, and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, Poland, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. As a result, these sales and related expenses are denominated in currencies other than the U.S. dollar. Because our financial results are reported in U.S. dollars, our results of operations may be positively or adversely affected by fluctuations in the rates of exchange between the U.S. dollar and other currencies, including:

•

a decrease in the value of currencies in certain countries of the Americas, EMEA, APAC, or Japan relative to the U.S. dollar, which would decrease our reported U.S. dollar revenue and deferred revenue, as we generate sales in these local currencies and report the related revenue in U.S. dollars;

•

an increase in the value of currencies in certain countries of the Americas, EMEA, APAC, or Japan relative to the U.S. dollar, which would increase our sales and marketing costs in these countries and would increase research and development costs in Israel; and

•

an increase in the value of currencies in certain countries of the Americas, EMEA, APAC, or Japan relative to the U.S. dollar, which would increase our reported U.S. dollar revenue, as we generate revenue in these local currencies and report the related revenue in U.S. dollars.

We attempt to limit foreign exchange exposure through operational strategies and by using forward contracts to offset the effects of exchange rate changes on intercompany trade balances. This requires us to approximate the intercompany balances. We may not be successful in making these estimates. If these estimates are overstated or understated during periods of currency volatility, we could experience material currency gains or losses on forward contracts and our financial position and results of operations may be significantly affected.

Acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value, or divert the attention of our management and may result in financial results that are different than expected. In July 2004, we acquired Appilog. In August 2003, we acquired Kintana. In addition, in May 2003, we completed our acquisition of Performant and in May 2001, we acquired Freshwater Software. In the event of any future acquisitions, we could:

•

issue stock that would dilute the ownership of our then-existing stockholders;

•

incur debt;

•

assume liabilities;

•

incur expenses for the impairment of the value of acquired assets; or

•

incur amortization expense related to intangible assets.

If we fail to achieve the financial and strategic benefits of past and future acquisitions, our operating results will be negatively affected.

Acquisitions involve numerous other risks, including:

•

difficulties in integrating or coordinating the different research and development, sales programs, facilities, operations, technologies, or products;

•

failure to achieve targeted synergies;

•

unanticipated costs and liabilities;

•

diversion of management’s attention from our core business;

•

adverse effects on our existing business relationships with suppliers and customers or those of the acquired organization;

•

difficulties in entering markets in which we have no or limited prior experience; and

•

potential loss of key employees, particularly those of the acquired organizations.

In addition, for purchase acquisitions completed to date, the development of these technologies remains a significant risk due to the remaining efforts to achieve technical feasibility, changing customer markets, and uncertainty of new product standards. Efforts to develop these acquired technologies into commercially viable products consist of planning, designing, experimenting, and testing activities necessary to determine that the technologies can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets, and could have a material adverse affect on our business and operating results.

In the normal course of business, we frequently engage in discussions with parties relating to possible acquisitions. As a result of such transactions, our financial results may differ from the investment community’s

expectations in a given quarter. Further, if market conditions or other factors lead us to change our strategic direction, we may not realize the expected value from such transactions. If we do not realize the expected benefits or synergies of such transactions, our consolidated financial position, results of operations, cash flows, and stock price could be negatively affected.

Future changes in financial accounting standards may adversely affect our reports results of operations. For example, under the newly-issued Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment, we will be required to account for equity under our stock plans using fair value based model on the option grant date and record it as a stock-based compensation expense. Our net income and our earnings per share will be significantly reduced or may reflect a loss. We currently calculate stock-based compensation expense using the Black-Scholes option-pricing model and disclose the pro forma effect on net income (loss) and net income (loss) per share in Note 1 to our consolidated financial statements for the years ended December 31, 2004, 2003, and 2002. A fair value based model such as the Black-Scholes option-pricing model requires the input of highly subjective assumptions and does not necessarily provide a reliable single measure of the fair value of our stock options. Assumptions used under the Black-Scholes option-pricing model that are highly subjective include the expected stock price volatility and expected life of an option. SFAS No. 123R requires us to adopt the new accounting provisions beginning in our third quarter of 2005, and will require us to expense shares issued under employee stock purchase plans and stock options as a stock-based compensation expense using a fair value based model.

Investments may become impaired and require us to reduce earnings. At December 31, 2004, our equity investments in non-consolidated companies were composed of investments in privately-held companies of $4.1 million, a private equity fund of $8.0 million and a warrant to purchase common stock of Motive of $0.9 million. At December 31, 2004, our total capital contributions to this private equity fund were $9.0 million. We have committed to make additional capital contributions to this private equity fund up to $6.0 million in the future. We may be required to incur expenses for the impairment of value of our investments. For the year ended December 31, 2004, we recorded losses of $0.5 million on one of our investments in privately-held companies and a loss of $0.6 million on our investment in the private equity fund. Unrealized gain related to a change in fair value of the Motive warrant was $0.5 million for the year ended December 31, 2004. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in privately-held companies, and a loss of $0.4 million on our investment in the private equity fund. The losses on our investments in privately-held companies and private equity fund for the year ended December 31, 2003 were partially offset by an unrealized gain of $0.4 million for the initial value of the Motive warrant. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million and $0.4 million on three of our investments in privately-held companies. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months. We closely monitor the financial health of the private companies in which we hold minority equity investments. We may continue to make investments in other companies. If we determine in accordance with our standard accounting policies that impairment has occurred, then additional losses would be recorded.

The Motive warrant is treated as a derivative instrument due to a net settlement provision. The warrant is recorded at its fair value on each reporting date using the Black-Scholes option-pricing model. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. Estimating the fair value of the warrant requires management judgment and may have an effect on our financial positions and results of operations.

If we fail to adequately protect our proprietary rights and intellectual property, we may lose a valuable asset, experience reduced revenue, and incur costly litigation to protect our rights. Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, service marks, trade secret, and contractual restrictions (including confidentiality provisions and licensing arrangements) to

establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and services and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfers, and disclosures of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the U.S. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase. If we fail to successfully enforce our intellectual property rights, our competitive position could suffer, which could harm our operating results. In addition, we are not significantly dependent on any of our patents as we do not generally license our patents to other companies and do not receive any revenue as a direct result of our patents.

In many cases, we enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products.

Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversions of our management resources, which could result in lower revenue, higher operating costs, and adversely affect our operating results.

Third parties could assert that our products and services infringe their intellectual property rights, which could expose us to litigation that, with or without merit, could be costly to defend. We may from time to time be subject to claims of infringement of other parties’ proprietary rights. We could incur substantial costs in defending ourselves and our customers against these claims. Parties making these claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the U.S. and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain licenses from third parties, develop alternative technology, or to alter our products or processes or cease activities that infringe the intellectual property rights of third parties. If we are required to obtain licenses, we cannot be sure that we will be able to do so at a commercially reasonable cost, or at all. Defense of any lawsuit or failure to obtain required licenses could delay shipment of our products and increase our costs. In addition, any such lawsuit could result in our incurring significant costs or the diversion of the attention of our management.

If we fail to obtain or maintain early access to third-party software, our future product development may suffer. Software developers have, in the past, provided us with early access to pre-generally available versions of their software in order to have input into the functionality and to ensure that we can adapt our software to exploit new functionality in these systems. Some companies, however, may adopt more restrictive policies in the future or impose unfavorable terms and conditions for such access. These restrictions may result in higher research and development costs for us in connection with the enhancement and modification of our existing products and the development of new products or may prevent us from being able to develop products which will work with such new systems, which could harm our business.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of our company, including an acquisition that would be beneficial to our stockholders. We have adopted a Preferred Shares Rights Agreement (which we refer to as our Shareholder Rights Plan) on July 5, 1996, as amended. In connection with the Shareholder Rights Plan, our Board of Directors declared and paid a dividend of one preferred share purchase right for each share of our common stock outstanding on July 15, 1996. In addition, each share of common stock issued after July 15, 1996 will be issued with an accompanying preferred stock purchase right. Because the rights

may substantially dilute the stock ownership of a person or group attempting to take us over without the approval of our Board of Directors, the Shareholder Rights Plan could make it more difficult for a third party to acquire us (or a significant percentage of our outstanding capital stock) without first negotiating with our Board of Directors regarding such acquisition.

Our Board of Directors also has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present plans to issue shares of preferred stock.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which will prohibit us from engaging in a business combination with an interested stockholder for a period of three years after the date that the person became an interested stockholder unless, subject to certain exceptions, the business combination or the transaction in which the person became an interested stockholder is approved in a prescribed manner.

Furthermore, certain provisions of our Amended and Restated Certificate of Incorporation may have the effect of delaying or preventing changes in our control or management, which could adversely affect the market price of our common stock.

Leverage and debt service obligations for $800.0 million in outstanding Notes may adversely affect our cash flow and operational results. On April 29, 2003, we issued our 2003 Notes, with a principal amount of $500.0 million, in a private placement, and in July 2000, we completed the offering of the 2000 Notes with a principal amount of $500.0 million. From December 2001 through December 31, 2004, we retired $200.0 million face value of our 2000 Notes. We continue to carry a substantial amount of outstanding indebtedness, primarily the 2000 Notes and the 2003 Notes. There is the possibility that we may be unable to generate cash sufficient to pay the principal of, interest on, and other amounts in respect of our indebtedness when due. Our leverage could have significant negative consequences, including:

•

increasing our vulnerability to general adverse economic and industry conditions;

•

requiring the dedication of a substantial portion of our expected cash flow from operations to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including capital expenditures and acquisitions; and

•

limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete.

In November 2002, we entered into an interest rate swap with Goldman Sachs Capital Markets, L.P. with respect to $300.0 million of our 2000 Notes. This interest rate swap could expose us to greater interest expense for our 2000 Notes.

In addition, 9,673,050 shares issuable upon the conversion of our 2003 Notes are included in our diluted net income per share calculation upon the adoption of Emerging Issues Task Force No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share in the fourth quarter of 2004. As required by EITF No. 04-08, we also retroactively adjusted previously reported diluted earnings per share.

Finally, our stock repurchase program was approved by the Board of Directors on July 27, 2004, which permits us to repurchase up to $400.0 million of our common stock may leave us with less cash to repay our 2000 Notes and 2003 Notes. Since inception of the stock repurchase program through March 4, 2005, we have repurchased 9,675,000 shares of our common stock at an average price of $34.33 per share for an aggregate purchase price of $332.2 million.

Economic, political, and market conditions may adversely affect demand for our products and services. Our customers’ decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. We believe that although the economy and business conditions appear to be improving, customers may continue to reassess their immediate technology needs, lengthen their purchasing decision-making processes, require more senior level internal approvals of purchases, and defer purchasing decisions, and accordingly, could reduce demand in the future for our products and services. In addition, the war on terrorism and the potential for other hostilities in various parts of the world have caused political uncertainties and volatility in the financial markets. Under these circumstances, there is a risk that our existing and potential customers may decrease spending for our products and services. If demand for our products and services is reduced, our revenue growth rates and operating results will be adversely affected.

The price of our common stock may fluctuate significantly, which may result in losses for investors and possible lawsuits. The market price for our common stock has been and may continue to be volatile. For example, during the 52-week period ended February 18, 2005, the closing sale prices of our common stock as reported on the NASDAQ National Market ranged from a high of $50.60 to a low of $32.36. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include:

•

actual or anticipated variations in our quarterly operating results and/or quarterly guidance;

•

announcements of technological innovations or new products or services by us or our competitors;

•

announcements by us or our competitors relating to strategic relationships, acquisitions or investments;

•

changes in financial estimates or other statements by securities analysts;

•

changes in general economic conditions;

•

consolidation in the software industry;

•

terrorist attacks, and the effects of war;

•

conditions or trends affecting the software industry and the Internet;

•

changes in the rating of our notes or other securities; and

•

changes in the economic performance and/or market valuations of other software and high-technology companies.

Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts at some time in the future, and the trading prices of our securities could decline as a result. In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public’s perception of software or internet software companies could depress our stock price regardless of our operating results. Because the 2000 Notes and 2003 Notes are convertible into shares of our common stock, volatility or depressed prices for our common stock could have a similar effect on the trading price of these Notes. Holders who receive common stock upon conversion also will be subject to the risk of volatility and depressed prices of our common stock.

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

Our exposure to market rate risk includes risk of change in interest rates, foreign exchange rate fluctuations, and loss in equity investments.

Interest rate risk

We mitigate market risk associated with our investments by placing our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer or issue. We have classified all of

our debt securities investments as either held to maturity or available-for-sale. Marketable equity securities are classified as short-term investments. At December 31, 2004, we did not hold any marketable equity securities. At December 31, 2004, $182.9 million, or 16.1% of our cash, cash equivalents, and investment portfolio have original maturities of less than 90 days, and an additional $447.5 million, or 39.3% of our cash, cash equivalents, and cash investment portfolio had original maturities of less than one year. All debt securities classified as held-to-maturity investments mature in less than three years as required by our policy. From time to time, we also invest in auction rate securities, which we classify as available-for-sale investments. Information about our investment portfolio in debt securities is presented in the table below which states notional amounts and the related weighted-average interest rates. Amounts represent maturities from the reporting date to the dates shown below for each of the twelve-month periods (in thousands):


	December 31,
	2005			2006			2007 and thereafter			Total			Fair Value
Investments maturing within 30 days at December 31, 2004:
Fixed rate	$	212,620		$	—		$	—		$	212,620		$	212,620
Weighted average rate		2.30	%		—			—			2.30	%		—
Investments maturing more than 30 days after December 31, 2004:
Fixed rate	$	228,620		$	223,576		$	399,669		$	851,865		$	849,021
Weighted average rate		2.21	%		2.57	%		1.74	%		2.08	%		—

Total investments	$	441,240		$	223,576		$	399,669		$	1,064,485		$	1,061,641

Weighted average rate		2.25	%		2.57	%		1.74	%		2.13	%		—

Our long-term investments include $532.2 million of government agency instruments, which have callable provisions and accordingly may be redeemed by the agencies should interest rates fall below the coupon rate of the investments.

The fair value of our 2000 Notes fluctuates based upon changes in the price of our common stock, changes in interest rates, and changes in our creditworthiness. The fair market value of our 2000 Notes at December 31, 2004 was $301.5 million while the face value and book value was $300.0 million and $304.5 million, respectively. To mitigate the risk of fluctuation in the fair value of our 2000 Notes, we entered into an interest rate swap arrangement. The fair value of our 2003 Notes fluctuates based upon changes in the price of our common stock and changes in our creditworthiness. The fair market value of the 2003 Notes at December 31, 2004 was $525.2 million while the face value and the book value was $500.0 million. See Note 8 to the consolidated financial statements for transactions regarding our 2000 Notes and 2003 Notes.

In January and February, 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. In November 2002, we merged the two interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) into a single interest rate swap with GSCM to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap of $300.0 million, with a maturing date of July 2007, is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on our 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value attributable to changes in the LIBOR throughout the life of our 2000 Notes. The interest rate swap creates a market exposure to changes in the LIBOR. If the LIBOR increases or decreases by 1%, our interest expense would increase or decrease by $750,000 quarterly on a pretax basis.

The value of the interest rate swap is determined using various inputs, including forward interest rates and time to maturity. Under the terms of the swap, we provided initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between Mercury and GSCM as swap rates and equity prices fluctuate. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of December 31, 2004 and 2003, but continues to decrease in value as interest rates rise. If market changes continue to negatively affect the value of the swap, the swap may become a liability in our consolidated balance sheets. In the event we chose to terminate the swap before maturity, and the swap was a liability due to an unfavorable value, we would be obligated to pay to our counterparty the market value of the swap at the termination date.

We classified the initial collateral and will classify any additional collateral as restricted cash in our consolidated balance sheets. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted our 2000 Notes. We have credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligations under the swap are guaranteed by the Goldman Sachs Group L.P.

See Notes 8, 14 and 19 (unaudited) to the consolidated financial statements for additional information regarding our 2000 Notes and 2003 Notes and the related interest rate swap activities. Please note that the information in this amended Annual Report on Form 10-K/A, including the descriptions of the Notes set forth herein, is as of December 31, 2004 and, therefore, does not reflect the modifications made to the terms of the Notes subsequent to December 31, 2004 which are described in Item 7 above and Note 19, “Subsequent Events (unaudited),” of the Notes to Consolidated Financial Statements.

Foreign exchange rate risk

A portion of our business is conducted in currencies other than the U.S. dollar. Our operating expenses in each of these countries are in the local currencies, which mitigates a significant portion of the exposure related to local currency revenue. We enter into foreign exchange forward contracts to minimize the short-term effect of foreign currency fluctuations on foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas; Europe, the Middle East, and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, Poland, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. We had outstanding forward contracts with notional amounts totaling $31.2 million and $31.5 million at December 31, 2004 and 2003, respectively. The forward contracts in effect at December 31, 2004 matured on January 31, 2005 and were hedges of certain foreign currency exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, South African Rand, Swedish Kroner, and Swiss Franc.

We also utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Canadian Dollar, Hong Kong Dollar, Israeli Shekel, and Singapore Dollar. We had outstanding forward contracts with notional amounts totaling $23.7 million and $42.6 million at December 31, 2004 and 2003, respectively.

Gains or losses on forward contracts are recognized as “Other income (expense), net” in our consolidated statements of operations in the same period as gains or losses on the underlying revaluation of intercompany balances and non-functional currency balances. Net gains or losses on forward contracts and the underlying

balances did not have any material effect to our financial position. We do not believe an immediate increase of 10% in the exchange rates of the U.S. dollar to other foreign currencies would have a material effect on our operating results or cash flows.

Investment risk

From time to time, we make equity investments in public companies, privately-held companies, and private equity funds for business and strategic purposes. At December 31, 2004, our investments in privately-held companies and a private equity fund were $4.1 million and $8.0 million respectively. Through December 31, 2004, we made capital contributions to the private equity fund totaling $9.0 million and we have committed to pay up to $6.0 million in the future.

If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. The decline in the U.S. stock market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on our investments in these public and private companies. We have a policy to review our equity investments portfolio. If we determine that the decline in value in one of our equity investments is other-than-temporary, we record a loss on investment in our consolidated statements of operations to write down these equity investments to the market value.

For the year ended December 31, 2004, we recorded losses of $0.5 million on one of our investments in privately-held companies and a loss of $0.6 million on our investment in the private equity fund. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in privately-held companies and a loss of $0.4 million on our investment in the private equity fund. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to new unrelated third party investors, and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

In addition, we have a warrant to purchase common stock of Motive, Inc. The warrant is treated as a derivative instrument due to a net settlement provision. The Motive warrant is marked to market at each reporting date, using the Black-Scholes option-pricing model. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. Any significant fluctuations in the common stock price of Motive may have an effect on our financial positions and results of operations. The fair value of the warrant was $0.9 million and $0.4 million as of December 31, 2004 and 2003, respectively.

Item 8.

Financial Statements and Supplementary Data

Financial statements required pursuant to this Item are presented beginning on page 85 of this report.

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosures

None.

Item 9A.

Controls and Procedures

Background Findings and Restatement

On November 2, 2005, we announced that the Special Committee had made certain determinations as a result of its review of the Company’s past stock option practices. The Special Committee found that certain stock option grants utilized a grant date, the date used to determine the strike price of the option, that differed from the date on which the option appeared to have been actually granted. In almost every such instance, the price on the actual grant date was higher than the price on the stated grant date, meaning that the misdating had the effect of permitting the recipients of the options to exercise at a strike price lower than the price on the actual grant date. The Special Committee found that the intentional selection of a favorable price for option grants had occurred in numerous instances, including the vast majority of stock option grants between January 1996 and April 2002, and occurred with respect to grants to all levels of employees. The Special Committee further found that our then Chief Executive Officer Amnon Landan, Chief Financial Officer Doug Smith, and General Counsel Susan Skaer (“Prior Management”) were each aware of and, to varying degrees, participated in these practices. Each of them also benefited personally from the practices. Although each of these officers asserts that he or she did not focus on the fact that the practices and their related accounting were improper, the Special Committee concluded that each of them knew or should have known that the practices were contrary to the option plan and proper accounting. The Special Committee also found that on at least three occasions, option exercises by Company executives including Mr. Landan appear to have been reported as having occurred on a date that differed from the date at which the exercise actually happened. This difference in reported versus actual dates reduced the executives’ taxable income significantly and exposed the Company to possible penalties for failure to pay withholding taxes. After reviewing the results of the investigation, our Board of Directors determined that it would be appropriate to accept the resignations of the Prior Management tendered on November 1, 2005.

Other findings by the Special Committee issued in this report included the following: (a) Questions should have been raised in the minds of the Compensation Committee members from 1998 to 2002 (who included present directors Igal Kohavi, Yair Shamir and Giora Yaron) as to whether grants they approved were properly dated. The Special Committee also concluded that it appears that the Compensation Committee members reasonably, but mistakenly, relied on certain former members of senior management to prepare the proper documentation for the option grants and to account for the options properly; (b) Five instances of stock option grants for which authorizing documents were not located; (c) Numerous instances in which employees terminating pursuant to separation agreements (with continued stock vesting) did not perform any significant duties during the separation period and were employees in name only; (d) Numerous factors that contributed to the administration of the stock option plans in a manner that was inconsistent with their terms, and the failure of the Company to identify more promptly those deviations as well as the ramifications of those practices; and (e) A $1.0 million loan to Mr. Landan in 1999 (which has since been repaid) lacked documentation supporting its approval by our Board of Directors.

In November 2005, following the resignation of Prior Management, our Board of Directors expanded the mandate of the Special Committee. Specifically, the Special Committee was requested to work in conjunction with the Company to conduct a supplemental review of the principal financial reporting control areas of the Company and the key individuals functioning in these areas during the relevant time periods. Specifically, the purpose of the supplemental review was to determine whether the work previously carried out by the Company could be relied upon with respect to matters other than the stock option related matters that were the subject of the Special Committee’s initial efforts (“recertification procedures”). These recertification procedures identified several instances in which other established controls appear to have been deliberately overridden between 1997 and early 2002 to permit certain former members of senior management (including our then CEO Amnon Landan and then CFO Sharlene Abrams) at times to manage or influence the timing of quarter-end shipments and influence the timing and level at which certain expense items and accruals were recorded to achieve a desired consistency of reported financial results. While the practice of influencing quarter-end shipments did not result in any misstatements of reported financial results or the need for any accounting adjustment, the lack of public disclosure of this practice was improper. In addition, the recertification procedures identified what appears to have been several instances of efforts to influence the timing and level at which certain expense items and accruals were recorded. These activities did not result in additional adjustments to the restated consolidated financial statements contained within this Form 10-K/A because they occurred in periods prior to the year ended December 31, 2002 and related principally to the timing of transactions. In addition, through our recertification procedures we also identified certain other errors in accounting determinations and judgments relating to transactions occurring in years 2004, 2003 and 2002 which, although immaterial, have been reflected in the restated consolidated financial statements contained herein.

Concurrent with the supplemental review, our management, under the oversight of the Audit Committee, completed an internal review in order to prepare the restated consolidated financial statements which included evaluations of the previously carried out accounting and led to adjustments for: (a) stock option grants made to persons before they became employees; (b) stock options exercised or exercisable with promissory notes; (c) modifications of stock options for employees in transition or advisory roles; (d) tax treatment for the disqualification of incentive stock options and conversion to non-qualified stock options; (e) stock issued in connection with our Employee Stock Purchase Plan; and (f) the assumptions, models and data used in connection with our pro forma disclosures pursuant to SFAS No. 123. The internal review included the evaluation of information and a number of transactions from 1994 to the present. During the course of completing this work, we also identified certain other errors in accounting determinations and judgments related to transactions occurring in fiscal years 2004, 2003 and 2002 that, although immaterial, current management has included in the restated consolidated financial statements. Restatement adjustments are further described in Note 3 of the Notes to the Consolidated Financial Statements.

On June 23, 2006, the SEC Staff, as part of the “Wells” process by which the SEC Staff affords individuals and companies the opportunity to present their views regarding potential action by the SEC, advised counsel for directors Igal Kohavi, Yair Shamir and Giora Yaron that the SEC Staff is considering recommending that the Commission file a civil enforcement proceeding against each of these directors under applicable provisions of the federal securities laws. If charges are brought, the SEC may seek a permanent injunction against further violations of the securities laws, an order permanently barring these directors from serving as officers or directors of any SEC registered company, and civil monetary penalties. The charges under consideration would allege that each of these directors knew or should have known about the manipulation of grant dates and that each knew, or was reckless in not knowing, the impact that option backdating would have on our financial results. The directors have advised the SEC Staff that they intend to file a Wells submission arguing that they did not violate the federal securities laws, that they did not participate in or know of option backdating, and that the charges under consideration are legally and factually without basis. Former officers are likely to receive or have received similar Wells notices. The formal SEC investigation of the Company is continuing. In light of the Wells notice, the aforementioned directors have offered to withdraw from their respective positions on the applicable committees of the Company’s Board of Directors, and the Board has accepted that offer.

Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our current Chief Executive Officer (“CEO”) and current Chief Financial Officer (“CFO”), we conducted an evaluation of the effectiveness of our disclosure controls and procedures, as such terms are defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of December 31, 2004, the end of the period covered by this Annual Report on Form 10-K/A. Disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported on a timely basis and that such information is accumulated and communicated to management, including the CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.

At the time that our Annual Report on Form 10-K for the year ended December 31, 2004 was filed on March 14, 2005, our then CEO and then CFO concluded that our disclosure controls and procedures were effective as of December 31, 2004. Subsequent to that evaluation, our management, including our current CEO and current CFO, concluded that our disclosure controls and procedures were not effective at a reasonable level of assurance as of December 31, 2004 because of the material weaknesses in our internal control over financial reporting discussed below. Notwithstanding the material weaknesses described below, our current management, based upon the substantial work performed during the restatement process, has concluded that the Company’s consolidated financial statements for the periods covered by and included in this Annual Report on Form 10-K/A are fairly stated in all material respects in accordance with generally accepted accounting principles in the United States of America for each of the periods presented herein.

Management’s Report on Internal Control Over Financial Reporting (Restated)

Our management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rule 13a-15(f). Our current CEO and current CFO conducted an evaluation of the effectiveness of our internal control over financial reporting as of December 31, 2004 using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Our current management identified the following material weaknesses in our internal control over financial reporting as of December 31, 2004:

Control environment. We did not maintain an effective control environment based on criteria established in the COSO framework. Specifically, we did not maintain controls adequate to prevent or detect instances of intentional override or intervention of our controls or intentional misconduct by certain former members of senior management. Also, there was a lack of attention to identifying and responding to such instances. This lack of an effective control environment permitted certain former members of senior management, including Prior Management, to deliberately override certain controls between 1992 through March 31, 2005 resulting in certain transactions not being properly accounted for in the Company’s consolidated financial statements and contributing to the need to restate certain of

our previously issued financial statements. Each of these former members of our senior management appears to have also personally benefited from these practices. In addition, the Compensation Committee of the Company’s Board of Directors mistakenly relied on certain former members of senior management to appropriately discharge the duties delegated to them. Furthermore, we did not adequately monitor certain of our control practices, demonstrate a commitment to integrity and objectivity and foster a consistent and open flow of information and communication between those initiating transactions and those responsible for their financial reporting. Certain former members of senior management intentionally exploited this environment as follows:

Stock-based compensation. Certain former members of senior management (including our then CEO and then CFO) intentionally deviated from our controls over the accounting for our stock option transactions, which resulted in the creation of misleading accounting records. Additionally, these certain former members of senior management either knew or should have known that the vast majority of our stock options transactions occurring between January 1996 and April 2002 were not appropriately accounted for in accordance with generally accepted accounting principles.

Earnings management. Between 1997 and 2002, we identified several instances where certain former members of senior management (including our then CEO and then CFO) appear to have deliberately overridden controls in order to manage or influence the timing of quarter-end shipments, without public disclosure, and to influence the timing and level at which certain expense items and accruals were made in order to inappropriately achieve a desired consistency of reported financial results, without appropriate public disclosure.

Executive compensation. In 1999, a loan was made to our former CEO (which has since been repaid) that lacked appropriate documentation including approval by the Company’s Board of Directors. The aforementioned loan was referred to in several of our periodic public disclosures but not all of its significant terms were clearly and completely disclosed. In addition, certain inappropriate expense reimbursements were made to our former CEO.

This control environment material weakness contributed to the override of controls by certain former members of senior management, which in turn resulted in the restatement of our consolidated financial statements for the years 2004, 2003, 2002, each of the quarters of 2004, and 2003, as well as the first quarter of 2005. Additionally, this control environment material weakness could result in misstatements of any of our financial statement accounts and disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, our management has determined that this control deficiency constitutes a material weakness.

The material weakness in our control environment contributed to the existence of the following additional material weakness.

Controls over stock-based compensation expense. We did not maintain effective controls over the accounting for and disclosure of our stock-based compensation expense. Specifically, effective controls, including monitoring, were not maintained to ensure the existence, completeness, valuation and presentation of our stock-based compensation transactions related to the granting, modifying and exercising (including in certain instances with promissory notes) of our stock options. In addition, effective controls were not maintained over the granting of stock purchase rights to employees through our Employee Stock Purchase Plan. This control deficiency resulted in the misstatement of our stock-based compensation expense and additional paid-in capital accounts and related financial disclosures, and in the restatement of the Company’s consolidated financial statements for the years 2004, 2003, 2002, each of the quarters of 2004, and 2003, as well as the first quarter of 2005. Additionally, this control deficiency could result in misstatements of the aforementioned accounts and disclosures that would result in a material misstatement of the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, our management has determined that this control deficiency constitutes a material weakness.

In Management’s Report on Internal Control Over Financial Reporting included in our original Annual Report on Form 10-K for the year ended December 31, 2004, our Prior Management, including our then CEO and then CFO, concluded that we maintained effective internal control over financial reporting as of December 31, 2004. Our current CEO and current CFO have subsequently concluded that the material weaknesses described above existed as of December 31, 2004. As a result, we have concluded that we did not maintain effective internal control over financial reporting as of December 31, 2004, based on the criteria in Internal Control-Integrated Framework issued by the COSO. Accordingly, management has restated its report on internal control over financial reporting.

Our assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report included in this Annual Report on Form 10-K/A.

Remediation of the Material Weaknesses in Internal Control Over Financial Reporting

It is important to note that based on the additional procedures performed as part of the Company’s restatement of its financial statements, current management has concluded that certain important improvements were made to the control environment commencing in mid-2002, including: (i) an improved commitment to competency manifested by the hiring of more experienced and senior finance and legal personnel, (ii) the implementation of additional financial controls that enhanced independent judgment and review, including as appropriate segregation of duties and increased employee responsibility and accountability for the completeness of the Company’s disclosures, (iii) the establishment of processes and procedures to increase communications between the financial reporting and accounting functions and senior management, including our Audit Committee, and (iv) instituting a formal code of conduct and whistle-blower policy. While we believe that the improvements made to our control environment after mid-2002, if viewed on a stand-alone basis, could be sufficient for an adequate control environment in areas other than stock-based compensation and the intentional override of controls by Prior Management, the fact that the Prior Management continued in their respective roles and in some instances exercised the ability to override stock option controls and proper accounting treatment during 2004, leads us to conclude that the material weaknesses described above existed as of December 31, 2004.

•

Company’s stock administration systems and have appropriate supporting documentation. In addition, we have modified the CEO expense reimbursement and other CEO payment procedures to be consistent with our standard control practices and subject to periodic review by our Internal Audit function.

•

Our Board of Directors has adopted certain further enhancements to our corporate governance and oversight, including a formal separation of the roles of Chairman and CEO, strengthening the independence of our Board of Directors by adding two additional independent members to provide additional expertise and independence, reconstituting the membership of our Board Committees and making additional advisory resources available to our Board of Directors and its committees, including the Compensation Committee.

Management is currently in the process of evaluating our internal control over financial reporting as of December 31, 2005 as prescribed by Section 404 of the Sarbanes-Oxley Act of 2002. Although the Company has not fully remediated the material weaknesses described above, it believes that it has made substantial progress. The Company is actively engaged in the implementation of other remediation efforts to address the material weaknesses identified in the Company’s internal control over financial reporting. As a result, we expect to conclude in our Annual Report on Form 10-K for the year ended December 31, 2005 that our internal control over financial reporting was not effective as of December 31, 2005.

Changes in Internal Control Over Financial Reporting

Other than the changes described above, there have been no other changes in our internal control over financial reporting during the most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART III

Certain information required by Part III is omitted from this amended Annual Report on Form 10-K/A and incorporated by reference to our definitive proxy statement filed on March 31, 2005 pursuant to Regulation 14A for our annual meeting of stockholders, which was held on May 19, 2005.

Item 10.

Directors and Executive Officers of the Registrant

As described in Note 19, “Subsequent Events (unaudited),” of the Notes to Consolidated Financial Statements, we have experienced several changes in our management since the original filing of our Annual Report on Form 10-K for the year ended December 31, 2004, including the resignations of Amnon Landan, Douglas P. Smith and Susan J. Skaer that we announced on November 2, 2005 and the appointment of Anthony Zingale as Chief Executive Officer and David J. Murphy as Chief Financial Officer on that date. The following list does not give effect to these or other changes in management that have occurred since February 28, 2005. Our executive officers as of February 28, 2005 were as follows:


Name	Age	Position
Amnon Landan	46	Chief Executive Officer and Chairman of the Board of Directors
Anthony Zingale	49	President, Chief Operating Officer, and Director
Douglas P. Smith	53	Executive Vice President and Chief Financial Officer
James Larson	46	Senior Vice President of Worldwide Field Operations
David J. Murphy	42	Senior Vice President, Corporate Development and Business Transformation
Yuval Scarlat	41	Senior Vice President, Products
Bryan J. LeBlanc	38	Vice President, Finance and Operations
Susan J. Skaer	41	Vice President, General Counsel and Secretary

Mr. Amnon Landan has served as our Chief Executive Officer since February 1997 and as our President from February 1997 to December 2004, has served as Chairman of the Board of Directors since July 1999, and has been a director since February 1996. From October 1995 to January 1997, he served as President, and from March 1995 to September 1995, he served as President of North American Operations. He served as Chief Operating Officer from August 1993 until March 1995. From December 1992 to August 1993, he served as our Vice President of Operations and from June 1991 to December 1992, he served as Vice President of Research and Development. From November 1989 to June 1991, he served with us in various technical positions.

Mr. Anthony Zingale joined us as our President and Chief Operating Officer on December 1, 2004 and has been a member of our Board of Directors since July 2002. Mr. Zingale was retired from April 2001 to November 2004. Prior to joining us, he served as the President and Chief Executive Officer of Clarify, a publicly traded enterprise technology company that was a leader in the customer relationship management market from March 1998 until it was acquired by Nortel Networks, Inc. in March 2000. Following the acquisition, he served as President of Nortel’s billion-dollar eBusiness Solutions Group from March 2000 to March 2001. From 1989 to December 1997 Mr. Zingale held various executive management positions at Cadence Design Systems, Inc., a leading supplier of electronic design products and services, leading to his role as Senior Vice President of Worldwide Marketing.

Mr. Douglas Smith has served as our Executive Vice President and Chief Financial Officer since November 2001. He served as our Executive Vice President of Corporate Development from May 2000 until November 2001. From September 1996 to May 2000, he served in various positions with Hambrecht & Quist, most recently as Managing Director and co-head of the Internet Group. From September 1994 to September 1996, he was the Chief Financial Officer and Executive Vice President of Strategy for ComputerVision Corporation.

Mr. James Larson has served as our Senior Vice President of Worldwide Field Operations since January 2005. From March 2004 to December 2004, Mr. Larson served as Vice President of Americas’ Field Operations and from July 2000 to February 2004, he served as Vice President, Americas’ Sales. From October 1998 to December 1999 Mr. Larson was Vice President, Western Area and from January 2000 to June 2000 he was Vice

President, U.S. Sales, PGP Security Division for Network Associates. Prior to that Mr. Larson held various sales and management positions at various technology companies, including Siebel Systems and Oracle.

Mr. David Murphy has served as our Senior Vice President, Corporate Development and Business Transformation since January 2005, and from January 2003 to December 2004 he served as our Vice President of Corporation Development and Business Transformation. From May 2001 to December 2002, he was President and Chief Executive Officer of Asera, a provider of business process enterprise solutions. Before joining Asera, from March 1998 to May 2001 Mr. Murphy was President and General Manager of Tivoli Systems at IBM, a division of IBM, and leading provider of systems management solutions. Prior to joining Tivoli, he was head of the private equity investments group at Perot Systems and a partner at McKinsey & Company.

Mr. Yuval Scarlat has served as our Senior Vice President, Products since January 2005 and from January 2004 to December 2004 he served as our Vice President of Products. From January 2002 to January 2004, he was Vice President and General Manager of Testing & Deployment. From January 2000 to January 2002, he served as our President of Managed Services. From July 1996 to December 2000, he served as our Vice President of Technical Services. From 1990 to July 1996, he served with us in various technical and marketing positions.

Mr. Bryan LeBlanc has served as our Vice President, Finance and Operations since March 2004 and from May 2002 to February 2004 he served as our Vice President of Finance. Prior to joining the company, he served as Executive Vice President and Chief Financial Officer for inSilicon Inc., a software company developing intellectual property for semiconductor communication, from March 2001 to May 2002. From March 2000 to March 2001, Mr. LeBlanc was Vice President of Finance and Chief Financial Officer of Fogdog, Inc., an online retailer of sports equipment, and from November 1999 to March 2000, he was the Director of Finance of Fogdog. From April 1997 to November 1999, Mr. LeBlanc was the Director of Corporate Finance for Documentum, Inc., an enterprise content management software development company. Prior to that, between 1988 and 1997, he held various financial management positions with Cadence Design Systems, Inc., an electronic design automation software company.

Ms. Susan Skaer has served as our Vice President, General Counsel and Secretary since November 2000. From October 1996 to November 2000, Ms. Skaer was a partner with the law firm GCA Law Partners LLP (formerly General Counsel Associates LLP). From September 1990 to October 1996, Ms. Skaer was an associate with the law firm Wilson Sonsini Goodrich & Rosati.

The information concerning our directors required by this Item is incorporated by reference to our proxy statement under the heading “Election of Directors—Nominees” in our proxy statement.

The information concerning our audit committee financial expert and our audit committee required by this Item is incorporated by reference to our proxy statement under the “Audit Committee” under the heading “Board Structure and Compensation”.

The information concerning compliance with Section 16(a) of the Exchange Act required by this Item is incorporated by reference to our proxy statement under the heading “Section 16(a) Beneficial Ownership Reporting Compliance”.

Our Code of Business Conduct and Ethics (including code of ethics provisions that apply to our principal executive officer, principal financial officer, controller and senior financial officers) is available on our website at www.mercury.com/us/company/ir/corp-governance/ under “Code of Business Conduct and Ethics”. We will post amendments to or waivers from a provision of the Code of Business Conduct and Ethics on our website at www.mercury.com/us/company/ir/corp-governance under “Code of Business Conduct and Ethics”.

Item 11.

Executive Compensation

The information required by this Item is incorporated by reference to our proxy statement under the heading “Executive Compensation”. Please note, however, that:

(a) As a result of the Special Committee’s investigation, as well as our internal review of our historical financial statements, we revised the grant dates of certain of our previously issued stock options. As a result of these grant date revisions, certain stock options with stated grant dates in the fourth quarter of 2001 granted to two of our Named Executive Officers (Douglas Smith, to purchase 400,000 shares of our common stock, and James Larson, to purchase 125,000 shares) have been deemed to have actually been granted during the first quarter of 2002. Those option grants are therefore now being treated as having been granted during 2002 and, therefore, should be disclosed in the “Summary Compensation Table” in our proxy statement as “Long-Term Compensation—Securities Underlying Options” issued to Messrs. Smith and Larson during 2002; and

(b) We have, subsequent to the date of our proxy statement, entered into agreements with each of Douglas Smith and Amnon Landan in the fourth quarter of 2005 and first quarter of 2006, respectively, which had the effect, among other things, of increasing exercise prices of certain stock options held by each of them. These agreements, which we have previously disclosed on Current Reports on Form 8-K, by increasing the exercise prices of certain of these individuals’ stock options, would have had the effect of decreasing the Value Realized (with respect to Mr. Smith) and the Value of Unexercised In-the-Money Options at Fiscal Year End (with respect to Messrs. Landan and Smith) disclosed in the table under the heading “Aggregate Option Exercises In Last Fiscal Year And Fiscal Year End Option Values” in our proxy statement, had those amended exercise prices been in effect as of December 31, 2004.

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information regarding security ownership of certain beneficial owners and management required by this Item is incorporated by reference to our proxy statement under the heading “Security Ownership of Certain Beneficial Owners and Management”.

The information regarding securities authorized for issuance under equity compensation plans required by this Item is incorporated by reference to our proxy statement under the heading “Equity Compensation Plan Information”.

Item 13.

Certain Relationships and Related Transactions

The information required by this Item is incorporated by reference to our proxy statement under the heading “Certain Relationships and Related Transactions”.

Item 14.

Principal Accountant Fees and Services

The information required by this Item is incorporated by reference to our proxy statement under the heading “Principal Auditor Fees and Services”.

PART IV

Item 15.

Exhibits and Financial Statement Schedules

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

1. Financial Statements.

The following financial statements of Mercury Interactive Corporation are filed as a part of this report:


		Page
Report of Independent Registered Public Accounting Firm		82
Consolidated Balance Sheets at December 31, 2004 and 2003 (as restated)		85
Consolidated Statements of Operations for the years ended December 31, 2004, 2003, and 2002 (as restated)		86
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2004, 2003, and 2002 (as restated)		87
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003, and 2002 (as restated)		89
Notes to Consolidated Financial Statements (as restated)		90

2. Schedules

Financial statement schedules not listed above have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.

3. Exhibits


Exhibit Number			Incorporated by Reference
Exhibit Number		Description	Form	File No.	Exhibit(s)	Filing Date
3.1		Certificate of Incorporation of Mercury, as amended and restated to date.	S-1	33-68554	3.3	October 29, 1993

3.2		Certificate of Amendment of Restated Certificate of Incorporation dated May 20, 1998.	10-Q	000-22350	3.1	November 16, 1998

3.3		Certificate of Amendment of Restated Certificate of Incorporation dated May 26, 1999.	S-3	333-95097	4.1	January 20, 2000

3.4		Certificate of Amendment of Restated Certificate of Incorporation dated May 24, 2000.	10-K	000-22350	3.2	March 29, 2001

3.5		Certificate of Amendment of Restated Certificate of Incorporation dated May 19, 2004.	10-Q	000-22350	3.1	August 9, 2004

3.6		Corrected Certificate of Amendment of Restated Certificate of Incorporation dated June 4, 2004.	10-Q	000-22350	3.2	August 9, 2004

3.7		Amended and Restated Bylaws of Mercury.	10-K	000-22350	3.3	March 5, 2004

10.1	*	Form of Directors’ and Officers’ Indemnification Agreement.	10-Q	000-22350	10.2	August 14, 2003


Exhibit Number			Incorporated by Reference
Exhibit Number		Description	Form	File No.	Exhibit(s)	Filing Date
10.2	*	Form of Change of Control Agreement entered into by Mercury with the President of European Operations.	10-K	000-22350	10.26	March 31, 1999

10.3	*	Form of Amended and Restated Change of Control Agreement entered into by Mercury with the Chairman and the Chief Financial Officer.	8-K	000-22350	10.2	December 21, 2004

10.4	*	Amended and Restated Change of Control Agreement by and between Mercury and Anthony Zingale dated December 15, 2004.	8-K	000-22350	10.3	December 21, 2004

10.5		Preferred Shares Rights Agreement dated July 5, 1996.	8-A12G	000-22350	1	July 9, 1996

10.6		Amendment to Rights Agreement dated March 31, 1999.	8-A12G/A	000-22350	1	April 2, 1999

10.7		Amendment No. Two to Rights Agreement, dated May 19, 2000.	8-A12G/A	000-22350	1	May 22, 2000

10.8		Amendment No. 3 to Preferred Shares Rights Agreement dated April 23, 2003.	10-Q	000-22350	4.3	April 30, 2003

10.9		Purchase and Sale Agreement by and between WHSUM Real Estate Limited Partnership and Mercury dated December 1, 2000.	10-K	000-22350	10.12	March 29, 2001

10.10		Form of Note for Mercury’s 4.75% Convertible Subordinated Notes due July 1, 2007.	10-Q	000-22350	4.1	August 14, 2000

10.11		Indenture between Mercury, as Issuer and State Street Bank and Trust Company of California, National Association, as Trustee dated July 3, 2000 related to Mercury’s 4.75% Convertible Subordinated Notes due July 1, 2007.	10-Q	000-22350	4.2	August 14, 2000

10.12		Registration Rights Agreement among Mercury and Goldman, Sachs & Co., Chase Securities Inc. and Deutsche Banc Securities Inc. dated July 3, 2000 related to Mercury’s 4.75% Convertible Subordinated Notes due July 1, 2007.	10-Q	000-22350	4.3	August 14, 2000

10.13		Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated January 17, 2002 (as revised on January 31, 2002), and Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated February 26, 2002.	10-K	000-22350	10.18	March 27, 2002


Exhibit Number			Incorporated by Reference
		Description	Form	File No.	Exhibit(s)	Filing Date
10.14		Indenture, dated as of April 29, 2003, by and between Mercury and U.S. Bank National Association related to Zero Coupon Senior Convertible Notes due 2008.	10-Q	000-22350	4.1	April 30, 2003

10.15		Form of Note for Mercury’s Zero Coupon Senior Convertible Notes due 2008.	10-Q	000-22350	4.1	April 30, 2003

10.16		Registration Rights Agreement, dated as of April 23, 2003, by and between Mercury and UBS Warburg LLC related to Zero Coupon Senior Convertible Notes due 2008.	10-Q	000-22350	4.2	April 30, 2003

10.17		Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated November 5, 2002.	10-Q	000-22350	10.1	April 30, 2003

10.18		Agreement and Plan of Merger among Freshwater Software, Inc., Mercury and Aqua Merger Company dated as of May 21, 2001.	10-Q	000-22350	10.1	August 14, 2001

10.19		Agreement and Plan of Merger dated as of June 9, 2003, among Kintana, Inc., Mercury, Kanga Merger Corporation, Kanga Acquisition L.L.C. and Raj Jain as Stockholders’ Representative.	10-Q	000-22350	10.1	August 14, 2003

10.20		Lease Agreement by and between 369 Whisman Associates, L.P. and Mercury, dated as of December 15, 2003.	10-K	000-22350	10.19	March 5, 2004

10.21	*	Mercury Long-Term Incentive Plan.	8-K	000-22350	10.1	December 21, 2004

10.22	*	401(k) Plan.	S-1	33-68554	10.12	October 29, 1993

10.23	*	Amended and Restated 1989 Stock Option Plan.	S-8	333-62125	4.1	August 24, 1998

10.24	*	1994 Directors’ Stock Option Plan and Forms of Notice of Grant and Stock Option Agreement.	S-8	33-95178	10.1	July 31, 1995

10.25	*	Amended and Restated 2000 Supplemental Stock Option Plan and Forms of Notice of Grant and Stock Option Agreement.	S-8	333-56316	4.2	February 28, 2001

10.26	*	Amended and Restated 1998 Employee Stock Purchase Plan and Form of Subscription Agreement.	S-8	333-111915	4.2	January 14, 2004

10.27	*	Amended and Restated 1999 Stock Option Plan and Forms of Notice of Grant and Stock Option Agreement.	S-8	333-111915	4.1	January 14, 2004

10.28	*	Conduct Ltd. 1998 Share Option Plan.	S-8	333-94837	4.1	January 18, 2000

10.29	*	Freshwater Software, Inc. 1997 Stock Plan.	S-8	333-61786	4.1	May 29, 2001


Exhibit Number			Incorporated by Reference
		Description	Form	File No.	Exhibit(s)	Filing Date
10.30	*	Performant, Inc. 2000 Stock Option/Restricted Stock Plan.	S-8	333-106646	4.1	June 30, 2003

10.31	*	Kintana, Inc. 1997 Equity Incentive Plan.	S-8	333-108266	4.1	August 27, 2003

10.32	*	Chain Link Technologies Limited Company Share Option Scheme.	S-8	333-108266	4.2	August 27, 2003

10.33	*	Appilog, Inc. 2003 Stock Option Plan.	S-8	333-117599	4.1	July 23, 2004

10.34	*	Letter Agreement by and between Mercury and Kenneth Klein, effective as of December 30, 2003.	10-K	000-22350	10.20	March 5, 2004

10.35	*	Employment Agreement dated December 1, 2004 by and between Mercury and Anthony Zingale.	8-K	000-22350	10.1	December 3, 2004

10.36	*	Amended and Restated Employment Agreement dated August 28, 2000 by and between Mercury and Douglas Smith.	10-K	000-22350	10.16	March 29, 2001

10.37	*	Employment Agreement dated February 11, 2005 by and between Mercury and Amnon Landan.	10-K	000-22350	10.37	March 14, 2005

10.38	*	Form of Notice of Grant and Stock Option Agreement between Mercury and Anthony Zingale.	8-K	000-22350	10.3	December 3, 2004

10.39	*	Form of Notice of Grant and Stock Option Agreement between Mercury and Amnon Landan	8-K	000-22350	10.2	February 9, 2005

10.40	*	Form of Notice of Grant and Stock Option Agreement between Mercury and Executive Officers	8-K	000-22350	10.3	February 9, 2005

10.41	*	Form of Mercury Long-Term Incentive Plan Participation Notice	8-K	000-22350	10.1	February 9, 2005

10.42	*	Amended and Restated Mercury Long-Term Incentive Plan	10-K	000-22350	10.42	March 14, 2005

10.43	*	Mercury 2005 Annual Executive Incentive Plan	10-K	000-22350	10.43	March 14, 2005

10.44		Agreement of Sublease dated February 28, 2005, by and between Netscape Communications Corporation and Mercury	10-K	000-22350	10.44	March 14, 2005

10.45	*	Change of Control Agreement, dated December 1, 2004, by and between Mercury and Anthony Zingale	8-K	000-22350	10.2	December 3, 2004

14.1	**	Code of Business Conduct and Ethics.

21.1		Subsidiaries of Mercury.	10-K	000-22350	21.1	March 14, 2005


Exhibit Number		Incorporated by Reference
Exhibit Number	Description	Form	File No.	Exhibit(s)	Filing Date

24.1‡	Power of Attorney (see page 81)

31.1‡	Certification of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2‡	Certification of the Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1†	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2†	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

*	Designates management contract or compensatory plan arrangements required to be filed as an exhibit of this amended Annual Report on Form 10-K/A.

**	See Item 10, Directors and Executive Officers of Registrant of this amended Annual Report on Form 10-K/A.

‡	Filed herewith.

†	Furnished herewith.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Mercury Interactive Corporation, a corporation organized and existing under the laws of the State of Delaware, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: July 3, 2006


MERCURY INTERACTIVE CORPORATION (Registrant)

By:		/S/ DAVID J. MURPHY
		David J. Murphy Senior Vice President and Chief Financial Officer (Principal Financial Officer)

By:		/S/ BRIAN A. STEIN
		Brian A. Stein Chief Accounting Officer (Principal Accounting Officer)

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints jointly and severally, Anthony Zingale and/or David J. Murphy and each one of them, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K/A and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.


Signature	Title	Date

/s/ ANTHONY ZINGALE Anthony Zingale	President and Chief Executive Officer (Principal Executive Officer) and Director	July 3, 2006

/s/ DAVID J. MURPHY David J. Murphy	Senior Vice President and Chief Financial Officer (Principal Financial Officer)	July 3, 2006

/s/ BRIAN A. STEIN Brian A. Stein	Chief Accounting Officer (Principal Accounting Officer)	July 3, 2006

/s/ BRAD BOSTON Brad Boston	Director	July 3, 2006

/s/ JOSEPH COSTELLO Joseph Costello	Director	July 3, 2006

/s/ STANLEY KELLER Stanley Keller	Director	July 3, 2006

/s/ IGAL KOHAVI Igal Kohavi	Director	July 3, 2006

/s/ CLYDE OSTLER Clyde Ostler	Director	July 3, 2006

/s/ YAIR SHAMIR Yair Shamir	Director	July 3, 2006

/s/ GIORA YARON Giora Yaron	Chairman of the Board of Directors	July 3, 2006

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

Mercury Interactive Corporation:

We have completed an integrated audit of Mercury Interactive Corporation’s 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements

In our opinion, the consolidated financial statements listed in the index appearing under Item 15 present fairly, in all material respects, the financial position of Mercury Interactive Corporation and its subsidiaries (the “Company”) at December 31, 2004 and December 31, 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. 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 of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 1 to the consolidated financial statements, effective October 1, 2004, the Company changed its method of accounting for contingently convertible equity securities in accordance with Emerging Issues Task Force Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings Per Share.

As discussed in Note 3 to the consolidated financial statements, the Company has restated its 2004, 2003, and 2002 consolidated financial statements.

Internal control over financial reporting

Also, we have audited management’s assessment, included in “Management’s Report on Internal Control Over Financial Reporting,” appearing under Item 9A, that Mercury Interactive Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of not maintaining (1) an effective control environment and (2) effective controls over the accounting for and disclosure of its stock-based compensation expense, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in

accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of December 31, 2004.

Control environment. The Company did not maintain an effective control environment based on criteria established in the COSO framework. Specifically, the Company did not maintain controls adequate to prevent or detect instances of intentional override or intervention of their controls or intentional misconduct by certain former members of senior management. Also, there was a lack of attention to identifying and responding to such instances. This lack of an effective control environment permitted certain former members of senior management, including Prior Management (as defined in Item 9A), to deliberately override certain controls between 1992 through March 31, 2005 resulting in certain transactions not being properly accounted for in the Company’s consolidated financial statements and contributing to the need to restate certain of the Company’s previously issued financial statements. Each of these former members of their senior management appears to have also personally benefited from these practices. In addition, the Compensation Committee of the Company’s Board of Directors mistakenly relied on certain former members of senior management to appropriately discharge the duties delegated to them. Furthermore, the Company did not adequately monitor certain of their control practices, demonstrate a commitment to integrity and objectivity and foster a consistent and open flow of information and communication between those initiating transactions and those responsible for their financial reporting. Certain former members of senior management intentionally exploited this environment as follows:

Stock-based compensation. Certain former members of senior management (including the Company’s then CEO and then CFO) intentionally deviated from the Company’s controls over the accounting for stock option transactions, which resulted in the creation of misleading accounting records. Additionally, these certain former members of senior management either knew or should have known that the vast majority of the Company’s stock options transactions occurring between January 1996 and April 2002 were not appropriately accounted for in accordance with generally accepted accounting principles.

Earnings management. Between 1997 and 2002, the Company identified several instances where certain former members of senior management (including our then CEO and then CFO) appear to have deliberately overridden controls in order to manage or influence the timing of quarter-end shipments, without public disclosure, and to influence the timing and level at which certain expense items and accruals were made in order to inappropriately achieve a desired consistency of reported financial results, without appropriate public disclosure.

Executive compensation. In 1999, a loan was made to the Company’s former CEO (which has since been repaid) that lacked appropriate documentation including approval by the Company’s Board of Directors. The aforementioned loan was referred to in several of the Company’s periodic public

disclosures but not all of its significant terms were clearly and completely disclosed. In addition, certain inappropriate expense reimbursements were made to the Company’s former CEO.

This control environment material weakness contributed to the override of controls by certain former members of senior management, which in turn resulted in the restatement of the Company’s consolidated financial statements for the years 2004, 2003, 2002, each of the quarters of 2004, and 2003, as well as the first quarter of 2005. Additionally, this control environment material weakness could result in misstatements of any of the Company’s financial statement accounts and disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, the Company’s management has determined that this control deficiency constitutes a material weakness.

The material weakness in the Company’s control environment contributed to the existence of the following additional material weakness.

Controls over stock-based compensation expense. The Company did not maintain effective controls over the accounting for and disclosure of its stock-based compensation expense. Specifically, effective controls, including monitoring, were not maintained to ensure the existence, completeness, valuation and presentation of the Company’s stock-based compensation transactions related to the granting, modifying and exercising (including in certain instances with promissory notes) of the Company’s stock options. In addition, effective controls were not maintained over the granting of stock purchase rights to employees through the Company’s Employee Stock Purchase Plan. This control deficiency resulted in the misstatement of the Company’s stock-based compensation expense and additional paid-in capital accounts and related financial disclosures, and in the restatement of the Company’s consolidated financial statements for the years 2004, 2003, 2002, each of the quarters of 2004, and 2003, as well as the first quarter of 2005. Additionally, this control deficiency could result in misstatements of the aforementioned accounts and disclosures that would result in a material misstatement of the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, the Company’s management has determined that this control deficiency constitutes a material weakness.

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.

Management and we previously concluded that the Company maintained effective internal control over financial reporting as of December 31, 2004. In connection with the restatement of the Company’s consolidated financial statements discussed in Note 3 to the consolidated financial statements, management has determined that the material weaknesses described above existed as of December 31, 2004. Accordingly, Management’s Report on Internal Control Over Financial Reporting has been restated and our present opinion on internal control over financial reporting, as presented herein, is different from that expressed in our previous report.

In our opinion, management’s assessment that Mercury Interactive Corporation did not maintain effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the COSO. Also, in our opinion, because of the effects of the material weakness described above on the achievement of the objectives of the control criteria, Mercury Interactive Corporation has not maintained effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the COSO.

/s/ PRICEWATERHOUSECOOPERS LLP

San Jose, California March 14, 2005, except for the restatement described in Note 3 to the consolidated financial statements and the matter described in the penultimate paragraph of Management’s Report on Internal Control Over Financial Reporting, as to which the date is July 3, 2006.

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)


	December 31, 2004			December 31, 2003
	(as restated) (1)			(as restated) (1)
ASSETS
Current assets:
Cash and cash equivalents	$	182,868		$	127,971
Short-term investments		447,453			589,389
Trade accounts receivable, net of sales reserve of $5,157 and $6,117, respectively		223,410			142,908
Deferred tax assets, net		3,445			442
Prepaid expenses and other assets		72,999			61,425

Total current assets		930,175			922,135
Long-term investments		508,120			516,348
Property and equipment, net		78,233			73,203
Investments in non-consolidated companies		13,031			13,928
Debt issuance costs, net		11,258			14,965
Goodwill		396,329			345,488
Intangible assets, net		38,452			45,126
Restricted cash		6,000			6,000
Interest rate swap		4,832			11,557
Long-term deferred tax assets, net		3,503			17,514
Other assets		23,548			17,456

Total assets	$	2,013,481		$	1,983,720

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	20,008		$	17,584
Accrued liabilities		143,815			103,623
Income taxes		65,114			54,451
Deferred tax liabilities, net		2			17,514
Short-term deferred revenue		311,576			213,224

Total current liabilities		540,515			406,396
Convertible notes		804,483			811,159
Long-term deferred revenue		102,205			67,909
Other long-term payables		2,386			541

Total liabilities		1,449,589			1,286,005

Commitments and contingencies (Notes 9, 10 and 19)
Stockholders’ equity
Preferred stock: par value $0.002 per share, 5,000 shares authorized; no shares issued and outstanding		—			—
Common stock: par value $0.002 per share, 560,000 shares authorized; 85,011 and 90,493 shares issued and outstanding, respectively		170			181
Additional paid-in capital		1,118,753			1,000,170
Treasury stock: at cost; 10,459 shares and 784 shares, respectively		(348,249	)		(16,082	)
Notes receivable from issuance of common stock		(5,456	)		(7,929	)
Unearned stock-based compensation		(9,822	)		(40,308	)
Accumulated other comprehensive loss		(13,182	)		(6,219	)
Accumulated deficit		(178,322	)		(232,098	)

Total stockholders’ equity		563,892			697,715

Total liabilities and stockholders’ equity	$	2,013,481		$	1,983,720

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

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

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)


	Year ended December 31,
	2004			2003			2002
	(as restated) (1)			(as restated) (1)			(as restated) (1)
Revenues:
License fees	$	261,382		$	200,839		$	192,214
Subscription fees		152,199			98,824			52,970

Total product revenues		413,581			299,663			245,184
Maintenance fees		196,215			159,023			122,262
Professional service fees		76,275			47,519			32,507

Total revenues		686,071			506,205			399,953

Costs and expenses:
Cost of license and subscription (including stock-based compensation*)		41,799			34,432			27,327
Cost of maintenance (including stock-based compensation*)		17,898			17,731			14,597
Cost of professional services (including stock-based compensation*)		63,737			40,321			25,510
Cost of revenue—amortization of intangible assets		10,019			5,189			1,833
Marketing and selling (including stock-based compensation*)		335,867			303,865			216,546
Research and development (including stock-based compensation*)		82,122			73,096			51,197
General and administrative (including stock-based compensation*)		63,802			55,904			30,914
Acquisition-related expenses		900			11,968			—
Restructuring, integration, and other related expenses		3,088			3,389			(537	)
Amortization of intangible assets		5,544			2,281			542
Excess facilities expense		8,943			16,882			—

Total costs and expenses		633,719			565,058			367,929

Income (loss) from operations		52,352			(58,853	)		32,024
Interest income		38,210			34,399			34,941
Interest expense		(24,627	)		(22,824	)		(24,994	)
Other income (expense), net		(1,261	)		(4,907	)		4,308

Income (loss) before provision for income taxes		64,674			(52,185	)		46,279
Provision for income taxes		10,898			10,401			9,219

Net income (loss)	$	53,776		$	(62,586	)	$	37,060

Net income (loss) per share—basic	$	0.61		$	(0.72	)	$	0.45

Net income (loss) per share—diluted	$	0.53		$	(0.72	)	$	0.42

Weighted average common shares—basic		87,668			86,609			82,712

Weighted average common shares and equivalents—diluted		103,237			86,609			87,214

* Stock-based compensation:
Cost of license and subscription	$	1,201		$	5,073		$	2,517
Cost of maintenance		1,725			5,433			2,926
Cost of professional services		798			3,180			1,174
Marketing and selling		16,305			60,425			22,736
Research and development		8,199			16,404			9,906
General and administrative		6,232			15,148			(850	)

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

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

Mercury Interactive Corporation

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

(in thousands)

(as restated) (1)


	Common stock				Additional paid-in Capital			Treasury stock			Notes receivable from issuance of common stock			Unearned stock-based compensation			Accumulated other comprehensive loss			Retained earnings/ (Accumulated deficit)			Total stockholders’ equity			Comprehensive income (loss)
	Shares		Amount		Additional paid-in Capital			Treasury stock			Notes receivable from issuance of common stock			Unearned stock-based compensation			Accumulated other comprehensive loss			Retained earnings/ (Accumulated deficit)			Total stockholders’ equity			Comprehensive income (loss)
Balance at December 31, 2001—as previously reported	82,849		$	166	$	232,750		$	(16,082	)	$	(11,164	)	$	(4,795	)	$	(2,265	)	$	155,735		$	354,345
Adjustment to opening stockholders’ equity	(8	)		—		494,466			—			(904	)		(132,336	)		—			(362,307	)		(1,081	)

Balance at December 31, 2001—as restated, see Note 3	82,841			166		727,216			(16,082	)		(12,068	)		(137,131	)		(2,265	)		(206,572	)		353,264
Unearned stock-based compensation	—			—		4,010			—			—			(4,010	)		—			—			—
Amortization of stock based compensation expense	—			—		—			—			—			36,891			—			—			36,891
Stock-based compensation expense	—			—		1,518			—			—			—			—			—			1,518
Reversal of unearned stock-based compensation	—			—		(15,410	)		—			—			15,410			—			—			—
Collection of notes receivable	—			—		—			—			879			—			—			—			879
Interest on notes receivable	—			—		638			—			(191	)		—			—			—			447
Stock issued under stock option and employee stock purchase plans	1,875			4		23,803			—			(769	)		—			—			—			23,038
Currency translation adjustments	—			—		—			—			—			—			540			—			540		$	540
Net income	—			—		—			—			—			—			—			37,060			37,060			37,060

Balance at December 31, 2002—as restated, see Note 3	84,716			170		741,775			(16,082	)		(12,149	)		(88,840	)		(1,725	)		(169,512	)		453,637		$	37,600

Unearned stock-based compensation	—			—		49,317			—			—			(49,317	)		—			—			—
Amortization of stock based compensation expense	—			—		—			—			—			90,995			—			—			90,995
Stock-based compensation expense	—			—		14,668			—			—			—			—			—			14,668
Reversal of unearned stock-based compensation	—			—		(8,425	)		—			—			8,425			—			—			—
Collection of notes receivable	—			—		—			—			4,186			—			—			—			4,186
Repurchase of shares upon cancellation of notes receivable	(20	)		—		(289	)		—			289			—			—			—			—
Interest on notes receivable	—			—		(100	)		—			(255	)		—			—			—			(355	)
Stock options assumed in conjunction with acquisitions	—			—		39,923			—			—			(1,571	)		—			—			38,352
Issuance of stock in conjunction with acquisitions	2,237			4		88,529			—			—			—			—			—			88,533
Stock issued under stock option and employee stock purchase plans	3,560			7		74,772			—			—			—			—			—			74,779
Currency translation adjustments	—			—		—			—			—			—			(4,494	)		—			(4,494	)	$	(4,494	)
Net loss	—			—		—			—			—			—			—			(62,586	)		(62,586	)		(62,586	)

Balance at December 31, 2003—as restated, see Note 3	90,493			181		1,000,170			(16,082	)		(7,929	)		(40,308	)		(6,219	)		(232,098	)		697,715		$	(67,080	)

Mercury Interactive Corporation

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY—(Continued)

(in thousands)

(as restated) (1)


	Common stock					Additional paid-in Capital			Treasury stock			Notes receivable from issuance of common stock			Unearned stock-based compensation			Accumulated other comprehensive loss			Retained earnings/ (Accumulated deficit)			Total stockholders’ equity			Comprehensive income (loss)
	Shares		Amount			Additional paid-in Capital			Treasury stock			Notes receivable from issuance of common stock			Unearned stock-based compensation			Accumulated other comprehensive loss			Retained earnings/ (Accumulated deficit)			Total stockholders’ equity			Comprehensive income (loss)
Unearned stock-based compensation	—			—			(7,073	)		—			—			7,073			—			—			—
Amortization of stock based compensation expense	—			—			—			—			—			18,454			—			—			18,454
Stock-based compensation expense	—			—			16,006			—			—			—			—			—			16,006
Reversal of unearned stock-based compensation	—			—			(4,959	)		—			—			4,959			—			—			—
Tax benefit from stock options	—			—			339			—			—			—			—			—			339
Collection of notes receivable	—			—			—			—			1,689			—			—			—			1,689
Repurchase of shares upon cancellation of notes receivable	(3	)		—			(718	)		—			718			—			—			—			—
Interest on notes receivable	—			—			304			—			66			—			—			—			370
Purchase of treasury stock	(9,675	)		(19	)		—			(332,167	)		—			—			—			—			(332,186	)
Stock options assumed in conjunction with acquisition	—			—			10,401			—			—			—			—			—			10,401
Stock issued under stock option and employee stock purchase plans	4,196			8			104,283			—			—			—			—			—			104,291
Currency translation adjustments	—			—			—			—			—			—			(6,963	)		—			(6,963	)	$	(6,963	)
Net income	—			—			—			—			—			—			—			53,776			53,776			53,776

Balance at December 31, 2004—as restated, see Note 3	85,011		$	170		$	1,118,753		$	(348,249	)	$	(5,456	)	$	(9,822	)	$	(13,182	)	$	(178,322	)	$	563,892		$	46,813

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

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

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)


	Year ended December 31,
	2004			2003			2002
	(as restated) (1)			(as restated) (1)			(as restated) (1)
Cash flows from operating activities:
Net income (loss)	$	53,776		$	(62,586	)	$	37,060
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		21,691			17,869			14,704
Sales reserve		1,873			1,193			3,342
Unrealized (gain) loss on interest rate swap		51			8			(406	)
Amortization of intangible assets		15,563			7,470			2,375
Stock-based compensation		34,460			105,663			38,409
Gain on early retirement of debt		—			—			(11,610	)
Loss on investments in non-consolidated companies		1,138			3,959			5,296
Loss on disposals of assets		642			—			—
Gain on sale of available-for-sale securities		(336	)		—			—
Unrealized gain on warrant		(502	)		(435	)		—
Write-off of in-process research and development		900			11,968			—
Excess facilities expense		8,943			16,882			—
Tax benefit from employee stock options		339			—			—
Deferred income taxes		(6,504	)		1,928			—
Changes in assets and liabilities, net of effect of acquisitions:
Trade accounts receivable		(76,186	)		(40,878	)		(27,698	)
Prepaid expenses and other assets		(13,617	)		(18,309	)		(4,614	)
Accounts payable		1,152			3,167			(451	)
Accrued liabilities		30,975			20,018			9,912
Income taxes		10,645			201			825
Deferred revenue		125,579			112,212			64,581
Other long-term payables		1,845			541			—

Net cash provided by operating activities		212,427			180,871			131,725

Cash flows from investing activities:
Maturities of investments		544,135			453,142			382,261
Purchases of held-to-maturity investments		(481,887	)		(809,395	)		(303,427	)
Increase in restricted cash		—			—			(6,000	)
Proceeds from sale of available-for-sale investments		1,124,255			1,498,549			637,635
Purchases of available-for-sale investments		(1,034,438	)		(1,687,095	)		(871,973	)
Proceeds from return on investment in non-consolidated company		1,525			—			—
Purchases of investments in non-consolidated companies		(2,625	)		(1,500	)		(2,244	)
Cash paid in conjunction with the acquisition of Performant, net		—			(22,028	)		—
Cash paid in conjunction with the acquisition of Kintana, net		(163	)		(136,653	)		—
Cash paid in conjunction with a technology purchase from Allerez		—			(1,270	)		—
Cash paid in conjunction with a domain name purchase		—			(650	)		—
Cash paid in conjunction with the acquisition of Appilog, net		(49,543	)		—			—
Net proceeds from sale of assets and vacant facilities		2,684			—			—
Acquisition of property and equipment, net		(32,684	)		(17,093	)		(8,164	)

Net cash provided by (used in) investing activities		71,259			(723,993	)		(171,912	)

Cash flows from financing activities:
Proceeds from issuances of convertible notes, net		—			488,056			—
Proceeds from issuances of common stock under stock option and employee stock purchase plans		103,981			74,779			23,038
Purchase of treasury stock		(332,186	)		—			—
Retirement of convertible subordinated notes		—			—			(64,640	)
Collection of notes receivable from issuance of common stock, net of tax		2,059			3,830			1,326

Net cash provided by (used in) financing activities		(226,146	)		566,665			(40,276	)

Effect of exchange rate changes on cash		(2,643	)		(194	)		1,287

Net increase (decrease) in cash and cash equivalents		54,897			23,349			(79,176	)
Cash and cash equivalents at beginning of year		127,971			104,622			183,798

Cash and cash equivalents at end of year	$	182,868		$	127,971		$	104,622

(1)	See Note 3, “Restatement of Consolidated Financial Statements,” of the Notes to Consolidated Financial Statements.

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

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—OUR SIGNIFICANT ACCOUNTING POLICIES

We were incorporated in 1989 and began shipping testing products in 1991. Since 1991, we have introduced a variety of software products and services for Business Technology Optimization (BTO) including application delivery and application management. With our acquisition of Kintana in August 2003, we commenced sales of Information Technology (IT) governance products. Our software products and services for BTO help customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance.

In July 2004, we acquired Appilog, Inc. In May and August of 2003, we acquired Performant, Inc. and Kintana, Inc., respectively. These transactions were accounted for as purchases, and accordingly, the operating results of Performant, Kintana, and Appilog have been included in our consolidated financial statements since the dates of the acquisition. See Note 6 for a full description of the acquisitions.

Basis of presentation

We have wholly-owned sales subsidiaries in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan for marketing, distribution and support of products and services. The Americas includes Brazil, Canada, Mexico, and the United States of America (the U.S.). EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, Poland, South Africa, Spain, Sweden, Switzerland, and the United Kingdom (the U.K.). APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. Research and development activities are primarily conducted in our Israeli subsidiary. The consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated.

Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. 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 financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Foreign currency translation

In preparing our consolidated financial statements, we are required to translate the financial statements of the foreign subsidiaries from the functional currency, generally the local currency, into U.S. dollars, the reporting currency. This process results in exchange gains or losses which, under the relevant accounting guidance, are either included within the consolidated statements of operations or as a separate component of stockholders’ equity under the caption “Accumulated other comprehensive loss”. If any subsidiary’s functional currency is deemed to be the local currency, then any gain or loss associated with the translation of that subsidiary’s financial statements is reflected as cumulative translation adjustments included in accumulated other comprehensive income (loss). However, if the functional currency is deemed to be the U.S. dollar, any gain or loss associated with the translation of these financial statements is recorded as “Other income (expense), net” in our consolidated statements of operations.

The functional currency of our subsidiary in Israel is the U.S. dollar. Assets and liabilities in Israel are translated at year-end exchange rates, except for property and equipment, which is translated at historical rates. Revenues and expenses are translated at average exchange rates in effect during the year. Foreign currency translation gains or losses are included in the consolidated statements of operations. See Note 2 for foreign currency translation gains or losses recognized in 2004, 2003, and 2002.

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The functional currencies of all other subsidiaries are the local currencies. Accordingly, all assets and liabilities of these subsidiaries are translated at the current exchange rate at the end of the period and revenues and expenses at average exchange rates in effect during the period. The gains or losses from translation of these subsidiaries’ financial statements are recorded as accumulated other comprehensive income or loss and included as a separate component of stockholders’ equity.

Derivative financial instruments

We enter into derivative financial instrument contracts to hedge certain foreign exchange and interest rate exposures in accordance with Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities and SFAS No. 149, Amendment of Statement 133 on Derivative Instruments Hedging Activities.

Under SFAS No. 133, as amended, we are required to recognize all derivatives on the consolidated balance sheets at fair value. Derivatives that are not hedges must be adjusted to fair value through the consolidated statements of operations. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings, or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The accounting for gains or losses from changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, as well as on the type of hedging relationship. See Note 14 for a full description of our derivative financial instruments and related accounting policies.

Cash and cash equivalents

We consider all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.

Short-term and long-term investments

We have categorized our debt securities as either held to maturity or available-for-sale securities in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. We classify all held-to-maturity securities with remaining maturities of less than one year as short-term investments and all held-to-maturity securities with remaining maturities greater than one year as long-term investments. As required by our policy, debt securities categorized as held-to-maturity have contractual maturities of less than three years, and are carried on our consolidated balance sheets at amortized cost. We categorize auction rate securities as available-for-sale short-term investments. Auction rate securities are reported on our consolidated balance sheets at cost, which approximates fair market value due to the interest rate reset feature of these securities. As such, no unrealized gains or losses related to these securities were recognized during the years ended December 31, 2004, 2003, and 2002. Gross realized gains and losses on sales of available-for-sale debt securities were not material for the years ended December 31, 2004, 2003, and 2002. The cost basis of securities sold is based on the specific identification method. See “Reclassifications” in Note 1 for information regarding prior period adjustments to the classification of auction rate securities.

We review our investments in debt securities for potential impairment on a regular basis. As part of the review process, we consider the credit ratings of these securities and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated improvement of the investee’s financial condition. We will record an impairment loss on investments for any other-than-temporary decline in fair value of these debt

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

securities below their cost basis. For the years ended December 31, 2004, 2003, and 2002, we did not record any impairment losses that were related to other-than-temporary declines in the fair value of our debt securities. At December 31, 2004, we did not record any unrealized losses on our debt securities related to an impairment determined to be temporary.

Marketable equity securities are classified as available-for-sale and are reported at fair value, based on quoted market prices, with unrealized gains or losses, net of tax, recorded as a component of “Accumulated other comprehensive income or loss” in our consolidated statements of stockholders’ equity. The cost basis of securities sold is based on the specific identification method. We evaluate whether or not any of our marketable equity securities has experienced an other-than-temporary decline in fair value on a regular basis. As part of the evaluation process, we consider factors such as earnings/revenue outlook, operational performance, management/ownership changes, competition, and stock price performance. If we determine that a decline in fair value of a marketable equity security below carrying value is other-than-temporary, it is our policy to record a loss on investment in our consolidated statements of operations and write down the marketable equity security to its fair value. Gains are recognized in our consolidated statements of operations when such gains are realized. At December 31, 2004 and 2003, we did not have any investments in marketable equity securities.

The portfolio of short-term and long-term investments (including cash and cash equivalents) consisted of the following (in thousands):


	December 31,
Available-for-Sale Securities	2004		2003
Auction rate securities	$	371,001	$	519,959


Held-to-Maturity Securities
Cash and interest bearing demand deposits	$	107,589	$	113,670
Corporate debt securities		127,626		121,489
Municipal and tax-advantaged securities		—		3,000
U.S. treasury and agency securities		532,225		475,590

	$	767,440	$	713,749

Investments in marketable securities	$	1,138,441	$	1,233,708

The portfolio of short-term and long-term investments (including a cash balance of $74.0 million) by their contractual maturities as of December 31, 2004 was included in the following captions in the consolidated balance sheet (in thousands):


Available-for-Sale Securities	December 31,								Fair Value
Available-for-Sale Securities	2005		2006		2007 and thereafter		Total		Fair Value
Investments	$	255,876	$	—	$	115,125	$	371,001	$	371,001


Held-to-Maturity Securities
Cash and cash equivalents	$	182,868	$	—	$	—	$	182,868	$	182,863
Investments		76,452		223,576		284,544		584,572		581,733

	$	259,320	$	223,576	$	284,544	$	767,440	$	764,596

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Concentration of credit risks

Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of cash, cash equivalents, investments, and accounts receivable. We invest primarily in marketable securities and place our investments with high quality financial, government, or corporate institutions. Accounts receivable are derived from sales to customers located primarily in the U.S., EMEA, and APAC. We perform ongoing credit evaluations of our customers and to date have not experienced any material losses. For the years ended December 31, 2004, 2003, and 2002, no single customer accounted for more than 10% of revenue.

Fair value of financial instruments

The carrying amount of our financial instruments, including cash, cash equivalents, investments, accounts receivable, and accounts payable approximates their respective fair values due to the short maturities of these financial instruments. The fair value of foreign currency forward contracts has been estimated using market quoted rates of foreign currencies at the applicable balance sheet dates. The value of the interest rate swap is determined using various inputs, including forward interest rates and time to maturity. Warrants are valued using the Black-Scholes option-pricing model.

The fair market value of our 4.75% Convertible Subordinated Notes due July 1, 2007 issued in 2000 (2000 Notes) was $301.5 million and $297.4 million at December 31, 2004 and 2003, respectively, based on the quoted market price. The fair market value of our Zero Coupon Senior Convertible Notes due 2008 issued in 2003 (2003 Notes) was $525.2 million and $574.5 million at December 31, 2004 and 2003, respectively, based on the quoted market price.

Property and equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation and amortization are provided using the straight-line method over the estimated economic lives of assets, which are five to seven years for office furniture and equipment, two to three years for computers and related equipment, three years for internal use software, ten years for building improvements, and thirty years for buildings. Leasehold improvements are depreciated using the straight-line method over the estimated economic lives or the remaining lease terms, whichever is shorter.

Internal use software

We recognize software development costs in accordance with the Statement of Position (SOP) No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Software development costs, including costs incurred to purchase third party software, are capitalized beginning when we have determined certain factors are present including, among others, that technology exists to achieve the performance requirements, and/or buy versus internal development decisions have been made. Capitalization of software costs ceases when the software is substantially complete, is ready for its intended use, and is amortized over its estimated useful life of generally three years using the straight-line method. At December 31, 2004 and 2003, we have capitalized internal use software of $24.9 million and $16.2 million, respectively. For the years ended December 31, 2004, 2003, and 2002, we incurred amortization expense of $4.8 million, $2.8 million, and $1.9 million, respectively.

When events or circumstances indicate the carrying value of internal use software might not be recoverable, we assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

flows and is recognized as a write down of the asset. In addition, when it is no longer probable that computer software being developed will be placed in service, the asset will be recorded at the lower of its carrying value or fair value, if any, less direct selling costs. We did not write down any internal use software during the years ended December 31, 2004, 2003, and 2002.

Software costs

We account for research and development costs in accordance with SFAS No. 86, Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed. Costs incurred in the research and development of new software products are expensed as incurred until technological feasibility is established. Development costs are capitalized beginning when a product’s technological feasibility has been established and ending when the product is available for general release to customers. Technological feasibility is reached when the product reaches the working model stage. To date, products and enhancements have generally reached technological feasibility and have been released for sale at substantially the same time and all research and development costs have been expensed. Consequently, no research and development costs have been capitalized in 2004, 2003, and 2002.

Investments in non-consolidated companies

Investments in non-consolidated companies consist of a warrant to purchase common stock of a publicly traded company, minority equity investments in privately-held companies, and private equity funds. We make these investments for business and strategic purposes. Investments in privately-held companies and private equity funds are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We record the warrant at its fair value at each reporting date using Black-Scholes option-pricing model because it is considered a derivative instrument under SFAS No. 133. We periodically monitor our investments for impairment and will record reductions in carrying values for investments in privately-held companies and private equity funds, if and when necessary. The evaluation process is based on information that we request from these privately-held companies. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above its estimated fair value, or if a company has completed a financing with new third-party investors based on a valuation significantly lower than the carrying value of our investment and the decline is deemed to be other-than-temporary, it is our policy to record a loss on investment in our consolidated statements of operations. In calculating the loss on our investments, we consider the most recent valuation of each of the companies based on recent sales of equity securities to unrelated third party investors and whether the companies have sufficient funds and financing to continue as a going concern for at least twelve months.

Consolidation of variable interest entities

In January 2003, the Financial Accounting Standard Board (FASB) issued FASB Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51, which relates to the identification of and financial reporting for variable-interest entities. FIN No. 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities, and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. The provisions of FIN No. 46 are effective immediately for all arrangements entered into after January 31, 2003. For those arrangements entered into prior to February 1, 2003, the provisions of FIN No. 46 are required to

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

be adopted at the beginning of the first interim or annual period beginning after June 15, 2003. In December 2003, the FASB issued FIN No. 46(R). The FASB deferred the effective date for variable interest entities that are non-special purpose entities created before February 1, 2003, to the first interim or annual reporting period that ends after March 15, 2004. The adoption of FIN No. 46(R) did not have a material effect on our financial position or results of operations.

Goodwill

Goodwill represents the excess of the purchase price over the fair value of tangible and intangible assets acquired in an acquisition. In January 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets, and as a result, we ceased to amortize goodwill and reclassified certain intangible assets to goodwill. We are also required to perform an impairment review of goodwill on an annual basis or more frequently if circumstances change.

The impairment review involves a two-step process as follows:

•

Step 1—We compare the fair value of our reporting units to the carrying value, including goodwill of each of these units. For each reporting unit where the carrying value, including goodwill, exceeded the unit’s fair value, we move on to Step 2. If the unit’s fair value exceeds the carrying value, no further work would be performed and no impairment expense would be necessary.

•

Step 2—If we determine in Step 1 that the carrying value of a reporting unit exceeded our fair value, we would perform an allocation of the fair value of the reporting unit to our identifiable tangible and non-goodwill intangible assets and liabilities. This would derive an implied fair value for the reporting unit’s goodwill. We would then compare the implied fair value of the reporting unit’s goodwill with the carrying amount of the reporting unit’s goodwill. If the carrying amount of the reporting unit’s goodwill is greater than the implied fair value of our goodwill, an impairment loss would be recognized for the excess.

Intangible assets

Intangible assets, including purchased technology and other intangible assets, are carried at cost less accumulated amortization. We amortize intangible assets on a straight-line basis over their estimated useful lives. The range of estimated useful lives for our identifiable intangible assets is three months to six years.

Impairment of long-lived assets

We assess the recoverability of long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The impairment of long-lived assets held for sale is measured at the lower of book value or fair value less cost to sell. The recoverability of long-lived assets held and used is assessed based on the carrying amount of the asset and its fair value, which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisal in certain instances. Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction.

We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

•

a significant decrease in the market price of a long-lived asset (asset group);

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

•

a significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;

•

a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;

•

an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group);

•

a current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

See Note 4 for excess facilities expenses recorded during the years ended December 31, 2004 and 2003. No excess facilities expense was recorded in the year ended December 31, 2002.

Income taxes

We account for income taxes in accordance with the liability method of accounting for income taxes. Under the liability method, deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. The provision for income taxes is comprised of the current tax liability and the change in deferred tax assets and liabilities. We have recorded a valuation allowance for the entire portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options.

Treasury stock

We account for treasury stock under the cost method. To date, we have not reissued or retired our treasury stock.

Stock-based compensation

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

award on that date. No compensation expense is recognized if the grant recipient’s exercise price equals the fair market value of our common stock on the date of grant. Stock compensation expense will be recognized over the vesting period using the ratable method, whereby an equal amount of expense is recognized for each year of vesting.

Promissory notes used in the past to exercise stock options are non-recourse in nature, and therefore we account for such transactions in accordance with Emerging Issues Task Force Consensus No. 95-16, “Accounting for Stock Compensation Arrangements with Employer Loan F

MERCURY INTERACTIVE CORP 10-K/A