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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2003

OR

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

For the Transition Period from ______ to_____

Commission File No. 0-17948

ELECTRONIC ARTS INC.

(650) 628-1500

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [x] NO [  ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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ELECTRONIC ARTS INC.
FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 2003

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PART I — FINANCIAL INFORMATION

Item 1. Unaudited Condensed Consolidated Financial Statements

ELECTRONIC ARTS INC. AND SUBSIDIARIES

See accompanying Notes to Condensed Consolidated Financial Statements.

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ELECTRONIC ARTS INC. AND SUBSIDIARIES

See accompanying Notes to Condensed Consolidated Financial Statements.

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ELECTRONIC ARTS INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

See accompanying Notes to Condensed Consolidated Financial Statements.

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ELECTRONIC ARTS INC. AND SUBSIDIARIES

(1) BASIS OF PRESENTATION

The Condensed Consolidated Financial Statements are unaudited and reflect all adjustments (consisting only of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the current interim periods are not necessarily indicative of results to be expected for the current year or any other period. Certain prior year amounts have been reclassified to conform to the fiscal 2004 presentation.

These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Electronic Arts Inc. (“EA”) Annual Report on Form 10-K for the fiscal year ended March 31, 2003 as filed with the Securities and Exchange Commission on June 10, 2003.

On October 20, 2003 EA’s Board of Directors authorized a two-for-one stock split of its Class A common stock which will be distributed on or about November 17, 2003 in the form of a stock dividend for shareholders of record at the close of business on November 3, 2003. All issued and outstanding share and per share amounts related to EA’s Class A common stock in the accompanying Condensed Consolidated Financial Statements and Notes thereto have been restated to reflect the stock split for all periods presented.

(2) FISCAL YEAR AND FISCAL QUARTER

EA’s fiscal year is reported on a 52/53-week period that ends on the final Saturday of March in each year. The results of operations for fiscal 2004 and 2003 contain 52 weeks. The results of operations for the fiscal quarters ended September 30, 2003 and September 30, 2002 each contain 13 weeks ending on September 27, 2003 and September 28, 2002, respectively. For simplicity of presentation, all fiscal periods are treated as ending on a calendar month end.

(3) STOCK

Tracking Stock

On March 22, 2000, the stockholders of EA authorized the issuance of a new series of common stock, designated as Class B common stock (“Tracking Stock”). The Tracking Stock was intended to reflect the performance of the EA.com business segment. As a result of the approval of the Tracking Stock Proposal, EA’s existing common stock was re-classified as Class A common stock and was intended to reflect the performance of the EA core business segment (see discussion in Note 8 of the Notes to Condensed Consolidated Financial Statements). With the authorization of the Class B common stock, EA transferred a portion of its consolidated assets, liabilities, revenue, expenses and cash flows to EA.com Inc., a wholly owned subsidiary of EA.

In March 2003, EA consolidated the operations of the EA.com business segment into EA’s core operations in order to increase efficiency, simplify EA’s reporting structure and more directly integrate EA’s online activities into its core console and PC business. As a result, EA has eliminated dual class reporting starting in fiscal 2004. The majority of outstanding Class B options and warrants not directly held by EA have been acquired or converted to Class A shares and warrants.

EA does not intend to issue additional Class B common stock, stock options or warrants to purchase Class B common stock. No further options are available for grant under EA’s Class B Equity Incentive Plan, and EA is currently in the process of repurchasing the remaining outstanding Class B shares acquired pursuant to the Class B Equity Incentive Plan.

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Stock Based Compensation

EA accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” and related interpretations. EA has adopted the disclosure-only provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”.

In fiscal 2003, EA adopted the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an Amendment of FASB Statement No. 123”, which provides alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. The Statement also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the methods used on reported results.

Had compensation cost for EA’s stock option plans and employee stock purchase plans been determined based on the estimated fair value at the grant dates in accordance with the provisions of SFAS No. 123, EA’s reported net income and net earnings per share would have been the amounts indicated below. The estimated fair value of each option grant is determined on the date of grant using the Black-Scholes option-pricing model.

The following weighted-average assumptions are used for grants made under the stock plans:

EA’s calculations are based on a multiple option valuation approach and forfeitures are recognized when they occur.

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During the three and six month periods ended September 30, 2003 and 2002, compensation cost for EA’s Class B stock option plans, based on the estimated fair value at the grant dates in accordance with the provisions of SFAS No. 123, would not have had a material impact on EA’s reported net income and net earnings per share.

At EA’s Annual Meeting of Stockholders, held on July 31, 2003, the stockholders elected (i) to amend the 2000 Equity Incentive Plan to increase by 11,000,000 the number of shares of EA’s Class A common stock reserved for issuance under the Plan and (ii) to amend the 2000 Employee Stock Purchase Plan to increase by 300,000 the number of shares of EA’s Class A common stock reserved for issuance under the Plan.

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(4) GOODWILL AND OTHER INTANGIBLE ASSETS, NET

During the six months ended September 30, 2003, EA recorded an additional $1.2 million of goodwill as a result of EA’s acquisition of Square Co., Ltd.’s (“Square”) 30 percent interest in Electronic Arts Square K.K. in May 2003. See Note 13 of the Notes to Condensed Consolidated Financial Statements for further discussion on the Square joint venture termination. Goodwill information is as follows (in thousands):

Other intangibles consisted of the following (in thousands):

Amortization expense for the three and six months ended September 30, 2003 was $0.8 million and $1.5 million, respectively. Amortization expense for the three and six months ended September 30, 2002 was $2.2 million and $4.5 million, respectively. Other intangible assets are amortized using the straight-line method over the lesser of their estimated useful lives or the agreement terms, typically from two to twelve years.

As of September 30, 2003, future intangible asset amortization expense is estimated as follows (in thousands):

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(5) PREPAID ROYALTIES, NET

Royalty advances are classified as current and non-current assets based upon estimated net product sales for the following year. The current portion of prepaid royalties, included in Other current assets, and the long-term portion, included in Other assets, is as follows (in thousands):

(6) INVENTORIES, NET

Inventories, net are stated at the lower of cost (first-in, first-out method) or market. Inventories, net at September 30, 2003 and March 31, 2003 consisted of (in thousands):

(7) ACCRUED AND OTHER LIABILITIES

Accrued and other liabilities at September 30, 2003 and March 31, 2003 consisted of (in thousands):

(8) SEGMENT INFORMATION

SFAS No. 131, “Disclosures About Segments of An Enterprise And Related Information”, establishes standards for the reporting by public business enterprises of information about operating segments, product lines, geographic areas and major customers. The method for determining what information to report is based on the way that management organizes the operating segments within the business enterprise for making operational decisions and assessments of financial performance.

EA’s Chief Operating Decision Maker is considered to be EA’s Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about net revenue by geographic region and by product lines for purposes of making operating decisions and assessing financial performance.

In fiscal 2003, EA operated and reviewed its business in two business segments:

•

EA Core business segment: creation, marketing and distribution of interactive entertainment software.

•

EA.com business segment: creation, marketing and distribution of interactive entertainment software which can be played or sold online, ongoing management of subscriptions of online games and website advertising.

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In March 2003, EA consolidated the operations of the EA.com business segment into its core business. EA considers online functionality to be integral to its existing and future products. Accordingly, beginning April 1, 2003, EA no longer manages its online products and services as a separate business segment, and has consolidated the reporting related to its online products and services into reporting for the overall development and publication of its core products for all reporting periods ending after that date. EA believes that this better reflects the way in which its Chief Operating Decision Maker reviews and manages the business and reflects the importance of the online products and services relative to the rest of the business. Concurrently, EA also eliminated separate reporting for its Class B common stock for all reporting periods ending after April 1, 2003.

Information about EA’s operations in North America and foreign areas for the three and six months ended September 30, 2003 and 2002 is presented below (in thousands):

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EA’s sales to Wal-mart Stores represented 15 and 14 percent of total net revenue for the three and six months ended September 30, 2003, respectively. EA’s sales to Wal-mart Stores represented 17 and 14 percent of total net revenue for the three and six months ended September 30, 2002, respectively.

Information about EA’s net revenue by product line for the three and six months ended September 30, 2003 and 2002 is presented below (in thousands):

(9) COMPREHENSIVE INCOME

SFAS No. 130, “Reporting Comprehensive Income”, requires classification of other comprehensive income in a financial statement and display of other comprehensive income separately from retained earnings and additional paid-in capital. Other comprehensive income primarily includes foreign currency translation adjustments and unrealized gains (losses) on investments.

The components of comprehensive income, net of tax, for the three and six months ended September 30, 2003 and 2002 are summarized as follows (in thousands):

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(10) NET EARNINGS (LOSS) PER SHARE

The following summarizes the computations of Basic Earnings Per Share (“EPS”) and Diluted EPS. Basic EPS is computed as net earnings divided by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur from common shares issuable through stock-based compensation plans including stock options, restricted stock awards, warrants and other convertible securities using the treasury stock method.

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Excluded from the above computation of weighted-average shares for Class A Diluted EPS for the three and six months ended September 30, 2003, were options to purchase 339,000 and 574,000 shares, respectively, as the options’ exercise prices were greater than the average market price of the common shares during the respective periods. For the three and six months ended September 30, 2003, the weighted-average exercise prices of these options were $44.49 and $40.78 per share, respectively.

Excluded from the above computation of weighted-average shares for Class A Diluted EPS for the three and six months ended September 30, 2002, were options to purchase 697,000 and 462,000 shares, respectively, as the options’ exercise prices were greater than the average market price of the common shares during the respective periods. For the three and six months ended September 30, 2002, the weighted-average exercise prices of these options were $31.87 and $31.72 per share, respectively.

For the three and six months ended September 30, 2002, the Diluted EPS calculation for Class A common stock, presented above, included the potential dilution from the conversion of Class B common stock to Class A common stock in the event that the initial public offering for Class B common stock did not occur. Net income used for the calculation of Diluted EPS for Class A common stock was $50.2 million for the three months ended September 30, 2002 and $57.6 million for the six months ended September 30, 2002. This net income included the remaining interest in EA.com, which was directly attributable to outstanding Class B common stock owned by third parties, and would have been included in the Class A common stock EPS calculation in the event that the initial public offering for Class B common stock did not occur. The remaining interest in EA.com was approximately 15 percent through August 2002, 12 percent through February 2003 and one percent through March 2003.

Due to the net loss attributable for the three and six months ended September 30, 2002 on a diluted basis to Class B common stock, stock options have been excluded from the Diluted EPS calculation as their inclusion would have been antidilutive. Had net income been reported for the three and six months ended September 30, 2002, an additional 226,000 and 422,000 shares, respectively, would have been added to diluted potential common shares for Class B common stock.

(11) RESTRUCTURING AND ASSET IMPAIRMENT CHARGES

2003 Studio Restructuring

During the third quarter of fiscal 2003, EA closed its office located in San Francisco, California and its studio located in Seattle, Washington. The office and studio closures were a result of EA’s strategic decision to consolidate local development efforts in Redwood City, California and Vancouver, British Columbia, Canada. EA recorded total pre-tax charges of $9.4 million, consisting of $7.3 million for consolidation of facilities, $1.5 million for the impairment

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of non-current assets and $0.6 million for workforce reductions. The facilities charge was net of a reduction in deferred rent of $0.5 million.

Additionally, during the fourth quarter of fiscal 2003, EA approved a plan to consolidate its Los Angeles, California, Irvine, California and Las Vegas, Nevada, studios into one major game studio in Los Angeles. These measures were taken in order to maximize efficiencies and streamline the creative development process and operations of EA’s studios. In connection with these consolidation activities, EA recorded a total pre-tax restructuring charge of $5.1 million, including $1.6 million for the shutdown of facilities related to non-cancelable lease payments for permanently vacated properties and associated costs, $2.0 million for the impairment of abandoned equipment and leasehold improvements at facilities that were permanently vacated and $1.5 million for employee severance expenses related to involuntary terminations.

Online Restructurings

Fiscal 2003 Restructuring
In March 2003, EA consolidated the operations of the EA.com business segment into its core business segment, and eliminated separate reporting for its Class B common stock for all reporting periods after fiscal 2003. During the fourth quarter of fiscal 2003, EA recorded restructuring charges of $67.0 million, consisting of $1.8 million for workforce reductions, $2.3 million for consolidation of facilities and other administrative charges, and $62.9 million for the impairment of non-current assets. The estimated costs for workforce reduction included severance charges for terminated employees, costs for certain outplacement service contracts and costs associated with the tender offer to retire employee Class B options. The consolidation of facilities resulted in the closure of EA.com’s Chicago, Illinois, and Charlottesville, Virginia facilities and an adjustment for the closure of EA.com’s San Diego, California studio in fiscal 2002.

The impairment charges on long-lived assets of $62.9 million included $24.9 million relating to customized internal-use software systems for the EA.com infrastructure, $25.6 million for other long-lived assets and $12.4 million of finite-lived intangibles relating to EA.com’s Kesmai and Pogo studios. The fair-value-based tests performed in accordance with EA’s annual procedures did not indicate an impairment of the recorded goodwill at the EA.com reporting unit level.

Fiscal 2002 Restructuring
In October 2001, EA announced a restructuring plan for the EA.com business segment. The restructuring initiatives involved strategic decisions to discontinue certain product offerings and focus only on key online priorities that aligned with its fiscal 2003 operational objectives. During fiscal 2002, EA recorded restructuring charges of $20.3 million, consisting of $4.2 million for workforce reductions, $3.3 million for consolidation of facilities and other administrative charges, and $12.8 million for the write-off of non-current assets and facilities. The estimated costs for workforce reduction included severance charges for terminated employees and costs for certain outplacement service contracts. The consolidation of facilities resulted in the closure of EA.com’s San Diego, California, studio and consolidation of its San Francisco, California, and Charlottesville, Virginia, facilities.

Impairment charges on long-lived assets amounted to $12.8 million, including $11.2 million relating to abandoned technologies consisting of customized internal-use software systems for the EA.com infrastructure, $1.0 million of Kesmai intangibles associated with discontinued products and services and $0.6 million of goodwill charges relating to EA.com’s San Diego studio closure.

The following table summarizes the activity in the accrued studio and online restructuring account for the three and six months ended September 30, 2003 (in thousands):

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EA expects the remaining accrued restructuring balance of $7.1 million to be fully utilized by December 31, 2006.

As of September 30, 2003, the estimated costs for consolidation of facilities included contractual rental commitments of $10.9 million under real estate leases for unutilized office space offset by $4.5 million of estimated future sub-lease income, costs to close or consolidate facilities, and costs to write off a portion of the assets from these facilities.

The restructuring accrual is included in other accrued expenses in Note 7 of the Notes to Condensed Consolidated Financial Statements.

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CONTINGENT LIABILITIES

Lease commitments

In July of 2003, EA entered into a lease agreement with Playa Vista-Water’s Edge LLC for a studio facility in Los Angeles, California, which commenced in October 2003 and expires in September 2013 with two five-year options to extend the lease term. Additionally, EA has options to purchase the property after five and ten years based on the fair market value of the property at the date of sale, a right of first offer to purchase the property upon terms offered by the landlord, and a right to share in the profits from a sale of the property. EA accounted for this arrangement as an operating lease in accordance with SFAS No. 13, “Accounting for Leases”, as amended. Existing campus facilities comprise a total of 243,000 square feet and provide space for research and development functions. The rental obligation under this agreement is $50.2 million over the initial ten-year term of the lease. EA will take possession of the property over a period of 18 months as the facilities become available for use. The above commitment is offset by sublease income of $5.8 million for the sublet to Playa Capital Company, LLC of 18,000 square feet of the Los Angeles facility, which commenced in October 2003 and expires September 2013 with options of early termination by Playa Capital Company, LLC after five years and by EA after four and five years.

Residual Value Guarantees

In February of 1995, EA entered into a build-to-suit lease with Keybank National Association on its headquarters facility in Redwood City, California, which was extended in July 2001 and expires in July 2006. EA accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. Existing campus facilities developed in phase one comprise a total of 350,000 square feet and provide space for sales, marketing, administration and research and development functions. EA has an option to purchase the property (land and facilities) for $145.0 million or, at the end of the lease, to arrange for (i) an additional extension of the lease or (ii) sale of the property to a third party while EA retains an obligation to the owner for the difference between the sale price and the guaranteed residual value of up to $128.9 million if the sales price is less than this amount, subject to certain provisions of the lease.

In December 2000, EA entered into a second build-to-suit lease with Keybank National Association for a five-year term from December 2000 to expand its headquarters facilities and develop adjacent property adding approximately 310,000 square feet to its campus. Construction was completed in June 2002. EA accounted for this arrangement as an operating lease in accordance with SFAS No. 13, as amended. The facilities will provide space for marketing, sales and research and development. EA has an option to purchase the property for $127.0 million or, at the end of

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the lease, to arrange for (i) an extension of the lease or (ii) sale of the property to a third party while EA retains an obligation to the owner for the difference between the sale price and the guaranteed residual value of up to $118.8 million if the sales price is less than this amount, subject to certain provisions of the lease.

EA believes the estimated fair value of both properties under these operating leases are in excess of their respective guaranteed residual values based in part on an independent third party appraisal.

See the Liquidity and Capital Resources section of Management’s Discussion and Analysis of Financial Condition and Results of Operations for a schedule of EA’s contractual obligations and commitments.

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SQUARE JOINT VENTURE

In May 1998, EA and Square, a leading developer and publisher of entertainment software in Japan, completed the formation of two new joint ventures in North America and Japan. In North America, the companies formed Square Electronic Arts, LLC (“Square EA”), which had exclusive publishing rights in North America for future interactive entertainment titles created by Square. Additionally, EA had the exclusive right to distribute in North America products published by this joint venture. EA contributed $3.0 million and owned a 30 percent minority interest in this joint venture while Square owned 70 percent. This joint venture was accounted for under the equity method. The joint venture agreements with Square expired as of March 31, 2003. EA’s distribution of Square products in North America terminated on June 30, 2003. On May 30, 2003 Square acquired EA’s remaining 30 percent ownership interest in the joint venture for $8.5 million and EA’s investment was removed from the Condensed Consolidated Balance Sheet.

In Japan, the companies established Electronic Arts Square K.K. (“EA Square KK”) in 1998, which localized and published in Japan EA’s properties originally created in North America and Europe, as well as developed and published original videogames in Japan. EA contributed cash and had a 70 percent majority ownership interest, while Square contributed cash and owned 30 percent. Accordingly, the assets, liabilities and results of operations for EA Square KK were included in EA’s Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Operations since June 1, 1998, the date of formation. Square’s 30 percent interest in EA Square KK has been reflected as “Minority interest in consolidated joint venture” on EA’s Condensed Consolidated Balance Sheet as of March 31, 2003, and Condensed Consolidated Statements of Operations for the three and six months ended September 30, 2002.

In May 2003, EA acquired Square’s 30 percent ownership interest in EA Square KK for approximately $2.5 million in cash. As a result of the acquisition, EA Square KK has become a wholly owned subsidiary of EA and has been renamed Electronic Arts K.K. The acquisition was accounted for as a step acquisition purchase and the excess purchase price over fair value of the net tangible assets acquired, $1.2 million, was allocated to goodwill.

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AMERICA ONLINE, INC. (“AOL”) AGREEMENT

In November 1999, Electronic Arts Inc., EA.com and AOL entered into a five-year $81.0 million carriage fee agreement (the “Prior Agreement”) which gave EA.com the exclusive right to provide online games and interactive entertainment content on the “Games” channels/areas of certain AOL online services and gain access to and sell its products to AOL subscribers and to users of AOL properties. This agreement provided for carriage fees, advertising commitments, advertising revenue sharing and other fees.

During the three months ended June 30, 2003, EA and AOL terminated the Prior Agreement and entered into a new two-year agreement (the “New Agreement”) under which EA will continue to provide its current online game content services, and launch new online game content and services, on the “Games” channels/areas of certain AOL online services in exchange for a programming fee from AOL.

Below is a discussion of the Prior Agreement and the changes in EA’s relationship with AOL that are reflected in the New Agreement.

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Carriage

The Prior Agreement provided for EA’s payment of a total of $81.0 million in carriage fees to AOL over the term of the Prior Agreement.

Of this amount, $36.0 million was paid upon signing the Prior Agreement with the remainder due in four equal annual installments of $11.25 million beginning with the first anniversary of the initial payment. EA made carriage payments to AOL of $11.25 million in each of the fiscal years 2003, 2002 and 2001. Due to the termination of the Prior Agreement in June 2003, EA is no longer required to make the last $11.25 million carriage payment. There was no carriage fee expense for the three and six months ended September 30, 2003. Carriage fee expense for the three and six months ended September 30, 2002 was $4.5 million and $8.9 million, respectively.

Carriage fee amounts paid under the Prior Agreement were capitalized as a prepaid asset as payments were made to AOL. Until April 1, 2003, the total carriage fee of $81.0 million that was provided for in the Prior Agreement was being expensed using the straight-line method over the remaining life of the Prior Agreement subsequent to EA.com’s site launch in October 2000. As the carriage fee was expensed, EA applied the portion that had been paid against the prepaid asset and recorded the remaining amount as a liability. Amortization expense was classified as “Marketing and sales” expense in EA’s Condensed Consolidated Statements of Operations. The prepaid asset and liability balances were classified as “Other assets” and “Accrued and other liabilities”, respectively, on EA’s Condensed Consolidated Balance Sheets.

Under the New Agreement, in July 2003, AOL refunded $18.0 million in carriage fees that EA had previously paid to AOL under the Prior Agreement. This refund was applied against the prepaid balance and the remaining asset, $6.4 million, is being amortized over the term of the New Agreement as a reduction to revenue.

Programming Fee

The New Agreement provides for payments by AOL to EA of $27.5 million over the two-year term of the New Agreement as a programming fee. $20.8 million of this $27.5 million pertains to existing online games content and services that EA currently provides on the “Games” channels/areas of the AOL properties, and is being recognized as revenue ratably over the term of the New Agreement. The remaining $6.7 million pertains to new online games content and services to be delivered during the term of the New Agreement. This portion of the programming fee will be recognized as revenue as the required new content and services are delivered. During the three and six months ended September 30, 2003, $2.4 million and $4.9 million have been recognized as programming fee revenue, respectively.

Advertising Commitment

Under the Prior Agreement, EA also made a commitment to spend $15.0 million in offline media advertisements prior to March 31, 2005 consisting of:

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$10.0 million on television, radio, print and outdoor advertising promoting the availability of EA.com games on certain AOL online services; and

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$5.0 million ($1.0 million per year over the five year agreement) on television, radio, print and outdoor advertising promoting the availability of a specific category of EA.com games (so-called “parlor games”) on certain AOL online services.

Under the Prior Agreement, EA was free to purchase this advertising from any television, radio, print or outdoor media property that it chose, not necessarily from any AOL-affiliated media property. EA did not purchase any advertisements from AOL, though it purchased some qualifying advertising from AOL affiliates. Through March 31, 2003, EA expensed the advertising as it was incurred. These costs were classified as “Marketing and sales” expense in EA’s Condensed Consolidated Statements of Operations. As of March 31, 2003, EA had spent approximately $4.3 million against this commitment.

Upon the termination of the Prior Agreement, this advertising commitment was extinguished, and there is no similar commitment provided for in the New Agreement.

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Advertising Revenue and Revenue Sharing

Advertising revenue is derived principally from the sale of banner and in-game advertisements. Banner and in-game advertising is typically generated from contracts in which either EA or AOL provides a minimum number of impressions over the term of the agreed-upon commitment. Revenue is recognized as the impressions are delivered, provided that no significant obligations remain and collection of the related receivable is probable. Under the Prior Agreement, advertising revenue generated on the AOL Games Channel was recorded net of the applicable revenue share owed to AOL.

The Prior Agreement required that AOL pay EA 50 percent of all revenue collected by AOL from the sale of advertisements on EA’s online games sites, until advertising revenue reached $16.0 million in a year (measured from October 1 through the following September 30). Thereafter, the Prior Agreement provided that AOL would pay EA 70 percent of all advertising revenue collected by AOL from the sale of advertisements on EA’s game sites. Under the New Agreement, AOL is entitled to retain all advertising revenue collected by AOL from the sale of advertisements on EA’s games sites on the AOL properties, until net advertising revenue reaches $20.0 million in the twelve months ended March 31, 2004, and until net advertising revenue reaches $35.0 million for the remainder of the term of the New Agreement. After advertising revenue exceeds these thresholds, AOL is required to pay EA 50 percent of the additional net advertising revenue.

Other Fee Arrangements

Under the Prior Agreement, EA was also required to pay AOL a percentage of its subscription, e-commerce and anchor tenancy revenue that exceeded certain amounts. These costs were expensed as incurred and were classified as “Cost of goods sold” in EA’s Condensed Consolidated Statement of Operations. EA does not net these costs against revenue because it maintains responsibility for providing e-commerce products and subscription services directly to the consumer and retains the primary inventory risk for its products and games service.

Under the New Agreement, EA is required to pay AOL a percentage of its revenue derived from game service subscriptions, e-commerce, downloadable games and prize games that EA makes available on the AOL online services. EA accounts for these amounts in a similar manner as described above.

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IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). This interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” addresses consolidation by business enterprises of variable interest entities (“VIEs”) that either: (i) do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (ii) are owned by equity investors who lack an essential characteristic of a controlling financial interest. This interpretation applies immediately to VIEs created after January 31, 2003. With regard to VIE’s already in existence prior to February 1, 2003, the implementation of FIN 46 has been delayed and currently applies to the first fiscal year or interim period beginning after December 15, 2003. FIN 46 requires disclosure of VIEs in financial statements issued after January 31, 2003, if it is reasonably possible that as of the transition date: (i) EA will be the primary beneficiary of an existing VIE that will require consolidation, or (ii) EA will hold a significant variable interest in, or have significant involvement with, an existing VIE. EA does not believe that it has any entities that will require disclosure or new consolidation as a result of adopting the provisions of FIN 46.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. We use words such as “anticipates”, “believes”, “expects”, “intends”, “future” and similar expressions to help identify forward-looking statements. These forward-looking statements are subject to business and economic risk and management’s expectations, and are inherently uncertain and difficult to predict. Our actual results could differ materially from management’s expectations due to such risks. We will not necessarily update information if any forward-looking statement later turns out to be inaccurate. Risks and uncertainties that may affect our future results include, but are not limited to, those discussed in this report below under the heading “Risk Factors”, as well as in our Annual Report on Form 10-K for the fiscal year ended March 31, 2003 as filed with the Securities and Exchange Commission (“SEC”) on June 10, 2003 and in other documents filed with the SEC.

CRITICAL ACCOUNTING POLICIES

Our Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these Condensed Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, contingent assets and liabilities, and revenue and expenses during the reporting period. The policies discussed below are considered by management to be critical because they are not only important to the portrayal of our financial condition and results of operations but also because application and interpretation of these policies requires both judgment and estimates on matters that are inherently uncertain and unknown. As a result, actual results may differ materially from our estimates.

Sales allowances and bad debt reserves

We principally derive revenue from sales of packaged interactive software games designed for play on videogame consoles (such as the PlayStation 2, Xbox and Nintendo GameCube), PCs and hand-held game machines (such as the Nintendo Game Boy Advance). Product revenue is recognized net of sales allowances. We also have stock-balancing programs for our PC products, which allow for the exchange of PC products by resellers under certain circumstances. We may decide to provide price protection for both our personal computer and videogame system products. In making this determination we evaluate: inventory remaining in the channel, the rate of inventory sell-through in the channel, and our remaining inventory on hand. It is our general practice to exchange products or give credits, rather than give cash refunds.

We estimate potential future product returns, price protection and stock-balancing programs related to current period product revenue. We analyze historical returns, current sell-through of distributor and retailer inventory of our products, current trends in the videogame market and the overall economy, changes in customer demand and acceptance of our products and other related factors when evaluating the adequacy of the sales returns and price protection allowances. In addition, management monitors and manages the volume of our sales to retailers and distributors and their inventories, as substantial overstocking in the distribution channel can result in high returns or substantial price protection requirements in subsequent periods. In the past, actual returns have not generally exceeded our reserves. However, actual returns and price protections may materially exceed our estimates as unsold products in the distribution channels are exposed to rapid changes in consumer preferences, market conditions or technological obsolescence due to new platforms, product updates or competing products. For example, the risk of product returns for our products may increase as the Xbox, Nintendo GameCube and PlayStation 2 consoles pass the midpoint of their lifecycle and an increasing number and aggregate amount of competitive products heighten pricing and competitive pressures. While management believes it can make reliable estimates regarding these matters, these estimates are inherently subjective. Accordingly, if our estimates changed, our returns reserves would change, which would impact the net revenue we report. For example, if actual returns were significantly greater than the reserves we have established, our actual results would decrease our reported net revenue. Conversely, if actual returns were significantly less than our reserves, this would increase our reported net revenue.

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Similarly, significant judgment is required to estimate our allowance for doubtful accounts in any accounting period. We determine our allowance for doubtful accounts by evaluating customer creditworthiness in the context of current economic trends. Depending upon the overall economic climate and the financial condition of our customers, the amount and timing of our bad debt expense could change significantly.

We cannot predict customer bankruptcies or an inability of any of our customers to meet their financial obligations to us. Therefore, our estimates could differ materially from actual results.

Prepaid royalties

Prepaid royalties consist primarily of advances paid to our co-publishing and/or distribution affiliates and license fees paid to celebrities, professional sports organizations and other organizations for our use of their trade names and content. Also included in prepaid royalties are prepayments made to independent software developers under development arrangements that have alternative future uses. Prepaid royalties are expensed at the contractual or effective royalty rate as cost of goods sold based on actual net product sales. We evaluate the future realization of prepaid royalties quarterly to determine amounts we deem unlikely to be realized through product sales. Any impairments determined before the launch of a product are charged to research and development expense. Impairments determined post launch are charged to cost of goods sold. In either case, we rely on forecasted revenue to evaluate the future realization of prepaid royalties. If actual revenue, or revised sales forecasts, falls below the initial forecasted sales, the charge taken may be larger than anticipated in any given quarter. If a charge has been taken prior to the product launch, that amount will not be expensed in future quarters when the product has shipped.

Valuation of long-lived assets

We evaluate both purchased intangible assets and other long-lived assets in order to determine if events or changes in circumstances indicate a potential impairment in value exists. This evaluation requires us to estimate, among other things, the remaining useful lives along with future estimates of cash flows of the business. All require the use of judgment and estimates. Our actual results could differ materially from our current estimates.

Under current accounting standards, we make judgments about the remaining useful lives of purchased intangible assets and other long-lived assets whenever events or changes in circumstances indicate a potential impairment in the remaining value of the assets recorded on our balance sheet. In order to determine if a potential impairment has occurred, management makes various assumptions about the future value of the asset, by evaluating future business prospects and estimated cash flows. Our future net cash flows are primarily dependent on the sale of products for play on proprietary videogame consoles, hand-held game machines and PC’s (“platforms”). The success of our products is affected by our ability to accurately predict which platforms and which products we develop will be successful. Also, our revenue and earnings are dependent on our ability to meet our product release schedules. Due to product sales shortfalls, we may not realize the future net cash flows necessary to recover our long-lived assets, which may result in an impairment charge being recorded in the future. During the six-month periods ended September 30, 2003 or September 30, 2002 no impairment charges were recorded on long-lived assets.

Income taxes

In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. As part of the process of preparing our Condensed Consolidated Financial Statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our current tax exposures in each jurisdiction including the impact, if any, of additional taxes resulting from tax examinations and making judgments regarding the recoverability of deferred tax assets. A valuation allowance is established to the extent recovery of deferred tax assets is not likely based on our estimation of future taxable income in each jurisdiction. Tax exposures can involve complex issues and may require an extended period to resolve. To determine the quarterly tax rate, we are required to estimate full-year income and the related income tax expense in each jurisdiction. The estimated effective tax rate is adjusted for the tax related to significant unusual items. Changes in the geographic mix or estimated level of annual pre-tax income can affect the overall effective tax rate.

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RESULTS OF OPERATIONS

Revenue

We principally derive revenue from sales of packaged interactive software games designed for play on videogame platforms. We also derive additional revenue from selling subscriptions to some of our online games, selling advertisements on our online web pages, selling our packaged goods through our online store, receiving programming fees for integrated online content and by allowing other companies to manufacture and sell our products in conjunction with other products.

Geographically, our net revenue for the three and six months ended September 30, 2003 and 2002 is presented below (in thousands):

Net Revenue

Net revenue for the three months ended September 30, 2003 increased by 17 percent as compared to the same period in the prior fiscal year. Foreign exchange rates (primarily the Euro and the Pound Sterling) strengthened reported net revenue by approximately $14.3 million or 3.0 percent in the current quarter. Strong sales of our PlayStation 2, Xbox and PC platform products were partially offset by a decline in net revenue from PlayStation products as we transition away from that platform. In addition, based on reported amounts, the net revenue increase was driven by the following:

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Tiger Woods PGA TOUR® 2004 and NHL® 2004 titles were released in the current quarter, while fiscal 2003’s Tiger Woods PGA TOUR and NHL titles were not released until our fiscal third quarter. This accounted for an aggregate increase of $50.5 million.

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Strong sales of other current-quarter sports-related titles including Madden NFL 2004, EA SPORT™ Rugby 2004 and NCAA® Football 2004, as well as strong sales of Soul Calibur II and Freedom Fighters® in Europe and Asia Pacific. These products accounted for an aggregate increase of $59.6 million.

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Partially offset by strong prior year sales of Kingdom Hearts, (from our Square EA joint venture, which was terminated in March 2003), Medal of Honor and The Sims franchise products for an aggregate decrease of $42.7 million.

Net revenue for the six months ended September 30, 2003 increased by 12 percent as compared to the same period in the prior fiscal year. Foreign exchange rates (primarily the Euro and the Pound Sterling) strengthened reported net revenue by approximately $35.5 million or 4.5 percent in the current period. Based on reported amounts, the net revenue increase was driven by the following:

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Strong sales of our PlayStation 2, Xbox and PC products for an aggregate increase of $103.4 million. The increase was driven primarily by NBA STREET Vol. 2, Def Jam VENDETTA, Tiger Woods PGA TOUR 2004, Madden NFL 2004 and The Sims franchise products. These increases were partially offset by strong net revenue in the six months ended September 30, 2002 for 2002 FIFA World Cup and the Medal of Honor franchise products.

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Net revenue from co-publishing and distribution products increased $20.8 million in the current period. This increase was due in large part to sales of Soul Calibur II, Aliens Natural Selection, Devil May Cry 2, the Battlefield 1942 TM franchise products and Final Fantasy Origins, partially offset by strong sales in the prior year of Kingdom Hearts (from our Square EA joint venture which was terminated in March 2003).

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Partially offset by a 64 percent decrease in PlayStation net revenue from $37.4 million in the six months ended September 30, 2002 to $13.3 million in the same period of the current fiscal year. The decrease has been expected as we transition away from this platform.

North America

For the three months ended September 30, 2003, net revenue from sales in North America increased by 14 percent as compared to the three months ended September 30, 2002. Based upon reported amounts, the net revenue increase was driven by the following:

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Strong sales of our Playstation 2 and Xbox products for an aggregate increase of $81.5 million. The increase was primarily due to strong EA Sports title net revenue on Madden, Tiger Woods PGA TOUR, NHL, and NCAA Football franchise products.

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PC net revenue increase of 15 percent to $53.6 million from $46.5 million in the three months ended September 30, 2002. The increase was due to strong sales of SimCityTM and Command & ConquerTM franchise products, partially offset by lower net revenue on The Sims franchise products.

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Partially offset by a 55 percent decrease in net revenue from co-publishing and distribution products to $20.2 million from $44.7 million in the same period of the prior fiscal year. The decrease was due in large part to strong sales in the three months ended September 30, 2002 of Kingdom Hearts (from our Square EA joint venture which was terminated in March 2003) and Buffy the Vampire Slayer, partially offset by the current fiscal year release of Aliens Natural Selection.

For the six months ended September 30, 2003, net revenue from sales in North America increased by 14 percent as compared to the six months ended September 30, 2002. The net revenue increase was driven by the following:

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Strong sales of our Playstation 2 and Xbox products for an aggregate increase of $93.2 million. NBA STREET vol. 2 and Def Jam VENDETTA releases plus additional strong sports title net revenue on Madden, Tiger Woods PGA TOUR, NHL and NCAA Football franchises were partially offset by a decrease in net revenue from Medal of Honor Frontline.

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PC net revenue increase of 11 percent to $90.5 million versus $81.3 million in the six months ended September 30, 2002. Strong sales of SimCityTM, Command & ConquerTM, Medal of Honor and Tiger Woods PGA TOUR franchise products were partially offset by lower net revenue on The Sims franchise products.

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Partially offset by an expected decrease in net revenue from products for Playstation of 68 percent or $17.3 million as we transition away from this platform.

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Also partially offset by a 26 percent decrease in net revenue from co-publishing and distribution products to $44.4 million versus $59.7 million in the six months ended September 30, 2002. The decrease was due in large part to net revenue in the six months ended September 30, 2002 for Kingdom Hearts and Buffy the

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Vampire Slayer, partially offset by net revenue in the same period of the current fiscal year of Battlefield 1942 franchise products and the current fiscal year release of Aliens Natural Selection.

International

Europe

For the three months ended September 30, 2003, net revenue from sales in Europe increased by 24 percent as compared to the three months ended September 30, 2002. Foreign exchange rates strengthened reported European net revenue by approximately $11.7 million or 10 percent. Based upon reported amounts, the net revenue increase was driven by the following:

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Co-publishing and distribution product sales increased by $20.4 million, or 48 percent, primarily due to net revenue from Soul Calibur II and Freedom Fighters, partially offset by decreases in the current fiscal year on Resident Evil and Buffy the Vampire Slayer.

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Playstation 2, Xbox and PC product sales increased by $11.8 million, or 31 percent, primarily due to the additional titles available on the Xbox console and strong current fiscal year net revenue on EA SPORTS Rugby 2004, Command & Conquer: Generals, and Tiger Woods PGA TOUR franchise products, as well as Lord of the Rings: The Two Towers, partially offset by strong sales in the same period of the prior fiscal year of Medal of Honor Frontline.

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This increase was also partially offset by a $4.6 million decrease for our PlayStation and Nintendo GameCube products primarily due to stronger sales in the three months ended September 30, 2002 from key titles, including F1 Challenge, SSX Tricky and our James Bond franchise products. The decrease in Playstation net revenue has been expected as we transition away from the Playstation platform.

For the six months ended September 30, 2003, net revenue from sales in Europe increased by 12 percent as compared to the six months ended September 30, 2002. Foreign exchange rates strengthened reported European net revenue by approximately $30.8 million or 13 percent. Based upon reported amounts, the increase was driven by the following:

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Co-publishing and distribution product sales which increased by $32.8 million, or 48 percent, primarily due to net revenue from Soul Calibur II, Freedom Fighters, Devil May Cry 2, Aliens Natural Selection and Anno franchise products, partially offset by decreases in the current fiscal year on Resident Evil, Onimusha Warlords and Buffy the Vampire Slayer.

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Xbox, PC and Game Boy Advance product sales, which increased by $12.9 million, or 17 percent, primarily due to additional titles available on the Xbox and Game Boy Advance consoles as well as strong current fiscal year net revenue on The Sims and Command & Conquer franchise products.

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This increase was partially offset by an $8.2 million decrease for PlayStation 2 and Nintendo GameCube products primarily due to stronger sales in the six months ended September 30, 2002 from key titles, including Medal of Honor Frontline and 2002 FIFA World Cup. Strong current fiscal year net revenue on The Sims, Def Jam VENDETTA and EA SPORTS Rugby 2004 partially offset these decreases.

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Playstation product sales decreased by $6.7 million primarily due to our transition away from this platform.

Asia Pacific

For the three months ended September 30, 2003, net revenue from sales in the Asia Pacific region, excluding Japan, increased by 28 percent to $17.6 million versus $13.8 million for the three months ended September 30, 2002. Foreign exchange rates strengthened reported Asia Pacific net revenue by approximately $2.4 million or 18 percent. Based upon reported amounts, the net revenue increase was driven by the following:

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PlayStation 2 product sales, which increased $2.2 million primarily due to stronger sales from key titles, including EA SPORTS Rugby 2004 and Tiger Woods PGA TOUR 2004.

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Co-publishing and distribution product sales, which increased by $1.6 million, or 39 percent. The increase was due primarily to net revenue from Soul Calibur II, Knights of the Old Republic, Aliens Natural Selection and Freedom Fighters, partially offset by decreases in the current fiscal year on Buffy the Vampire Slayer and Battlefield 1942.

For the six months ended September 30, 2003, net revenue from sales in the Asia Pacific region, excluding Japan, increased by 11 percent to $32.1 million versus $29.0 million for the six months ended September 30, 2002. Foreign exchange rates strengthened reported Asia Pacific net revenue by approximately $3.9 million or 14 percent. Based upon reported amounts, the net revenue increase was driven by the following:

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PlayStation 2 product sales, which increased $2.0 million primarily due to stronger sales from titles including EA SPORTS Rugby 2004, The Sims franchise products, Tiger Woods PGA TOUR 2004, NBA STREET Vol. 2, Madden NFL 2004, Def Jam VENDETTA and Lord of the Rings: The Two Towers, partially offset by strong net revenue in the same period of the prior fiscal year for Medal of Honor Frontline.

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Co-publishing and distribution product sales, which increased by $1.1 million, or 13 percent, primarily due to net revenue from Soul Calibur II.

Japan

For the three months ended September 30, 2003, net revenue from sales in Japan decreased by 3 percent to $9.2 million from $9.5 million. Foreign exchange rates strengthened reported net revenue in Japan by approximately $0.1 million or 1 percent. Based upon reported amounts, the net revenue decrease was driven by the following:

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Co-publishing and distribution product sales, which decreased by $1.4 million, or 26 percent, primarily due to strong prior year net revenue in the three months ended September 30, 2002 from Ever17, Tenkatouitsu 4 and Gundam Net Op, partially offset by the current fiscal year release of Memo Off Mix.

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Partially offset by PlayStation 2 and PC product sales, which increased $0.9 million primarily due to stronger sales from key products, including F1 Career Challenge, SimCity 4 and Def Jam VENDETTA.

For the six months ended September 30, 2003, net revenue from sales in Japan decreased by 18 percent to $21.3 million versus $26.1 million for the six months ended September 30, 2002. Foreign exchange rates strengthened reported net revenue in Japan by approximately $0.8 million or 3 percent. Based upon reported amounts, the net revenue decrease was driven by the following:

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PlayStation 2 product sales, which decreased $6.9 million, primarily due to reduced sales on FIFA franchise products, partially offset by The Sims, MVP Baseball and NBA STREET Vol. 2.

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Offset partially by co-publishing and distribution product sales, which increased by $2.2 million, or 31 percent, primarily due to net revenue from Max Payne and Memo Off Mix.

Revenue by Product Line

Our worldwide net revenue by product line for the three and six months ended September 30, 2003 and 2002 is summarized below (in thousands):

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