9

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

The following discussion and analysis should be read in conjunction with the Company's consolidated financial statements and notes thereto.

From time to time, the Company or its representatives have made or may make forward-looking statements, orally or in writing. Such forward-looking statements may be included in, without limitation, press releases, oral statements made with the approval of an authorized executive officer of the Company and filings with the Securities and Exchange Commission. The words or phrases "anticipates," "believes," "expects," "intends," "will continue," "estimates," "plans," "projects," or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995.

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The Company's forward-looking statements are subject to certain risks, trends, and uncertainties that could cause actual results to vary materially from anticipated results, including, without limitation, delays in new product releases, delays in acceptance of the Company's products in the marketplace, failures by the Company's outside vendors to perform as promised, changes in the software operating systems for which the Company's products are written, increased competition, and changes in general market conditions. These factors are discussed in further detail below under "Risks and Uncertainties." Should any one or more of these or other risks or uncertainties materialize, or should any underlying assumptions prove incorrect, actual results may vary materially from those discussed herein as expected, believed, estimated, intended or anticipated. The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements.

Timberline Software Corporation develops, manufactures and licenses accounting, cost estimating, and service management software primarily for the construction and real estate industries. We also provide related services to our users, including annual maintenance and support service plans, on-site consulting services, and training. Approximately, twenty-five thousand companies use one or more of our software products.

The Company's results of operations for the years ended December 31, 2001, 2000 and 1999 and the changes on a year over year comparison are set forth below:

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The following table presents the Company's operating statement data expressed as a percentage of net revenue for the years indicated:

Net Revenue. Net revenue in 2001 increased 12% over 2000 as we experienced growth in both of the two major components of net revenue - software license revenue and service fees. In 2000, net revenue declined 7% compared to 1999, as we experienced the first year-over-year decline in software license revenue since 1991.

Software license revenue in 2001 increased 7% over 2000. While we managed to grow our software revenue in 2001, we believe the tragic events of September 11^th and the uncertainty surrounding the recovery of the U.S. economy caused many prospective buyers to delay their purchasing decision, despite our increased marketing and sales efforts. During the first six months of 2001, software license revenue increased 18% over the first six months of 2000. During the last six months of 2001, software license revenue decreased 3% from the comparable period in 2000. Our growth in software license revenue in 2001 was mainly due to the introduction of new software products and our entry into new segments of the construction industry.

Our Accounting software license revenue, which comprised 69% of our total license revenue in 2001, increased 8%. This increase was primarily related to our concerted effort in targeting the specialty contractor segment of the construction industry. The introduction of service management applications in August 2000 combined with our introduction of purchase order and inventory applications at the end of 1999 enabled us to compete effectively in this area. The service management applications contributed in generating software orders totaling $2,455 in software license revenue in 2001, or 10% of total software license revenue in 2001. By comparison, service management applications contributed in generating software orders totaling $1,116 in software license revenue, or 5% of total software license revenue in 2000. In September 2001, we introduced an investment management application to assist real estate companies, owners and facility managers in their capital budgeting and cash flow forecasting needs. Becau se of its release in the latter part of the year, revenue from this product was not significant in 2001. Estimating software license revenue in 2001, which accounted for 31% of our total software license revenue, increased 4% over the previous year. This increase was primarily due to our efforts to target owners and facility managers of large companies with our Estimating products. In June 2001, we introduced a new digitizer product and our model estimating product. The modeling application contributed to our ability to effectively sell to owners and facility managers.

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Software license revenue in 2000 declined 22% compared to 1999. Accounting software license revenue declined 26%, while Estimating software license revenue declined 12%. We believe the decrease in Accounting software license revenue was primarily due to the decrease in the demand for software within the construction industry. Many companies in the few years prior to 2000 upgraded or replaced their existing software that was not year 2000 compliant, resulting in lower demand in 2000. Additionally, because of the uncertainty in the U.S. economy and signs of a slowdown in the construction industry during the latter part of 2000, we believe that many prospective buyers delayed their computer software purchasing decision. Partially offsetting the effect of the decline in the demand was additional revenue from new products introduced in 2000. These new products include the purchase order and inventory applications, which were introduced at the end of 1999, and service management applications, which were introdu ced in August 2000. The service management applications contributing in generating software orders totaling $1,116 in software license revenue in 2000, or 5% in total software license revenue in 2000. Estimating software license revenue declined in 2000 compared to 1999, primarily as a result of a large software order in 1999, which was the single largest software order in the Company's history. Excluding that order from 1999, Estimating software revenue in 2000 increased slightly over 1999.

We distribute our software products primarily in the United States through a blended sales channel involving third party resellers (which we refer to as solution providers) and a direct sales group. Our solution providers accounted for 71%, 77% and 80% of total software license revenue in 2001, 2000 and 1999, respectively, with the remaining percentage coming from our direct sales group. The increase in our software license revenue in 2001 was primarily from our direct sales group. International software license revenue accounted for 5%, 7% and 6% of total software license revenue in 2001, 2000 and 1999, respectively. We have no single customer that accounts for more than 10% of our net revenue.

Service fee revenue is comprised primarily of recurring fees from annual maintenance and support service plans and fees for consulting and training. We invoice our users for twelve-month service plans and recognize that revenue ratably over the service plan period. Because revenue from our service plans is generated from our entire customer base and not just from new users added during the year, the revenue from service plans does not necessarily fluctuate correspondingly with the increase or decrease in our yearly software license revenue. Revenue from our service plans amounted to $27,500, $23,166 and $18,776 in 2001, 2000 and 1999, respectively. This represents a 19% increase in 2001 over 2000 and a 23% increase in 2000 over 1999. Service plan revenue comprised 86% of our total service fee revenue in 2001 and 2000 and 78% of total service fee revenue in 1999. About one-half of the increase in service plan revenue in 2001 relates to an increase in the number of users on a service plan and the rem aining one-half is due to a price increase in our service plan offerings. The increase in service plan revenue in 2000 over 1999 is primarily due to the increase in users on a support plan as a result of the large increase in our user base during 1999. Consulting and training revenue increased 14% in 2001 compared to 2000 and declined 28% in 2000 from 1999. The level of consulting and training revenue is closely tied to our U.S. software license revenue. As a percentage of our U.S. software license revenue, consulting and training revenue remained fairly constant in 2001, 2000 and 1999.

Cost of Revenue. Cost of revenue consists primarily of software documentation, assembly and shipping costs, royalties paid to outside developers, amortization of capitalized software development costs and outside costs for training and consulting. Cost of revenue increased in both 2001 and 2000 over the preceding year. The increase in 2001 was primarily due to a $428 increase in royalties paid to outside developers on our software products and a $62 increase in consulting costs. Both software and consulting revenue increased in 2001 over 2000. The increase in cost of revenue in 2000 over 1999 was primarily due to a $467 increase in the amortization of capitalized software costs and a $564 increase in royalties. These increases were due to the release of new software products during the year. This increase was partially offset by a $371 decline in consulting costs and a $182 decrease in software costs due to a decline in both consulting and software license revenue in 2000 compared to 1999. As a pe rcentage of net revenue, cost of revenue in 2001 remained constant compared to 2000 at 10%. The cost of revenue percentage increased from 9% in 1999, primarily due to the increase in royalties and amortization of capitalized software development costs.

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In 2002, we believe cost of revenue will increase as a percentage of net revenue, primarily due to higher amortization of capitalized software development costs. We have been capitalizing (or deferring) software development costs related to new products. When those products are released for distribution, we amortize those costs as a cost of revenue. Although we expect to realize significant revenue with respect to the new products, cost of revenue should increase as a result of the amount of costs capitalized with respect to those new products. See our discussion below about product development expenses.

Operating Expenses. Operating expenses amounted to $49,675, $42,134 and $34,969 in 2001, 2000 and 1999, respectively. These expenses increased 18% in 2001 and 20% in 2000 over the preceding year. As a percentage of net revenue, operating expenses increased to 87% in 2001 from 82% in 2000 and 63% in 1999. In November 2001, as a result of the downturn in the U.S. economy and the uncertainty surrounding the timing of its recovery, we made a concerted effort to reduce our operating expenses. These actions included a small reduction in force and a 4% across-the board wage reduction, as well as our continuing efforts to review our expenses and operations to become more efficient. The reduction in force and wage reduction, net of severance and other related costs, resulted in a savings of $132 in the fourth quarter of 2001. For 2002, we expect savings of approximately $1,800 in operating expenses as a result of those actions. For 2001, we also did not make a matching employer contribution to our 401(k) plan . Based on the same percentage of contribution we had been providing in recent years, that amount would have been approximately $780 for 2001.

Client services expenses increased in both 2001 and 2000 over the previous years, primarily as a result of an increase in personnel costs in order to manage and service the increased volume of technical support calls from our user base as well as improve the quality of support services being provided. The call volume to our client services group increased 18% and 20% in 2001 and 2000, respectively, over the preceding year. The average number of employees in client services increased 14% to 198 in 2001 from 174 in 2000. In 2000, the average number of employees in this group increased 12% from 155 in 1999. The increase in personnel costs accounted for $1,671 of the increase in client services expenses in 2001 over 2000 and accounted for $1,347 of the increase in 2000 compared to 1999. As a percentage of service fee revenue, client services expenses decreased to 44% in 2001 from 46% in 2000. In 1999, that percentage was 43%.

Product development expenses represent costs for research and development on new software products as well as enhancements and ongoing updates to our existing software products, less the amount of development costs capitalized with respect to new products. In 2001 and 2000, product development expenses increased over the preceding year, primarily due to an increase in personnel and the additional use of outside contract developers to maintain and enhance our growing number of software products. Cost for personnel and outside contract developers, net of capitalized software development costs, increased $1,875 in 2001 over 2000 and increased $1,860 in 2000 compared to 1999. Additionally, in 2000, we incurred higher equipment, depreciation and travel costs amounting to $319, primarily due to increased personnel. In 2001, we spent $877 for outside consultants to assist us in re-engineering our product development process. In 2002, we will be implementing the new process and believe that we will realize op erating efficiencies that will enable us to deliver software enhancements to our customers in a more timely manner and shorten the development time required to bring new software applications to the marketplace. The amount to be expended in 2002 for outside consultants to conclude the re-engineering project should be substantially less than the amount spent in 2001.

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The amount of development costs to be capitalized in 2002 is expected to be significantly less than the amount capitalized in 2001 and 2000. We have been working on a number of new software products during the past two years and with the release of products in 2002 related to our project management strategy, we will have completed many of the new products we have been developing. Once those products are released, we will no longer capitalize costs on those products, but will expense those costs as incurred. Consequently, product development expenses will increase because the amount of costs capitalized will be less. Based on our current development plan, development costs to be capitalized in 2002 are expected to be around $2,000 to $2,500, compared to $4,990 in 2001 and $5,183 in 2000.

Sales and marketing expenses increased in 2001 and 2000 over the preceding year, both in dollar amounts and as a percentage of net revenue. In 2001, sales expenses increased $890 over the previous year. Most of this increase was attributed to an increase in personnel costs as a result of an increase in software revenue from our direct sales group. We added to our direct sales group to increase our ability to sell directly to prospective customers in certain areas within the U.S. and established a telesales group during 2001 to sell additional software applications to our user base. Software revenue from our direct sales and telesales groups increased $1,753, or 34% over the prior year. Marketing expenses in 2001 increased $988 over 2000, primarily due to an increase in our lead development efforts to generate more leads and referrals to our solution provider channel and our direct sales group. As a result, we incurred additional expenses for telemarketing personnel, outside telemarketing services, direct mail campaigns and trade show costs.

In 2000, sales expenses increased $413 over 1999. Of this increase, $224 was for personnel costs as we added personnel to boost our software license revenue in certain areas within the U.S. where we believed we had a greater opportunity to increase our current market share, and as we targeted additional segments within the construction industry to which to market our products and services - specialty contractors and owners, facility managers and design/build firms. The remainder of the increase was primarily due to the opening of a sales office in Sydney Australia during the first quarter of 2000 to increase our presence in the Asia Pacific region and to provide better support to our distribution channel in that region. Marketing expenses increased $897 in 2000 over 1999, primarily due to an aggressive marketing campaign into the two new segments mentioned above. We also spent additional funds in 2000 on a new marketing campaign and public relations to increase our presence in these new areas, as well as to gain more exposure to customers and prospects of our project management and e-commerce strategy.

General and administrative expenses increased in 2001 over 2000, but as a percentage of net revenue remained about the same. Personnel costs increased $570, depreciation expense increased $118 and outside service costs increased $143, all primarily in the internal information systems area as we expanded our capabilities in this area. Legal fees also increased $129 over the prior year due to an increase in new agreements and contracts.

General and administrative expenses in 2000 increased over 1999 in both absolute dollar amounts and as a percentage of net revenue. The increase was primarily due to an increase in personnel costs, depreciation and amortization, and outside service costs. Personnel costs increased $307, primarily due to the establishment of a human resources and legal affairs group to coordinate these functions within the Company. Depreciation and amortization increased $336 primarily due to additional capital expenditures in 2000 and 1999 to expand the capabilities and functionality of our telecommunication system and information system. The latter became operational in September 1999. Outside service costs for insurance and legal fees increased $229 due to higher insurance rates and increased use of legal counsel for new agreements and contracts.

Other Income. Other income is primarily composed of interest income on cash and cash equivalents and temporary investments. Other income decreased in 2001 compared to 2000 due to lower interest rates and a decrease in the amount of cash and temporary investments compared to the prior year. In 2000, other income increased over 1999 primarily due to an increase in the amount of average funds invested in 2000 over the previous year and higher interest rates in 2000.

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Provision for Income Taxes. The Company's effective tax rate was 25%, 33% and 37% in 2001, 2000 and 1999, respectively. The decrease in this rate in 2001 over the previous two years is primarily due to the decrease in the Company's pre-tax earnings and a greater effect of the research tax credit on its effective tax rate. For more information about the provision for income taxes, see Note 5 of Notes to Consolidated Financial Statements.

We generally meet our liquidity needs through cash generated from operations. Net cash provided by operations was $7,635 in 2001 compared to $8,809 and $17,852 in 2000 and 1999, respectively. The changes in the amount of cash generated from operations from year-to-year were primarily due to the level of profitability during those years.

The Company's financial position continues to be strong. We continue to have no long-term debt. Cash and cash equivalents and temporary investments amounted to $9,765 at December 31, 2001, representing 19% of the Company's total assets. These cash resources decreased $2,100 during 2001, primarily due to our investment in product development on new applications supporting our project management and e-commerce strategy, capital expenditures, cash dividends and share repurchases under the our stock repurchase plan. During 2001, we expended $4,990 for capitalized software development costs and $1,867 on cash dividends to our shareholders. We also spent $549 during the first quarter of 2001 to repurchase 146 shares. That concluded our stock repurchase plan, which we originally announced in March 2000.

Capital expenditures amounted to $2,520, $3,857 and $2,744 in 2001, 2000 and 1999, respectively. Normal capital expenditures are computers for new employees, periodic upgrades of existing computers for employees, and expansion of the Company's telecommunication system. In 2001, we purchased additional software to expand the capabilities of our internal information system, amounting to $505. In 2000, there were additional capital expenditures for work related to the design of the future development of the Company's corporate properties amounting to $509 and productivity software for our Client Services group amounting to $276. In 1999, there were expenditures amounting to $574 related to our new internal information system, which became operational in September 1999.

Accounts receivable - net at December 31, 2001 increased since the end of 2000, primarily due to an increase in software and service plans billings during the month of December 2001 compared to the previous December. DSO's (Days Sales Outstanding) in accounts receivable increased to 38 days from 34 days at December 31, 2000.

Other receivables decreased $906 during 2001, primarily due to the receipt of income tax refunds during the year.

The amount of unamortized capitalized software costs at December 31, 2001 increased $3,893 during 2001, primarily due to the amount of development costs capitalized in 2001, as mentioned above. This balance should decrease over the next several years as the amount amortized to cost of revenue should exceed the amount of capitalized software development costs added during this period.

Accounts payable at the end of 2001 decreased $431 since the end of 2000, primarily due to a decrease in amounts owed at the end of the year for outside contract developers. Accrued employee expenses decreased $508 during 2001, primarily due to no employer-matching contribution to the 401(k) plan.

Deferred revenues, which consist primarily of billings related to our annual maintenance and support service plans, increased $1,439 during 2001 to $16,854 at December 31, 2001. This increase was primarily due to the year-over-year increase in service plan billings in 2001 compared to 2000. Because billings for these plans generally cover a twelve-month period, practically all of the deferred revenues at the end of 2001 will be recognized as revenue in 2002.

Deferred income taxes increased $752 during 2001 primarily as a result of a $1,695 increase in the deferred income tax liability related to capitalized software development costs. This was partially offset by research tax credit carryforwards amounting to $813. For further analysis of our deferred income tax liability, see Note 5 of Notes to Consolidated Financial Statements.

We believe that our current cash balances and temporary investments, along with future cash generated from operations will be sufficient to meet our short-term operating needs. Given the nature of our business, and the rapid technological changes in the computer industry, we could experience fluctuations in cash generated from operations. As we currently have no long-term debt, should events occur that limit our ability to generate cash from operations or require funds in excess of what we have available, we may borrow money against our real properties or seek additional debt or equity financing.

We plan to continue to invest significant resources toward product development, which may include internal software development, acquiring new technology or new products that will complement our existing product lines, and other strategic opportunities that arise. Other future cash needs will, or may, include additional investments for equipment for personnel, upgrading and expanding telecommunication and internal information systems, additional expenditures for expansion of the corporate offices, and the payment of cash dividends. We currently pay regular quarterly cash dividends and plan to continue to pay such dividends, consistent with our capital needs, income levels and long-term dividend policy. Total cash dividends paid in 2001 amounted to $1,867 or $.16 per share, compared to $2,015 or $.16 per share in 2000 and $1,675 or $.13 per share in 1999.

In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminates the pooling of interests method of accounting for business combinations and is effective for such transactions initiated after June 30, 2001. SFAS No. 142 changes the accounting for goodwill and intangible assets with indefinite useful lives. Under previous accounting standards, goodwill and intangible assets with indefinite useful lives were assumed to have finite lives and were amortized over a period of time. Under the new standard, these assets are presumed to have indefinite lives, but will be tested annually and adjusted whenever events or circumstances indicate that they have been impaired. SFAS No. 142 is effective for the Company commencing in 2002. The Company believes the adoption of that new pronouncement will not have a material impact on the Company's fina ncial position or results of operations.

Also in June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 addresses financial accounting and reporting obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It is required to be adopted by the Company on January 1, 2003. The Company does not currently have any retirement obligations with respect to its long-lived assets.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This pronouncement supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," and certain aspects of Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." SFAS No. 144 retained the method for recording an impairment of long-lived assets established in SFAS No. 121 and provided further implementation guidance on this matter. SFAS No. 144 is effective for the Company commencing in 2002. The Company believes the adoption of this new pronouncement will not have a material impact on the Company's financial position or results of operations.

This discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of our financial statements requires us to select appropriate accounting policies and to continually evaluate such policies to ensure they remain appropriate based on changing conditions and circumstances. Our significant accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. We believe our significant accounting policies are reasonable and appropriate. The preparation of our financial statements also requires us to make estimates and assumptions that affect the reported amounts of our assets, liabilities, revenue, cost and expenses and disclosures related to contingencies. We believe our estimates and assumptions, which are based on historical experience, current conditions and other matters of judgment, a re reasonable and appropriate. However, actual results may differ from our estimates.

We believe the following are the critical accounting policies used in the preparation of our financial statements.

Revenue recognition. We recognize software license revenue and service plan revenue in accordance with the provisions of Statement of Position 97-2, "Software Revenue Recognition," issued by the American Institute of Certified Public Accountants. Software license revenue is generally recognized upon shipment, provided that we have a signed license agreement, the license fee is determinable, collection is probable, and we have no significant future obligations to the customer related to the software. Service plans for maintenance and support of the software generally cover a one-year period and are billed in advance. Billings for service plans are included in deferred revenue and the revenue from these billings is recognized ratably over the service plan period.

Capitalized software costs. At December 31, 2001, unamortized capitalized software costs amounted to $10,720, representing 21% of our total assets. We capitalize software development costs on new software products when technological feasibility has been established and amortize those costs as cost of revenue when the products are released. Judgment is involved in determining when technological feasibility has occurred and in determining whether our estimate of the net realizable value associated with each software product exceeds its unamortized costs. The net realizable value is primarily based on our estimate of future revenue to be generated from each product. Estimating the amount of future revenue involves the consideration of many subjective factors and making judgment as to the effect those factors will have on future revenue. Such factors include the degree to which the product is accepted in the market and technological changes that may shorten the useful life of the product or render it obs olete. At December 31, 2001, we believe the net realizable value associated with each product exceeds its unamortized cost. However, should we experience changes in the marketplace and new technological advances that adversely affects our products, a write-down of unamortized software development costs may be required.

Income taxes. Our provision for income taxes includes the benefit to be realized from research tax credits, including the benefit of research tax credit carryforwards for the year ended December 31, 2001. While we believe the amount of the research tax credit is proper, the credit is subject to challenge by the taxing authorities. If the credit we have recognized is more than what the taxing authorities allow, additional income tax expense may be recognized in subsequent years. We also believe the tax credit carryforward benefit will be realized in subsequent years; however, the extent to which the benefit will be realized will depend on the level of our future profitability and our ability to use such credits prior to their expiration. If we are not able to realize the full benefit of the tax credit, additional income tax expense may be required in subsequent years.

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From time to time, the Company may make forward-looking statements as such term is defined in the Federal securities laws. The following risks and uncertainties, among others, should be considered in evaluating the Company's forward-looking statements. Factors that may cause actual results to differ materially from those contained in such forward-looking statements include the following:

Competition. The computer software market is highly competitive and subject to change because of the rapid technological changes in the computer industry. The number of software vendors with which the Company competes varies from product to product and from region to region within the United States. Although the Company believes it is a major supplier of accounting and cost estimating software for the construction and real estate industries, and that there are economical and technological barriers to discourage new specialty software vendors from entering into its segment of the software market, there can be no assurance that larger, well-known software developers will not target this segment of the market. Such competitors are considerably larger, more diversified, and have greater financial and other resources and enjoy greater brand recognition for their products than the Company. The Company must also compete with other larger, well-known software developers for the hiring and retention of highly qualified technical personnel. As a result, the Company may have to expend additional financial resources to hire and retain qualified technical personnel. If the Company is not able to secure the services of employees with the level of technical expertise it requires, the development of new products would likely be delayed and would result in a decrease in the quality of new software products and enhancements to its existing software products. A delay in the development, or failure to maintain the quality of new software products by the Company would likely have a material adverse effect on the financial position, results of operations and cash flows of the Company.

Dependence on Microsoft Operating System; Obsolescence and Technological Changes. The Company is a specialty software developer, an industry characterized by rapid technological change. Its software is designed to work with specific operating systems developed by Microsoft Corporation. If substantial changes are made to those operating systems or if new operating systems are adopted, the Company's software may not function properly, necessitating that the Company invest additional resources to adapt its software to those changes. Also, other operating systems may be introduced on which the Company's software may not function, which may also cause additional resources to be expended which would otherwise be devoted to improving the Company's software or developing new software.

To remain competitive, the Company must continue to make substantial expenditures for product development. Although the Company plans to continue to enhance its existing products and to develop new products, the Company's competitors may develop products with superior capabilities and/or market their products more effectively at lower prices, by "bundling" their software with other software or through other methods. The Company believes its existing software products are widely accepted in its segment of the marketplace. However, a delay in the release of new products or modifications to existing products, or a delay in the acceptance by the marketplace of any new products or modifications to existing products, could similarly delay the recognition of revenue, or have an adverse effect on the Company's revenue and earnings.

Substantial Dependence on Single Industry. Because the Company sells a large majority of its software products and services to the construction industry, adverse economic conditions in that industry could have a material adverse effect on the Company's revenue and earnings. The construction industry is particularly sensitive to a significant increase in interest rates, which in the past has resulted in substantial financial distress across the industry. In addition, a downturn in general economic conditions in the United States could adversely affect the construction industry.

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Product Protection. The Company regards its software as proprietary and attempts to protect it by relying upon copyrights, trade secrets, internal nondisclosure agreements and transferability restrictions incorporated into its software license agreements. The Company believes the risk of unauthorized transfers of the Company's proprietary information is reduced because program source listings are not released to third parties. Despite these restrictions, it may be possible for competitors or users to copy aspects of the Company's products or to obtain information which the Company regards as proprietary. The Company's competitive position could be adversely affected by unauthorized use of its proprietary information. Third parties may also assert infringement or other claims against the Company with respect to any existing or future products. Litigation to protect the Company's proprietary information or to determine the validity of any third-party claims could result in significant expense to the Co mpany and, whether or not such litigation is determined in favor of the Company, divert the efforts of the Company's technical and management personnel from further development and support of the Company's software products.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risks for changes in interest rates is primarily related to our cash and temporary cash investments balances. We do not have any derivative instruments. We mitigate some of the risk related to changes in interest rates by investing in high-quality debt instruments in accordance with our investment policy. We believe that our exposure to changes in interest rates is not material to our operating results or cash flows.

We have a subsidiary company in Australia, which exposes us to foreign currency fluctuations. However, due to the size of its operations, we believe the market risks related to foreign currency fluctuations are not material to our operating results or cash flows.

Item 8. Financial Statements and Supplementary Data

The financial statements required pursuant to this item are included in Item 14 of this Annual Report on Form 10-K.

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

None.

PART III

Item 10. Directors and Executive Officers of the Registrant

The information called for by this item is included under the caption, "Agenda Item 1. Election of Directors," contained in our definitive proxy statement for the annual meeting of shareholders to be held on April 30, 2002, and is hereby incorporated by reference.

Item 11. Executive Compensation

The information called for by this item is included under the caption, "Executive Compensation" within "Agenda Item 1. Election of Directors" contained in our definitive proxy statement for the annual meeting of shareholders to be held on April 30, 2002, and is hereby incorporated by reference.

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Item 12. Security Ownership of Certain Beneficial Owners and Management

The information called for by this item is included under the caption, "Stock Ownership of Certain Beneficial Owners and Management" contained in our definitive proxy statement for the annual meeting of shareholders to be held on April 30, 2002, and is hereby incorporated by reference.

Item 13. Certain Relationships and Related Transactions

None.

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PART IV

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

a(1). Financial Statements

The following consolidated financial statements of Timberline Software Corporation are filed as part of this report:

Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth in the schedules is included in the consolidated financial statements or related notes.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

TIMBERLINE SOFTWARE CORPORATION

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

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TIMBERLINE SOFTWARE CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands except per share amounts)

See notes to consolidated financial statements.

F-1

TIMBERLINE SOFTWARE CORPORATION

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands)

See notes to consolidated financial statements.

F-2

TIMBERLINE SOFTWARE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

See notes to consolidated financial statements.

F-3

TIMBERLINE SOFTWARE CORPORATION

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

(Amounts in thousands except per share amounts)

See notes to consolidated financial statements.

F-4

TIMBERLINE SOFTWARE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands except per share amounts and percentages)

Note 1 Summary of significant accounting policies and line of business

Line of business and credit risks: The Company develops and markets computer software programs primarily for the construction and real estate industries. The Company sells its products and services primarily to customers and to authorized resellers (Timberline Solution Providers) throughout the United States. Credit is granted to certain customers and Timberline Solution Providers generally without collateral. An allowance for doubtful accounts is provided based on historical experience and anticipated losses.

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

Consolidated financial statements: The accompanying financial statements include the accounts of the Company as well as its wholly-owned subsidiary, which was opened in Australia during March 2000. The functional currency of the subsidiary is Australian dollars. Gains and losses resulting from foreign currency translation are recorded as other comprehensive income and accumulated as a separate component of shareholders' equity. All significant intercompany balances and transactions are eliminated in consolidation.

Financial instruments: The carrying amount reported in the balance sheet for cash and cash equivalents, temporary investments, accounts receivable, accounts payable and other current assets and liabilities approximates fair value because of the immediate or short-term maturity of these financial instruments.

Revenue recognition: Revenue from the "license to use" computer software programs is generally recognized at the point of shipment. Revenue from service fees is generated from the sale of computer software maintenance and technical support plans, training classes, consulting and other client services. Revenue from maintenance and technical support plans is recognized ratably over the period the service is provided. Revenue from other service fees is recognized at the time the service is provided.

Software development costs: Costs of developing computer software are capitalized when technological feasibility has been established for the computer software product. These costs are amortized over a two- to four-year period. Costs capitalized for the development of computer software were $4,990 in 2001, $5,183 in 2000 and $2,015 in 1999. Amortization of capitalized computer software development costs was $1,097 in 2001, $1,071 in 2000 and $604 in 1999. Expenses incurred, but not capitalized, on research and development of computer software products were $14,290 in 2001, $11,522 in 2000 and $9,325 in 1999. At December 31, 2001, management believes these costs are fully realizable.

Cash and cash equivalents: Cash and cash equivalents include cash on hand, cash deposited with banks and financial institutions, money market funds and highly liquid debt instruments purchased with maturity dates of three months or less at the date of acquisition.

F-5

TIMBERLINE SOFTWARE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands except per share amounts and percentages)

Temporary investments: Temporary investments represent debt securities which have maturity dates over three months from the purchase date. The Company has classified these investments as "available for sale" because the Company may decide not to hold these investments to maturity. Accordingly, the investments have been recorded at fair value. The unrealized gain or loss on these investments, net of income taxes, is reported as accumulated other comprehensive income within the shareholders' equity section of the balance sheet.

Inventories: Inventories consist of marketing literature and of software components. Inventories are stated at the lower of average cost or market.

Property and equipment: Property and equipment are recorded at cost. Depreciation on furniture and equipment is provided using the straight-line method over the estimated useful lives of the related assets ranging from two to ten years. The building is being depreciated on a straight-line basis over forty years. The Company periodically reviews its property and equipment whenever new events or changes in circumstances indicate there may be an impairment of its property and equipment. The Company does not believe there has been any impairment of the carrying amount of its property and equipment.

Accrued rent expense: Rent expense on operating leases with scheduled rent increases is recognized on a straight-line basis over the lease term. Accrued rent expense represents the excess of rent charged to expense over the amount of scheduled rent paid.

Income taxes: Deferred tax assets and liabilities are established based on the temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. These assets and liabilities are recorded at the enacted tax rates expected to be in effect when they are realized or settled.

Stock options: The Company applies the intrinsic value-based method described in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related accounting interpretations in accounting for stock options granted to its employees, officers and non-employee directors.

Earnings per share (EPS): The Company computes basic EPS by dividing net income by the weighted-average number of common shares outstanding and diluted EPS by dividing net income by the sum of the weighted-average number of common shares outstanding and the dilutive effect of stock options outstanding as if such options were exercised or converted into common shares.

F-6

TIMBERLINE SOFTWARE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands except per share amounts and percentages)

A reconciliation of the common shares used in the denominator for computing basic and diluted EPS for the years ended December 31, 2001, 2000 and 1999 is as follows:

Reclassifications: Certain reclassifications have been made in the 2000 and 1999 financial statements to conform to the 2001 presentation.

Recent accounting pronouncements: In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 eliminates the pooling of interests method of accounting for business combinations and is effective for such transactions initiated after June 30, 2001. SFAS No. 142 changes the accounting for goodwill and other intangible assets with indefinite useful lives. Under previous accounting standards, goodwill and other intangible assets with indefinite useful lives were assumed to have finite lives and were amortized over a period of time. Under the new standard, these assets are presumed to have indefinite lives, but will be tested annually and adjusted whenever events or circumstances indicate that goodwill and other intangible assets have been impaired. SFAS No. 142 is effective for the Company commencing in 2002. The Company believes the adoption of that new pronouncement will not have a material impact on the Company's financial position or results of operations.

Also in June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." SFAS No. 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It is required to be adopted by the Company on January 1, 2003. The Company does not currently have any retirement obligations with respect to its long-lived assets.

In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." This pronouncement supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," and certain aspects of Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." SFAS No. 144 retained the method for recording an impairment of long-lived assets established in SFAS No. 121 and provided further implementation guidance on this matter. SFAS No. 144 is effective for the Company commencing in 2002. The Company believes the adoption of that new pronouncement will not have a material impact on the Company's financial position or results of operations.

F-7

TIMBERLINE SOFTWARE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands except per share amounts and percentages)

Note 2 Investments

Investments at December 31, 2001 and 2000 are composed of the following: